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chapter 11 Diversification and Risky Asset Allocation “It is the part of a wise man not to venture all his eggs in one basket.” –Miguel de Cervantes Learning Objectives Intuitively, we all know that diversification is important for managing investment To get the most out of this chapter, diversify your study time across: efficiently diversified portfolio? Insightful answers can be gleaned from the modern How to calculate expected returns and variances for a security How to calculate expected returns and variances for a portfolio The importance of portfolio diversification The efficient frontier and the importance of asset allocation risk But how exactly does diversification work, and how can we be sure we have an theory of diversification and asset allocation In this chapter, we examine the role of diversification and asset allocation in investing Most of us have a strong sense that diversification is important After all, Don Cervantes’s advice against “putting all your eggs in one basket” has become a bit of folk wisdom that seems to have stood the test of time quite well Even so, the importance of diversification has not always been well understood Diversification is important because portfolios with many investments usually produce a more consistent and stable total return than portfolios with just one investment When you own many stocks, even if some of them decline in price, others are likely to increase in price (or stay at the same price) CFA™ Exam Topics in This Chapter: Discounted cash flow applications (L1, S2) Statistical concepts and market returns (L1, S2) Probability concepts (L1, S2) Portfolio management: An overview (L1, S12) Portfolio risk and return—Part I (L1, S12) Basics of portfolio planning and construction (L1, S12) Portfolio concepts (L2, S18) Asset allocation (L3, S8) Go to www.mhhe.com/jmd7e for a guide that aligns your textbook with CFA readings PART You might be thinking that a portfolio with only one investment could very well if you pick the right solitary investment Indeed, had you decided to hold only Dell stock during the 1990s or shares of Medifast (MED) or Apple (AAPL) in the 2000s, your portfolio would have been very profitable However, which single investment you make today that will be very profitable in the future? That’s the problem If you pick the wrong one, you could get wiped out Knowing which investment will perform the best in the future is impossible Obviously, if we knew, then there would be no risk Therefore, investment risk plays an important role in portfolio diversification The role and impact of diversification on portfolio risk and return were first formally explained in the early 1950s by financial pioneer Harry Markowitz These aspects of portfolio diversification were an important discovery—Professor Markowitz shared the 1986 Nobel Prize in Economics for his insights on the value of diversification Surprisingly, Professor Markowitz’s insights are not related to how investors care about risk or return In fact, we can talk about the benefits of diversification without having to know how investors feel about risk Realistically, however, it is investors who care about the benefits of diversification Therefore, to help you understand Professor Markowitz’s insights, we make two assumptions First, we assume that investors prefer more return to less return, and second, we assume that investors prefer less risk to more risk In this chapter, variance and standard deviation are measures of risk 11.1 Expected Returns and Variances In Chapter 1, we discussed how to calculate average returns and variances using historical data We begin this chapter with a discussion of how to analyze returns and variances when the information we have concerns future returns and their probabilities We start here because the notion of diversification involves future returns and variances of future returns EX P E C T E D R E T UR N S www See how traders attempt to profit from expected returns at www.earningswhispers.com expected return Average return on a risky asset expected in the future We start with a straightforward case Consider a period of time such as a year We have two stocks, say, Starcents and Jpod Starcents is expected to have a return of 25 percent in the coming year; Jpod is expected to have a return of 20 percent during the same period In a situation such as this, if all investors agreed on these expected return values, why would anyone want to hold Jpod? After all, why invest in one stock when the expectation is that another will better? Clearly, the answer must depend on the different risks of the two investments The return on Starcents, although expected to be 25 percent, could turn out to be significantly higher or lower Similarly, Jpod’s realized return could be significantly higher or lower than expected For example, suppose the economy booms In this case, we think Starcents will have a 70 percent return But if the economy tanks and enters a recession, we think the return will be 220 percent In this case, we say that there are two states of the economy, which means that there are two possible outcomes This scenario is oversimplified, of course, but it allows us to illustrate some key ideas without a lot of computational complexity Suppose we think boom and recession are equally likely to happen, that is, a 50–50 chance of each outcome Table 11.1 illustrates the basic information we have described and some additional information about Jpod Notice that Jpod earns 30 percent if there is a recession and 10 percent if there is a boom Obviously, if you buy one of these stocks, say, Jpod, what you earn in any particular year depends on what the economy does during that year Suppose these probabilities stay the same through time If you hold Jpod for a number of years, you’ll earn 30 percent about half the time and 10 percent the other half In this case, we say your expected return on Jpod, E(RJ), is 20 percent: E(RJ) 50 30% 50 10% 20% Chapter 11 Diversification and Risky Asset Allocation 373 TABLE 11.1 States of the Economy and Stock Returns State of Economy Security Returns If State Occurs Probability of State of Economy Starcents Jpod 30% Recession 50 220% Boom 50 70 10 1.00 TABLE 11.2 Calculating Expected Returns Starcents (1) State of Economy Jpod (2) Probability of State of Economy (3) Return If State Occurs (4) Product (2) (3) Recession 50 220% 210% Boom 50 70 35 1.00 (5) Return If State Occurs (6) Product (2) (5) 30% 15% 10 05 E(RS ) 25% E(RJ ) 20% In other words, you should expect to earn 20 percent from this stock, on average For Starcents, the probabilities are the same, but the possible returns are different Here we lose 20 percent half the time, and we gain 70 percent the other half The expected return on Starcents, E(RS ), is thus 25 percent: E(RS ) 50 220% 50 70% 25% Table 11.2 illustrates these calculations In Chapter 1, we defined a risk premium as the difference between the returns on a risky investment and a risk-free investment, and we calculated the historical risk premiums on some different investments Using our projected returns, we can calculate the projected or expected risk premium as the difference between the expected return on a risky investment and the certain return on a risk-free investment For example, suppose risk-free investments are currently offering an percent return We will say that the risk-free rate, which we label Rf , is percent Given this, what is the projected risk premium on Jpod? On Starcents? Because the expected return on Jpod, E(RJ), is 20 percent, the projected risk premium is: Risk premium Expected return Risk-free rate (11.1) E(RJ) Rf 20% 8% 12% Similarly, the risk premium on Starcents is 25% 8% 17% In general, the expected return on a security or other asset is simply equal to the sum of the possible returns multiplied by their probabilities So, if we have 100 possible returns, we would multiply each one by its probability and then add up the results The sum would be the expected return The risk premium would then be the difference between this expected return and the risk-free rate EXAMPLE 11.1 Unequal Probabilities Look again at Tables 11.1 and 11.2 Suppose you thought a boom would occur 20 percent of the time instead of 50 percent What are the expected returns on Starcents and Jpod in this case? If the risk-free rate is 10 percent, what are the risk premiums? The first thing to notice is that a recession must occur 80 percent of the time (1 2 .20 80) because there are only two possibilities With this in mind, Jpod has a 30 percent return in 80 percent of the years and a 10 percent return in 20 percent of (continued ) 374 Part Portfolio Management the years To calculate the expected return, we just multiply the possibilities by the probabilities and add up the results: E(RJ ) 80 30% 20 10% 26% If the returns are written as decimals: E(RJ ) 80 30 20 10 26 Table 11.3 summarizes the calculations for both stocks Notice that the expected return on Starcents is 22 percent The risk premium for Jpod is 26% 10% 16% in this case The risk premium for Starcents is negative: 22% 10% 212% This is a little unusual, but, as we will see, it’s not impossible TABLE 11.3 Calculating Expected Returns Starcents (1) State of Economy Jpod (2) Probability of State of Economy (3) Return If State Occurs (4) Product (2) (3) Recession 80 220% 216% Boom 20 70 14 1.00 (5) Return If State Occurs 30% (6) Product (2) (5) 24% 10 E(RS ) 22% E(RJ ) 26% C AL C UL AT I N G T HE VA R I A N C E O F E XP E C T E D R E T U R N S www There’s more on risk measures at www.investopedia.com and www.teachmefinance.com To calculate the variances of the expected returns on our two stocks, we first determine the squared deviations from the expected return We then multiply each possible squared deviation by its probability Next we add these up, and the result is the variance To illustrate, one of our stocks in Table 11.2, Jpod, has an expected return of 20 percent In a given year, the return will actually be either 30 percent or 10 percent The possible deviations are thus 30% 20% 10% or 10% 20% 210% In this case, the variance is: Variance 50 (10%)2 50 (210%)2 50 (.10)2 50 (2.10)2 01 Notice that we used decimals to calculate the variance The standard deviation is the square root of the variance: _ Standard deviation Ï.01 10 10% Table 11.4 contains the expected return and variance for both stocks Notice that Starcents has a much larger variance Starcents has the higher expected return, but Jpod has less risk You could get a 70 percent return on your investment in Starcents, but you could also lose 20 percent However, an investment in Jpod will always pay at least 10 percent Which of these stocks should you buy? We can’t really say; it depends on your personal preferences regarding risk and return We can be reasonably sure, however, that some investors would prefer one and some would prefer the other You’ve probably noticed that the way we calculated expected returns and variances of expected returns here is somewhat different from the way we calculated returns and variances in Chapter (and, probably, different from the way you learned it in your statistics course) TABLE 11.4 Expected Returns and Variances Expected return, E(R ) Variance of expected return, Standard deviation of expected return, Chapter 11 Starcents Jpod 25, or 25% 20, or 20% 2025 0100 45, or 45% 10, or 10% Diversification and Risky Asset Allocation 375 The reason is that we were examining historical returns in Chapter 1, so we estimated the average return and the variance based on some actual events Here, we have projected future returns and their associated probabilities Therefore, we must calculate expected returns and variances of expected returns EXAMPLE 11.2 More Unequal Probabilities Going back to Table 11.3 in Example 11.1, what are the variances on our two stocks once we have unequal probabilities? What are the standard deviations? Converting all returns to decimals, we can summarize the needed calculations as follows: (2) Probability of State of Economy (3) Return Deviation from Expected Return (4) Squared Return Deviation Recession 80 2.20 (2.02) 2.18 0324 Boom 20 70 (2.02) 72 5184 (1) State of Economy (5) Product (2) (4) Starcents 02592 10368 S2 12960 Jpod Recession 80 30 26 04 0016 Boom 20 10 26 2.16 0256 00128 00512 2J 00640 Based on these calculations, the standard deviation for Starcents is S Ï.1296 36% The standard deviation for Jpod is much smaller, J Ï.0064 , or 8% CHECK THIS 11.1a How we calculate the expected return on a security? 11.1b In words, how we calculate the variance of an expected return? 11.2 Portfolios portfolio Group of assets such as stocks and bonds held by an investor Thus far in this chapter, we have concentrated on individual assets considered separately However, most investors actually hold a portfolio of assets All we mean by this is that investors tend to own more than just a single stock, bond, or other asset Given that this is so, portfolio return and portfolio risk are of obvious relevance Accordingly, we now discuss portfolio expected returns and variances PO RT F O L IO W E I G HT S portfolio weight Percentage of a portfolio’s total value invested in a particular asset There are many equivalent ways of describing a portfolio The most convenient approach is to list the percentages of the total portfolio’s value that are invested in each portfolio asset We call these percentages the portfolio weights For example, if we have $50 in one asset and $150 in another, then our total portfolio is worth $200 The percentage of our portfolio in the first asset is $50/$200 25, or 25% The percentage of our portfolio in the second asset is $150/$200 75, or 75% Notice that the weights sum up to 1.00 (100%) because all of our money is invested somewhere.1 376 Part Some of it could be in cash, of course, but we would then just consider cash to be another of the portfolio assets Portfolio Management TABLE 11.5 Expected Portfolio Return (1) State of Economy (2) Probability of State of Economy (3) Portfolio Return If State Occurs (4) Product (2) (3) Recession 50 50 220% 50 30% 5% 2.5 Boom 50 50 70% 50 10% 40% 20.0 E(RP ) 22.5% PO RT F O L I O E XP E C T E D R E T UR N S Let’s go back to Starcents and Jpod You put half your money in each The portfolio weights are obviously 50 and 50 What is the pattern of returns on this portfolio? The expected return? To answer these questions, suppose the economy actually enters a recession In this case, half your money (the half in Starcents) loses 20 percent The other half (the half in Jpod) gains 30 percent Your portfolio return, RP, in a recession will thus be: RP 50 220% 50 30% 5% Table 11.5 summarizes the remaining calculations Notice that when a boom occurs, your portfolio would return 40 percent: RP 50 70% 50 10% 40% As indicated in Table 11.5, the expected return on your portfolio, E(RP ), is 22.5 percent We can save ourselves some work by calculating the expected return more directly Given these portfolio weights, we could have reasoned that we expect half of our money to earn 25 percent (the half in Starcents) and half of our money to earn 20 percent (the half in Jpod) Our portfolio expected return is thus: E(RP) 50 E(RS ) 50 E(RJ ) 50 25% 50 20% 22.5% This is the same portfolio return that we calculated in Table 11.5 This method to calculate the expected return on a portfolio works no matter how many assets are in the portfolio Suppose we had n assets in our portfolio, where n is any number at all If we let xi stand for the percentage of our money in Asset i, then the expected return is: E(RP ) x1 E(R1) x2 E(R2) … xn E(Rn) (11.2) Equation (11.2) says that the expected return on a portfolio is a straightforward combination of the expected returns on the assets in that portfolio This result seems somewhat obvious, but, as we will examine next, the obvious approach is not always the right one EXAMPLE 11.3 More Unequal Probabilities Suppose we had the following projections on three stocks: Returns Probability of State of Economy Stock A Stock B Stock C Boom 50 10% 15% 20% Bust 50 State of Economy We want to calculate portfolio expected returns in two cases First, what would be the expected return on a portfolio with equal amounts invested in each of the three stocks? Second, what would be the expected return if half of the portfolio were in A, with the remainder equally divided between B and C? (continued ) Chapter 11 Diversification and Risky Asset Allocation 377 From our earlier discussion, the expected returns on the individual stocks are: E(RA) 9.0% E(RB) 9.5% E(RC ) 10.0% (Check these for practice.) If a portfolio has equal investments in each asset, the portfolio weights are all the same Such a portfolio is said to be equally weighted Since there are three stocks in this case, the weights are all equal to 1/3 The portfolio expected return is thus: E(RP) 1/3 9.0% 1/3 9.5% 1/3 10.0% 9.5% In the second case, check that the portfolio expected return is 9.375% PO RT F O L IO VA R I A N C E O F E XP E C T E D R E T UR N S From the preceding discussion, the expected return on a portfolio that contains equal investments in Starcents and Jpod is 22.5 percent What is the standard deviation of return on this portfolio? Simple intuition might suggest that half of our money has a standard deviation of 45 percent, and the other half has a standard deviation of 10 percent So the portfolio’s standard deviation might be calculated as follows: P 50 45% 50 10% 27.5% Unfortunately, this approach is completely incorrect! Let’s see what the standard deviation really is Table 11.6 summarizes the relevant calculations As we see, the portfolio’s standard deviation is much less than 27.5 percent—it’s only 17.5 percent What is illustrated here is that the variance on a portfolio is not generally a simple combination of the variances of the assets in the portfolio We can illustrate this point a little more dramatically by considering a slightly different set of portfolio weights Suppose we put 2/11 (about 18 percent) in Starcents and the other 9/11 (about 82 percent) in Jpod If a recession occurs, this portfolio will have a return of: RP 2/11 220% 9/11 30% 20.91% If a boom occurs, this portfolio will have a return of: RP 2/11 70% 9/11 10% 20.91% Notice that the return is the same no matter what happens No further calculation is needed: This portfolio has a zero variance and no risk! This portfolio is a nice bit of financial alchemy We take two quite risky assets and, by mixing them just right, we create a riskless portfolio It seems very clear that combining assets into portfolios can substantially alter the risks faced by an investor This observation is crucial We will begin to explore its implications in the next section.2 Earlier, we had a risk-free rate of percent Now we have, in effect, a 20.91 percent risk-free rate If this situation actually existed, there would be a very profitable opportunity! In reality, we expect that all riskless investments would have the same return TABLE 11.6 Calculating Portfolio Variance and Standard Deviation (1) State of Economy (2) Probability of State of Economy (3) Portfolio Returns If State Occurs (4) Squared Deviation from Expected Return* (5) Product (2) (4) Recession 50 5% (5 22.5)2 306.25 153.125 Boom 50 40 (40 22.5)2 306.25 153.125 Variance, 306.25 P _ Standard deviation, P Ï306.25 17.5% * Notice that we used percents for all returns Verify that if we wrote returns as decimals, we would get a variance of 030625 and a standard deviation of 175, or 17.5% 378 Part Portfolio Management EXAMPLE 11.4 Portfolio Variance and Standard Deviations In Example 11.3, what are the standard deviations of the two portfolios? To answer, we first have to calculate the portfolio returns in the two states We will work with the second portfolio, which has 50 percent in Stock A and 25 percent in each of stocks B and C The relevant calculations are summarized as follows: Returns Probability of State of Economy Stock A Stock C Portfolio Boom 50 10% 15% 20% 13.75% Bust 50 5.00 State of Economy Stock B The portfolio return when the economy booms is calculated as: RP 50 10% 25 15% 25 20% 13.75% The return when the economy goes bust is calculated the same way Check that it’s percent and also check that the expected return on the portfolio is 9.375 percent Expressing returns in decimals, the variance is thus: 2P 50 (.1375 09375)2 50 (.05 09375)2 0019141 The standard deviation is: _ P Ï.0019141 04375, or 4.375% Check: Using equal weights, verify that the portfolio standard deviation is 5.5 percent Note: If the standard deviation is 4.375 percent, the variance should be somewhere between 16 and 25 (the squares of and 5, respectively) If we square 4.375, we get 19.141 To express a variance in percentage, we must move the decimal four places to the right That is, we must multiply 0019141 by 10,000—which is the square of 100 CHECK THIS 11.2a What is a portfolio weight? 11.2b How we calculate the variance of an expected return? 11.3 Diversification and Portfolio Risk Our discussion to this point has focused on some hypothetical securities We’ve seen that portfolio risks can, in principle, be quite different from the risks of the assets that make up the portfolio We now look more closely at the risk of an individual asset versus the risk of a portfolio of many different assets As we did in Chapter 1, we will examine some stock market history to get an idea of what happens with actual investments in U.S capital markets T HE E F F E C T O F D I VE R S I F I C AT I O N : A N O T HE R L E S S O N F R O M M A R KE T HI S T O RY In Chapter 1, we saw that the standard deviation of the annual return on a portfolio of large-company common stocks was about 20 percent per year Does this mean that the standard deviation of the annual return on a typical stock in that group is about 20 percent? As you might suspect by now, the answer is no This observation is extremely important To examine the relationship between portfolio size and portfolio risk, Table 11.7 illustrates typical average annual standard deviations for equally weighted portfolios that contain different numbers of randomly selected NYSE securities Chapter 11 Diversification and Risky Asset Allocation 379 TABLE 11.7 Portfolio Standard Deviations (1) Number of Stocks in Portfolio (2) Average Standard Deviation of Annual Portfolio Returns 49.24% (3) Ratio of Portfolio Standard Deviation to Standard Deviation of a Single Stock 1.00 37.36 76 29.69 60 26.64 54 24.98 51 10 23.93 49 20 21.68 44 30 20.87 42 40 20.46 42 50 20.20 41 100 19.69 40 200 19.42 39 300 19.34 39 400 19.29 39 500 19.27 39 1,000 19.21 39 Source: These figures are from Table in Meir Statman, “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis 22 (September 1987), pp 353–64 They were derived from E J Elton and M J Gruber, “Risk Reduction and Portfolio Size: An Analytic Solution,” Journal of Business 50 (October 1977), pp 415–37 © 1987 School of Business Administration, University of Washington In column of Table 11.7, we see that the standard deviation for a “portfolio” of one security is just under 50 percent per year at 49.24 percent What this means is that if you randomly select a single NYSE stock and put all your money into it, your standard deviation of return would typically have been about 50 percent per year Obviously, such a strategy has significant risk! If you were to randomly select two NYSE securities and put half your money in each, your average annual standard deviation would have been about 37 percent The important thing to notice in Table 11.7 is that the standard deviation declines as the number of securities is increased By the time we have 100 randomly chosen stocks (and 1 percent invested in each), the portfolio’s volatility has declined by 60 percent, from 50 percent per year to 20 percent per year With 500 securities, the standard deviation is 19.27 percent per year, similar to the 20 percent per year we saw in Chapter for large-company common stocks The small difference exists because the portfolio securities, portfolio weights, and the time periods covered are not identical An important foundation of the diversification effect is the random selection of stocks When stocks are chosen at random, the resulting portfolio represents different sectors, market caps, and other features Consider what would happen, however, if you formed a portfolio of 30 stocks, but all were technology companies In this case, you might think you have a diversified portfolio But because all these stocks have similar characteristics, you are actually close to “having all your eggs in one basket.” Similarly, during times of extreme market stress, such as the Crash of 2008, many seemingly unrelated asset categories tend to move together—down Thus, diversification, although generally a good thing, doesn’t always work as we might hope We discuss other elements of diversification in more detail in a later section For now, read the nearby Investment Updates box for another perspective on this fundamental investment issue 380 Part Portfolio Management INVESTMENT UPDATES B A C K T O T H E D R AW I N G B O A R D The recent financial crisis has all but torn up the investment rule book—received wisdoms have been found wanting if not plain wrong Investors are being forced to decide whether the theoretical foundations upon which their portfolios are constructed need to be repaired or abandoned Some are questioning the wisdom of investing in public markets at all Many professional investors have traditionally used a technique known as modern portfolio theory to help decide which assets they should put money in This approach examines the past returns and volatility of various asset classes and also looks at their correlation—how they perform in relation to each other From these numbers wealth managers calculate the optimum percentage of a portfolio that should be invested in each asset class to achieve an expected rate of return for a given level of risk It is a relatively neat construct But it has its problems One is that past figures for risk, return and correlation are not always a good guide to the future In fact, they may be downright misleading “These aren’t natural sciences we’re dealing with,” says Kevin Gardiner, head of investment strategy for Europe, the Middle East and Africa at Barclays Wealth in London “It’s very difficult to establish underlying models and correlations And even if you can establish those, it’s extremely difficult to treat them with any confidence on a forward-looking basis.” Modern portfolio theory assumes that diversification always reduces risk—and because of this, diversification is often described as the only free lunch in finance But Lionel Martellini, professor of finance at Edhec Business School in Nice, believes that this isn’t always true “Modern portfolio theory focuses on diversifying your risk away,” he says “But the crisis has shown the limits of the approach The concept of risk diversification is okay in normal times, but not during times of extreme market moves.” Wealth investors are beginning to question the usefulness of an approach that doesn’t always work, especially if they can’t tell when it is going to give up the ghost So what are the alternatives? On what new foundations should investors be looking to construct their portfolios? There are two schools of thought and, unhelpfully, they are diametrically opposed On the one hand, there are those that suggest investors need to accept the limits of mathematical models and should adopt a more intuitive, less scientific approach On the other hand, there are those who say that there is nothing wrong with mathematical models per se It is just that they need to be refined and improved Mr Gardiner is in the former camp “It’s not that there’s a new model or set of theories to be discovered,” he says “There is no underlying model or structure that defines the way financial markets and economics works There is no stability out there All you can hope to is establish one or two rules of thumb that perhaps work most of the time.” He argues that investment models can not only lead investors to make mistakes, they can lead lots of investors to make the same mistakes at the same time, which exacerbates the underlying problems Prof Martellini, however, believes more complex models can offer investors a sound basis for portfolio construction Last September, he and fellow Edhec academics published a paper describing a new portfolio construction system, which Prof Martellini contends will be a great improvement on modern portfolio theory It relies on combining three investment principles already in use by large institutional investors and applying them to private client portfolios Crucially, this approach has a different outcome for each individual investor, and therefore does not result in a plethora of virtually identical portfolios Prof Martellini says: “These three principles go beyond modern portfolio theory, and if they are implemented would make private investment portfolios behave much better.” The first principle is known as liability-driven investment With this approach, investors make asset allocations that give the best chance of meeting their own unique future financial commitments, rather than simply trying to maximize risk-adjusted returns Modern portfolio theory is founded on the premise that cash is a risk-free asset But if the investor knows, say, that he or she wants to buy a property in five years’ time, then an asset would have to be correlated with real-estate prices to reduce risk for them The second principle is called life-cycle investing This takes account of the investor’s specific time horizons, something which modern portfolio theory doesn’t cater for The final part of the puzzle involves controlling the overall risk of the client’s investments to make sure it is in line with their risk appetite—this is called risk-controlled investing There is also a third option to choosing a more discretionary approach to investment or looking to improve investment models: to shun the markets altogether Edward Bonham Carter, chief executive of Jupiter Investment Management Group, believes that, rather than a bull or bear market, we are currently experiencing a “hippo” market Hippos spend long periods almost motionless in rivers and lakes But when disturbed, they can lash out, maiming anything in reach Nervous of this beast, wealthy investors are starting to back away from publicly quoted instruments whose prices are thrashing around wildly David Scott, founder of Vestra Wealth, says: “I would say half my wealthier clients are more interested in building their businesses than playing the market.” Source: John Ferry and Mike Foster, The Wall Street Journal, November 17, 2009 Reprinted with permission of The Wall Street Journal © 2009 Dow Jones & Company, Inc All Rights Reserved Worldwide Chapter 11 Diversification and Risky Asset Allocation 381 Equations Index Page numbers followed by an n indicate notes A Abnormal return, 228 After-tax yield, 642–643 Alpha, 444, 445–447 American call option price, 525 American put option price, 525 Announcements, 408 Arithmetic average dividend growth rate, 184 Arms, 278 Assets, 582 B Balance sheet, 582 Beta correlation and, 425 equity, 197 portfolio, 414–415, 418 systematic risk, 423 Black-Scholes formulas, 551–554 Black-Scholes-Merton formulas, 568 Blume’s formula, 28–29 Bond after-tax yield, 642–643 Bond conversion, 621 Bond duration, 352, 354–355 Bond equivalent taxable yield, 641–642 Bond equivalent yield, 308 Bond portfolio hedging, 489 Bond prices callable bonds, 347 conversion, 621 discount, 341–342 future value, 358 municipal bond, 639 percentage change in, 352 premium, 341–342 present value, 339, 358 straight bond, 339–340, 632 STRIPS, 317, 629, 631 Bond yields, 345–346 Book value per share (BVPS), 194, 586 C Call options Black-Scholes-Merton formula, 568 delta, 557–558 intrinsic value, 510 price, 525, 544–545, 551–554 value, 541 694 Callable bond price, 347 Capital asset pricing model, 420–421 Capital gains yield, Carrying-charge market, 483 Cash flow per share (CFPS), 586 Characteristic line, 445 Clean surplus relationship (CSR), 194 Constant perpetual growth, 181–183, 194, 197–198 Conversion price, 621 Conversion ratio, 621 Conversion value, 621 Correlations, 385, 425 Coupon rate, 338 Critical marginal tax rate, 643 Critical price, 56, 62 Current price, 305 Current yield, 338 D Delta, 544–545, 557–558, 562 Discount bond duration, 355 Discount bonds, 341–342 Discount rate, 192 Dividend-adjusted spot-futures parity, 485 Dividend discount models constant perpetual growth, 181–183, 194, 197–198 discount rate, 192 geometric average dividend growth rate, 184 nonconstant growth, 190 present value of future dividends, 181 return on equity, 185, 186 sustainable growth rate, 185–186 Dividend growth model, 190 Dividend yield, Dollar value of an 01, 356 DuPont formula, 186–187 Duration, 352, 354–355 Duration of a futures contract, 489 E Earnings per share (EPS), 586 Earnings yield, 199 Economic Value Added (EVA), 194 Effective annual return (EAR), 6, 94, 309 Equity beta, 197 Equity value, 197 Equivalent taxable yield, 641–642 European call option price, 525, 551–554 European put option price, 525, 551–554 Expected portfolio return, 377, 415–416, 444, 445, 458–459 Expected price, 201 Expected return, 373, 375, 423 F Firm value, 198 Forward rate, 323 Free cash flow (FCF), 196–198 Future value, 300 Future value of a bond price, 358 Futures for market risk, 488 Futures for portfolio hedging, 488 Futures price, 484 G Geometric average dividend growth rate, 184 Geometric average return, 26 Gross margin, 584 H Hedging with index options, 562 interest rate risk, 489 stock market risk, 488 with stock options, 559–560, 562 I Index level, 169 Index options, 562 Information ratio, 447–448 Interest rate, nominal, 326–327 Interest rate, real, 319 Interest rate futures contracts, 489 Inverted market, 483 J Jensen’s alpha, 444 M Macaulay duration, 352, 354 Margin accounts, 56, 62 Market risk hedging, 488 Market risk premium, 420 Market sentiment index, 274 Minimum variance portfolio, 391 Modified duration, 353 Money multiplier, 670 Municipal bond price, 639 N Net asset value, 105–106 Net income, 582 Nominal interest rate, 326–327 Nonconstant growth, 190 O One-period binomial option pricing model, 544–545 Operating margin, 584 Options; see also Call options; Put options hedging strategies, 559–560, 562 intrinsic value, 510, 541 portfolio of a stock, put, and call, 526 portfolio value at expiration of, 526 put-call parity, 528, 541 P Par value bond duration, 354 Percentage change in bond price, 352 Percentage return, Portfolio beta, 414–415, 418 Portfolio expected return, 377, 415–416, 444, 445, 458–459 Portfolio hedging with futures, 489 Portfolio of a stock, put, and call, 526 Portfolio return, 392, 415–416 Portfolio value at option expiration, 526 Portfolio variance, 378, 386–387, 390, 392 Premium bonds, 341–342 Present value future value relationship to, 317 of a bond price, 358 of bond principal, 340 of bond semiannual coupons, 339 of future cash flows, 181, 194 time value of money and, 300 Price-book (P/B) ratio, 200, 586 Price-cash flow (P/CF) ratio, 200, 586 Price-earnings (P/E) ratio, 199, 586 Price ratio analysis, 201 Price-sales (P/S) ratio, 200 Price-weighted index level, 169 Prices; see also Bond prices call options, 525, 544–545, 551–554 conversion, 621 critical, 56, 62 current, 305 expected, 201 futures, 484 put options, 525, 544, 551–554 stock, 182–183, 190–191 Treasury bill, 309 Put-call parity, 528, 541 Put-call parity with dividends, 528 Put options annualized return, 94 delta, 557–558 intrinsic value, 510 price, 525, 544, 551–554 R R-squared, 448 Real interest rate, 319 Required earnings per share, 194 Residual income model (RIM), 194 Return on assets (ROA), 584 Return on equity (ROE), 185, 186, 584 Return with systematic/unsystematic components, 410 Reward-to-risk ratio, 416, 418 Risk premium, 374 S Security market line, 420–421 Sharpe-optimal portfolio, 452–454 Sharpe ratio, 443, 452 Short sale margin calls, 62 Spot-futures parity, 484–485 Standard deviation, 19–21, 375, 378, 387, 390, 458–459 Stock index futures contracts, 488 Stock index options, 562 Stock market hedging, 488 Stock options, 559–560 Stock price, 182–183, 190–191 Straight bond price, 339–340, 632 STRIPS price, 317, 629, 631 STRIPS yield, 629, 631 Surprise announcements, 408 Surprise component of return, 410 Sustainable growth rate, 185–186 Systematic portion of surprise, 423 Systematic portion of the unexpected return, 423–424 Systematic risk, 410, 423 T Taxable equivalent yield, 641–642 Three-asset portfolio risk, 387 Three-asset portfolio variance, 392 Total percent return, Total return, 410, 423 Total risk, 411 Treasury bill price, 309 Treasury note futures contracts, 489 Treynor ratio, 416n, 443 Two-asset portfolio return, 452 Two-asset portfolio risk, 386 Two-asset portfolio variance, 391, 452 Two-period binomial option pricing model, 545–549 Two-stage dividend growth model, 188, 601 U Unexpected return, 407, 423–424 Unsystematic portion of the unexpected return, 424 V Valuation of a firm, 197–198 VaR risk analysis, 455, 457, 458–459 Variance of expected returns, 375 historical, 19–21 minimum variance portfolio, 391 portfolio, 378, 386–387, 390, 392 three-asset portfolio, 392 two-asset portfolio, 391, 452 Y Yield to call, 347–348 Yield to maturity, 319, 345–346 Yield value of a 32nd, 357 Yields after-tax, 642–643 bond, 345–346 bond equivalent, 308 capital gains, current, 338 dividend, taxable equivalent, 641–642 Equations Index 695 Subject Index Page numbers followed by an n indicate notes; by an f, figures; by a t, tables A Abnormal return, 228 Acadian, 430 Accenture, 158 Account equity, 53 Accrued interest, 344 Active investment strategy, 48 Actively managed mutual funds, 234–236 Adaptive Allocation Fund, 117 Adjustable-rate bonds, 627 Advance/decline line, 276–278 Advanced Medical Optics, Inc., 226–228 Advanced Micro Devices, Inc., 622 AIG, 518 Aladdin Capital LLC, 519 Alcoa, Inc., 60 Alltel, 287 Alpha, 444–447 AlphaSimplex Group, 455 Altria, 117 Amazon.com, 152, 428 Ambac Financial Group, 642 America Online (AOL), 408 American Electric Power, 155, 183, 186 American Express, 155, 189, 511 American Football Conference, 285–286 American options arbitrage strategies, 523–525 definition, 91, 500 index options, 506 time value, 510–511 American Stock Exchange, 503 Amex Internet Index, 246, 247f Amortization, 203 Ampco-Pittsburgh, 86f Analysis; see also Financial statements analysis; Technical analysis fundamental, 180, 224 industry, 671–675 price ratio, 199–203, 207–208 ratio, 584–586, 599–600 top-down, 660–661 Analytic Investors, 430 Anchoring, 260 Ancora Homeland Security Fund, 117 Announcements and news, 226–228, 241, 407–409 Annual percentage rate (APR), 309–311, 339 Annual reports, 107, 579 Annualizing returns, 6–7, 56–57 696 Anomalies, market, 237–241 Apollo, 147 Apple Inc., 84–85, 161, 203, 245, 373, 431 APR (annual percentage rate), 309–311, 339 Arbitrage cash-futures, 481–483 hedge fund, 134–135 index, 486–487 limits to, 271–272 market efficiency and, 222–223, 258 option, 523–525 put-call parity, 529–530, 541n2 stock mispricing scenarios, 272–273 Arbitrage pricing theory (APT), 421n Arbitration, 51–52 Arca, 154 Arch Coal, 84f, 86f Arithmetic average dividend growth rate, 183–185 Arithmetic average return, 26–29, 130–131 Asian stock market crash, 245–246 Ask price, 150, 632 Asset allocation definition, 388 diversification and, 388–390 investor objectives and, 47–48, 66–67, 351 Markowitz efficient frontier, 392–394 risk tolerance and, 456 three-asset portfolios, 392–393 two-asset portfolios, 388–390 Asset allocation funds, 118–119 Asset beta, 197–198 Asset-specific risk, 409, 411 Asset turnover, 187 Assets current, 580 derivative, 87, 470, 500, 517 fixed, 580–581 goodwill, 581 primary, 87 underwater, 270–271, 565–566 AT&T, 60, 512 AT&T Wireless, 152 At-the-money options, 511–512 Auctions, 149, 304, 634–636 Availability bias, 268 Average returns arithmetic, 26–29 calculating, 15, 25 dollar-weighted, 29–31 forecasting, 29 geometric, 26–29 historical record, 15 risk premiums and, 15–18 B Back-end load, 108 Backtesting, 274 Backwardation, 483, 484–485 Balance sheet definition and overview, 580–582 pro forma, 588–591, 592t, 597–599, 600t Starbucks Corp., 594t, 597–599, 600t Balanced funds, 118 Baltimore Colts, 286 Bank discount basis, 305–306 Bank discount yield, 305–306, 308–309 Bank of America, 84f, 519 Banker’s acceptance, 303–304 Barclays Bank, 131–132 Barclays Capital, 313, 646 Barclays U.S High Yield index, 648 Barclays Wealth, 381 Barings Bank, 261 Base-year values, 169–170 Basis, 482 Basis points, 305 Basketball shooting percentages, 267 Bass Pro Shops, 287 BATS Global Markets, 245 BB&T Corp., 81 Bear call spreads, 521 Bear markets; see also Bubbles and crashes Asian market crash, 245 definition, 275 diversification impact of, 388 fear of, 242 2008 crash, 12–14, 23 Bear Stearns, 248, 518 “Beating the market,” 222 Behavioral finance arbitrage limits, 271–272 definition and introduction, 258 herding, 269 heuristics, 269 investor biases, 260, 268, 269–270 overconfidence, 262–265 prospect theory, 258–262 randomness and chance events, 265–269 Bell curve, 22–23 Bellwether rate, 301 Berkshire Hathaway, 46, 83, 232 Best efforts underwriting, 148–149 Beta (coefficient) asset beta versus equity beta, 197–198 calculating, 424–428 correlation and, 424–426 definition, 193, 412 disparity between, 428–429 Fama-French three-factor model, 430–432 portfolio, 414–415 portfolio expected return and, 415–418 portfolio hedging with futures, 487–488 returns and, 423–424 reward-to-risk ratio, 416 risk premium and, 415–416 systematic risk and, 412–415, 423–424 total risk versus, 414 Biases, investor, 260, 268, 269–270 Bid-ask spread, 632 Bid price, 150 Black-Scholes-Merton option pricing model, 566–568 Black-Scholes option pricing model, 551–554, 557–559, 563, 567 Block trades, 278 Blue Chip Growth Fund, 122, 124f, 125f Blue chip stocks, 122n6 Blue Chip Winery Fund, 117 Blue Fund, 117 Blue Oyster Cult, 241n Blume’s formula, 28 BMO Capital Markets, 312 Bollinger bands, 283 Bond equivalent yield, 307–311 Bond features or types adjustable-rate, 627 callable, 346–348 catastrophe, 626 convertible, 84, 338, 621–624 discount, 341–342, 355 exchangeable, 624 extendible, 621 floating-rate, 627 high-yield, 645–649 hybrid, 640–641 moral obligation, 640–641 par, 341–342, 354 plain vanilla, 616 premium, 341–342 private activity, 643 putable, 338, 621, 640 revenue, 316, 640 serial, 624–625, 639 term bonds, 624–625 Yankee, 315 zero coupon, 316, 353, 356, 359–360, 629–631 Bond funds, 116–118 Bond market indexes, 313, 315f Bond portfolio management, 357–360, 488–489 Bond prices and yields; see also Duration; Yield to maturity calculating yields, 345–348 clean price, 344 dedicated portfolios, 358 dirty price, 344 discount bonds, 341–342 dollar value of an 01, 356–357 immunization, 360–362 interest rate risk, 348–349 Malkiel’s theorems, 349–351 premium bonds, 341–342 reinvestment risk, 359–360 relationship between, 339, 349, 350, 627, 632–633 straight bond prices, 339–344 yield to call, 346–348 yield value of a 32nd, 357 Bond refunding, 618 Bonds; see also Bond features or types; Bond prices and yields; Corporate bonds; Government bonds asset allocation and, 388–390 basics, 338–339, 616–617, 628, 637–639 credit ratings, 643–649 credit spreads, 645–646, 647 interest payment accounting, 584 introduction, 615–616 Book-to-market ratio, 430–432 Book value per share (BVPS), 586, 593, 599 Borg Corporation financial statements balance sheet, 580–582 capacity usage, 590–592 cash flow statement, 583–584 financing decisions, 590 income statement, 582–583 percentage of sales approach, 587 performance ratios, 584–586, 593 price ratios, 584–586, 593 pro forma balance sheet, 588–591, 592t pro forma financial statements, 586–587 pro forma income statement, 587–588 profitability and price ratio projections, 593 Boston Options Exchange, 503 Boston Stock Exchange, 153 Breaking the buck, 112, 113 Breckinridge Capital, 642 British American Tobacco, 117 British Bankers Association, 304 Brokerage accounts, 49 Brokers, 49–52, 150–152 Bubbles and crashes; see also Crash of 2008 Asian stock market, 245–246 definitions, 241 dot-com stocks, 246 fear of, 242 May 2010, 158 October 1929, 241–242 October 1987, 242–245, 285 trading system failures, 158, 159, 244–245 Buffett-Falk & Co., 232 Bull call spreads, 521 Bull market, 275; see also Bubbles and crashes Bullet bonds, 616 Business cycles, 662–664 Butterfly call spreads, 522 BVPS (book value per share), 586, 593, 599 C California Public Employees’ Retirement System (Calpers), 17 Call deferment period, 347 Call money rate, 52, 303 Call option intrinsic value, 509–510 Call options; see also Option valuation covered calls, 520–521 definition and overview, 90, 500 employee stock options as, 565–568 hedging stock with, 560 intrinsic value for, 509–510, 512 payoff diagrams, 513–515 prices, 92f, 523–525 profit diagrams, 515–516 put-call parity, 526–529 risk management with, 519–520 stock investment versus, 93, 504–506 Call premium, 618 Call price, 346 Call protection period, 347, 618–619 Call provisions, 618–621, 640 Call writers, 513 Callable at par, 346 Callable bond, 346–348 Capacity usage, 590–592 Capital appreciation funds, 114–115 Capital asset pricing model (CAPM), 192, 420–421, 429–432 Capital gains yield, 4, Capital intensity ratio, 588 Capital IQ, 152 Carlsberg A/S, 117 Carrying-charge market, 483 Cash account, 52 Cash flow, 200, 583 Cash flow analysis; see Financial statements analysis Cash flow per share (CFPS), 200, 586, 593 Cash flow statement, 580, 583–584 Cash-futures arbitrage, 481–483 Cash holdings, 203 Cash market, 481 Cash price, 481 Catastrophe bonds, 626 Caterpillar, Inc (CAT), 155 CBOE (Chicago Board Options Exchange), 499, 501, 502, 503, 506, 508, 552, 561, 564 CBOT (Chicago Board of Trade), 469–470, 473 CDC (Centers for Disease Control and Prevention), 226–227 CDOs (collateralized debt obligations), 518 CDs (certificates of deposit), 303 CDSC (contingent deferred sales charge), 108, 111 CDSs (credit default swaps), 517–519 Centers for Disease Control and Prevention (CDC), 226–227 Cerberus, 147 Certificates of deposit (CDs), 303 CFA Institute, 451 CFPS (cash flow per share), 200, 586, 593 CFTC (Commodities Futures Trading Commission), 504 Characteristic line, 426–427 Charles Schwab, 106 Charting Bollinger bands, 283 head and shoulders, 280, 281f MACD, 283, 284f money flow, 283–284 moving averages, 280–282 online resources, 282–283 Subject Index 697 Charting—Cont open-high-low-close, 280 price channel, 280, 281f Cheapest-to-deliver option, 490 Chesapeake Energy, 84f ChevronTexaco, 280, 281f Chicago Board of Trade (CBOT), 88, 469–470, 473 Chicago Board Options Exchange (CBOE), 499, 501, 502, 503, 506, 508, 552, 561, 564 Chicago Mercantile Exchange (CME), 469–470 Chicago Stock Exchange, 153 Chicken Little Growth Fund, 117 Chrysler, 147 Churning, 51 CIBC World Markets Corp., 312 Circuit breakers, 158–159, 244–245 Cisco Systems, Inc., 5, 152 Citigroup, 81, 132, 232, 519 Clawback provision, 145–146 Clean price, 344 Clean surplus relationship (CSR), 194–195 Cliffs Natural Resources, 86f Closed-end funds, 104–105, 125–127 Closing Arms (TRIN), 278 Closing tick, 278 Clustering illusion, 267 CME Group, Inc., 88, 89, 469–470, 482n, 485 CNBC, 86 CNET Networks, 280, 281f CNN Money, 428 Coca-Cola Company, 102, 117, 156, 187, 279, 567 Coffee, Sugar, and Cocoa Exchange (CSCE), 470 Cognitive errors, 258 Coin toss strategies, 259, 265–266 Collateralized debt obligations (CDOs), 518 Collective Brands, 84f Columbia University, 43 Combination, 522–523 Commercial Metals, 86f Commercial paper, 303 Commodities Futures Trading Commission (CFTC), 504 Commodity futures, 88; see also Futures contracts Common Sense Growth Fund, 108 Common stock bonds compared with, 616 options on, 500–503 overview, 82 price quotes, put-call parity and, 526–529 Common stock valuation; see also Dividend discount models cautions about, 180 free cash flow model, 196–199 price ratio analysis, 199–203, 207–208 Procter & Gamble example, 203–208 residual income model, 193–195, 205–207 stock price behavior anomalies, 237–241 bubbles and crashes, 158, 159, 241–248 event studies, 226–228 news and announcements, 226–228, 241, 407–409 past returns as predictor of future, 225–226 random walk and, 225–226 two-stage dividend growth model, 188–193 698 Subject Index Company life cycles, 673–674 Company size–based funds, 115 Company-sponsored retirement plans, 58, 259 Competition, 224–225 Compounding, Concannon Plastics, Confirmation, 275 Congressional Effect Fund, 117 Constant perpetual growth model, 181–183, 194–195, 197–198 Consumer Price Index (CPI), 7, 9, 13t, 667–668 Consumer spending, 666 Contango, 483, 484–485, 530 Contingent deferred sales charge (CDSC), 108, 111 Continuation patterns, 280 Conversion price, 621 Conversion ratio, 621 Conversion value, 621, 624 Convertible bond funds, 119 Convertible bonds, 84, 338, 621–624 Convex price-yield relationship, 619, 620 Corporate bonds adjustable-rate, 627 basics, 615–616 call provisions, 618–621 conversion provisions, 621–624 credit ratings, 643–649 high-yield, 645–649 historical returns, 7–14, 18t, 22f, 27t indentures, 617–618 maturity and principal payments, 624–625 prices, 80–81, 314–315 protective covenants, 626–627 put provisions, 621 seniority provisions, 618 sinking fund provisions, 625–626, 639 Corporate risk management, 519–520 Corrections, 226, 227f, 275 Correlation calculating, 424–426 definition, 385 diversification and, 385–386, 390–391 diversification during bear markets, 380–381, 388, 664–665 Markowitz efficient portfolios and, 393–394 R-squared and, 448 risk-return trade-off and, 390–391 of two assets, 385–386, 388, 390 Correlation coefficient, 385–386, 390–391 Counterparty risk, 503, 518 Coupon, 79, 338–341, 584, 616, 625–626 Coupon rate, 79, 338–339, 341–342, 344, 625–626 Coupon strips, 629 Covariance, 425 Covered calls, 520–521 Covering the position, 59 CPI (Consumer Price Index), 7, 9, 13t, 667–668 Crash, defined, 241; see also Bubbles and crashes Crash of 2008 arithmetic versus geometric losses, 27 causes of, 246–247 credit default swap role, 517–518 credit ratings system, 645 diversification and stock return correlation, 380–381, 388, 664–665 DJIA, 23–24, 247–248 flight to quality, 301 hedge fund roles, 133 junk bond features, 648 money market mutual funds, 112–113 open market operations and, 669–670 overview, 12–14 sector analysis, 671 Credit default swaps (CDSs), 517–519 Credit ratings, 643–649 Credit spreads, 645–646, 647 Critical marginal tax rate, 643 Critical price, 56, 62 Cross-hedge, 487 Cross-term, 387 CSCE (Coffee, Sugar, and Cocoa Exchange), 470 CSR (clean surplus relationship), 194–195 Cubes (QQQQ), 128 Cumulative abnormal return, 228 Cumulative preferred stock, 82 Curing the short, 59 Currency exchange rate effects, 665–666 Current assets, 580 Current liabilities, 581 Current yield, 79, 338–339, 344 Cyclical sectors, 664, 671 D Data snooping problem, 233 Day-of-the-week effect, 237 Daytona 500 indicator, 286–287 DDM; see Dividend discount models Dealers, 150–152 Dealogic, 152 Debentures, 618 Debt; see also Bonds long-term, 581 unsecured, 617 U.S national, 670–671 Dedicated portfolios, 358, 360–362 Deep-discount brokers, 49–50 Default premium, 327–328 Default risk, 326–328, 638, 641 Defensive sectors, 661, 664, 671 Deferred call provision, 618 Defined benefit pension plans, 103 Defined contribution pension plans, 103 Delayed reaction, 226, 227f Dell, 5, 161, 373 Delta, 543–545, 547–548, 557–559, 562 Depreciation, 196–197, 203 Derivative assets or securities, 87, 470, 500, 517; see also Futures contracts; Options Designated market maker (DMM), 154, 156, 161 Deutsche Bank, 132, 242, 485, 646 Deutsche Bank Private Wealth Management, 642 Deutsche Boerse, 153 Deutsche Börse, 665 DeWalt Tools, 287 “Diamonds” (Dow Jones Industrial Average ETF), 128 Direct Edge Holdings, 162 Direxion ETFs, 132 Dirty price, 344 Discount, 305 Discount basis, 79, 628 Discount bonds, 341–342, 355 Discount brokers, 49–50 Discount rate, 192–193, 303, 669 Discount yield, 305–306 Disney, 49, 117, 202, 674 Display book, 154 Diversifiable risk, 382, 411 Diversification asset allocation and, 388–390 company stock plans and, 236 correlation and, 385–386, 390–391 expected returns, 373–376 global economy and stock returns, 380–381, 388, 664–665 historical returns and, 14 introduction, 372–373 Markowitz efficient frontier, 392–394 mutual funds and, 103, 104 overconfidence and, 263 portfolio, 376–379 portfolio risk and, 379–384, 386–388 portfolio variance and standard deviation, 390 principle of, 382 risk-return trade-off, 390–391 systematic risk and, 411 time fallacy, 382–384 unsystematic risk and, 411 variance of expected returns, 375–376 Dividend discount models (DDMs) constant perpetual growth, 181–183, 194–195, 197–198 definition and introduction, 180–181 discount rates for, 192–193 free cash flow model versus, 197–198 historical growth rates, 183–185 observations on, 193 Procter & Gamble valuation, 205 ROE analysis, 186–188 sustainable growth rate, 185–186 two-stage growth model, 188–193, 601–602 Dividend yield, 4, Dividends Black-Scholes-Merton option pricing model and, 566–568 dollar returns and, on financial statements, 582, 584 overview, 82, 85–87 put-call parity with, 528 spot-futures parity with, 484–485 terminal, 181 in value-weighted indexes, 170 DJIA; see Dow Jones Industrial Average DJTA (Dow Jones Transportation Average), 275 DMM (designated market maker), 154, 156, 161 DMM’s post, 156 Dodd-Frank Act, 133 Dollar payout, 588 Dollar returns, 2–4 Dollar value of an 01, 356–357 Dollar-weighted average return, 29–31 DoMark International, 163 Dominated portfolios, 389–390 Dot-com bubble and crash, 246 Dow Jones company, 275 Dow Jones divisors, 169 Dow Jones indexes, 485 Dow Jones Industrial Average (DJIA) bubbles and crashes, 23–24, 158, 242–244, 247–248 circuit breakers, 159 component stocks, 166f as Dow theory component, 275 ETFs representing, 128 futures contracts on, 486 hedging with index options, 563 historical returns, 23–24 option contracts on, 506 overview, 164, 165f price quotes, 89 Dow Jones Industrial Average ETF (“Diamonds”), 128 Dow Jones stock indexes, 164, 167f, 168 Dow Jones Transportation Average (DJTA), 275 Dow theory, 275 Dreyfus Funds, 106 DTE Energy Co., 183, 186 Dual-class shares, 82, 83 Duckwall-ALCO Stores, Inc., 195 Duff & Phelps, Inc., 643–644 Dumb luck problem, 231–233 DuPont, 286 DuPont formula, 186–187 Duration callable bonds and, 620 definition, 352 discount bond, 355 immunization, 360–362 of interest rate futures, 489 Macaulay, 352–356 modified, 353, 355 par bond, 354 properties of, 355–356 risk measures based on, 356–357 Dutch auction underwriting, 149 Dynamic immunization, 361–362 E EAFE Index, 128 EAR (effective annual rate), 6–7, 309–311, 339 Earnings, 185, 194, 584 Earnings analysis; see Financial statements analysis Earnings announcements, 241 Earnings per share (EPS) definition, 87 financial statement analysis, 586, 593, 599 required, 194 stock valuation and, 185–186, 194, 199–203 Earnings yield (EP), 199 eBay, 146, 413t EBITDA (earnings before interest, taxes, depreciation, and amortization), 202–203 ECNs (Electronic Communication Networks), 155, 161 Economic activity CPI and, 667–668 fiscal policy, 670–671 industry analysis, 671–675 labor markets, 666–667 macroeconomic, 661–666 monetary policy, 668–670 top-down analysis and, 660–661 Economic indicators, 664 Economic Value Added (EVA), 194 EDGAR (Electronic Data Gathering and Retrieval), 579 Edhec Business School, 381 Edward Jones, 49 Effective annual rate (EAR), 6–7, 309–311, 339 Effective duration, 620 Effective maturity, 353 Efficient market reaction, 226, 227f Efficient markets hypothesis (EMH), 222 Efficient portfolios, 390, 392–394 EFN (external financing needed), 590–592 Electronic Communication Networks (ECNs), 155, 161 Electronic Data Gathering and Retrieval (EDGAR), 579 Elliott wave theory, 275–276 Emergency Medical Services Corp., 648 Emerging markets funds, 115 Emerson Electric Co., 517, 520–521 EMH (efficient markets hypothesis), 222 Emory University, 270 Employee stock options (ESOs), 565–568 Employment rate, 666–667 Endowment effect, 260, 262 Energy Transfer Partners, 81 Enterprise value (EV), 202–203 E/P (earnings yield), 199 EPS; see Earnings per share Equities, 82–87, 388; see also Common stock Equity, 581–582, 586 Equity beta, 197–198 Equity income funds, 115 Equity multiplier, 187 Equivalent taxable yield, 641–642 Erratic dividend growth, 184–185 ESOs (employee stock options), 565–568 ETFs; see Exchange-traded funds (ETFs) ETNs (exchange-traded notes), 129, 131–133, 483, 530 E*TRADE, 49, 160 Euro LIBOR (EURIBOR), 304 Eurodollars, 304 European Central Bank, 312, 669 European options arbitrage strategies, 523–525 definition, 91, 500 index options, 506, 561 put-call parity, 526–529 time value, 511 valuation models, 545–549, 551 EV (enterprise value), 202–203 EV/EBITDA ratio, 202 EVA (Economic Value Added), 194 Event studies, 226–228 Excess return, 15, 222 Exchange rate effects, 665–666 Exchange-traded funds (ETFs) commodity-based, 483, 484–485 creation, 128 index funds compared with, 128–130 introduction, 127–128 leveraged, 130–131, 132 Exchange-traded notes (ETNs), 129, 131–133, 483, 530 Exchangeable bonds, 624 Exercise price, 91, 500 Subject Index 699 Expectations theory, 323–324, 325 Expected returns abnormal returns and, 228 beta and, 416–418, 423–424 definition and overview, 373 Markowitz efficient portfolios and, 393–394 portfolio, 377–378, 415–418 systematic risk and, 410, 412, 419–420 three-asset portfolios, 377–378, 387 two-asset portfolios, 377–380, 452 unexpected returns and, 407 variance and, 373–376, 378–379 Expected risk premium, 374–375 Expiration day, 91 Expiry, 551 Exponential moving average, 281–282 Extendible bonds, 621 External financing needed (EFN), 590–592 ExxonMobil, 412, 413t, 513 F Face value, 616, 628 Facebook, 83, 150, 152 FactSet Research Systems, 430 Fair Disclosure (Regulation FD), 579–580 Fallen angels, 646 False consensus, 268 False piercings, 280 Fama-French three-factor model, 430–432 Fannie Mae, 304, 315–316, 636 FASB (Financial Accounting Standards Board), 566, 567 FCF (free cash flow), 196–197 FDIC (Federal Deposit Insurance Corporation), 50 Federal Farm Credit Bank, 636 Federal Financing Bank, 636 Federal funds rate, 302, 669 Federal Home Loan Bank, 636 Federal Home Loan Mortgage Corporation (FHLMC), 304, 315–316, 636 Federal Housing Finance Agency (FHFA), 636 Federal National Mortgage Association (FNMA), 304, 315–316, 636 Federal Reserve financial crisis roles, 113, 636 initial margin regulator, 53 monetary policy and, 300–303, 320, 669–670 Treasury security auctions, 634 FGIC Corp., 642 FHFA (Federal Housing Finance Agency), 636 FHLMC (Federal Home Loan Mortgage Corporation), 304, 315–316, 636 Fibonacci numbers, 285 Fidelity Investments, 106–107, 109–110, 122, 124f, 129, 132, 450 Fidelity Magellan Fund, 111, 225 Financial Accounting Standards Board (FASB), 566, 567 Financial Engines, 455 Financial futures, 88 Financial Guaranty Insurance Co., 642 Financial Industry Regulatory Authority (FINRA), 80–81, 132, 159 Financial leverage, 55 700 Subject Index Financial Security Assurance Inc., 642 Financial statements balance sheet, 580–582 cash flow statement, 580, 583–584 income statement, 580, 582–583, 587–588, 595–597 performance ratios, 584–586 price ratios, 586 Financial statements analysis; see also Starbucks financial statement analysis information sources, 579–580 introduction, 578–579 Financial statements forecasting financing decisions, 590 fixed asset capacity usage, 590–592 percentage of sales approach, 587 pro forma balance sheet, 588–591, 592t pro forma income statement, 587–588 profitability and price ratio projections, 593 Financing cash flow, 584 Financing options, 145–147, 197–198, 590–592 FINRA (Financial Industry Regulatory Authority), 80–81, 132, 159 Firm commitment underwriting, 148 Firm-specific risk, 271 First-stage financing, 146 Fiscal policy, 670–671 Fisher hypothesis, 320, 324 Fitch Investors Service, 642, 643–644 Fixed assets, 580–581 Fixed assets capacity usage, 590–592 Fixed-income securities, 79–82, 311–316; see also Bonds; U.S Treasury securities Flash Crash of 2010, 158 Flexible portfolio fund, 118–119 Floating-rate bonds, 627 Floor brokers, 154 Floor value, 624 FNMA (Federal National Mortgage Association), 304, 315–316, 636 Follow-on offering, 147 Football indicators, 285–286 Ford Motor Co., 84f, 271, 385–386, 674 Forecasts, 29; see also Financial statements forecasting Forest River Inc., 232 Forward contracts, 469 Forward rate, 323–324 401(k) plans, 58, 103, 269 Fourth market, 162 Frame dependence, 259–260 Franklin Funds, 106 Fraud, investment, 51 Freddie Mac, 304, 315–316, 636 Free cash flow (FCF), 196–197 Free cash flow model, 196–199 Freeport McMoran, 86f Frequency distribution, 18–19 Friedman Industries, 86f Front-end load, 108 Full faith and credit bonds, 640 Full hedge, 476 Full price, 344 Full-service brokers, 49–50 Fundamental analysis, 180, 224 Fundamental indexing, 170 Fundamentals, 180 Funds of funds, 135 Future value, 300, 317, 324, 326 Future value of an annuity, 358 Futures contracts basics, 469, 470–471 cash-futures arbitrage, 481–483 cash prices, 481 definition and overview, 87–90, 469 delivery options, 471, 490 hedging with, 475–479, 488–489 history, 469–470 interest rate risk and, 488–489 option contracts versus, 91 prices, 469, 471–474, 481 speculation with, 474–475 spot-futures parity, 483–485 stock index futures, 486–488 trading accounts, 479–481 Futures margin, 480 Futures price, 469 G GAAP (Generally Accepted Accounting Principles), 163 Gambler’s fallacy, 268 Gap, The, 565–566 GDP (gross domestic product), 661–662 Gender and trading frequency, 263 General cash offers, 147 General equity mutual fund (GEF), 234 General Motors (GM), 102, 152, 200, 263–264, 385–386 General mutual funds, 118 General obligation (GO) bonds, 316, 638, 640, 641 Generally Accepted Accounting Principles (GAAP), 163 Geometric average dividend growth rate, 183–185 Geometric average return, 26–29, 130–131 GICS (Global Industry Classification System), 674 Ginnie Mae, 315–316, 636 Global funds, 115 Global Industry Classification System (GICS), 674 Global Investment Performance Standards (GIPS), 451 Global macroeconomic activity business cycles, 662–664 economic indicators, 664 exchange rate effects, 665–666 real GDP, 661–662, 663f, 667–668 stock return correlation with, 664–665 Global stock markets, 15–16 Globex, 471 GM (General Motors), 102, 152, 200, 263–264, 385–386 GNMA (Government National Mortgage Association), 118, 315–316, 636 GO (general obligation) bonds, 316, 638, 640, 641 Go Daddy, 154 Gold, Golden mean, 285 Goldman Sachs, 81, 132, 147, 287, 519 Goodwill, 581 Google, 83, 149, 161, 428 Government bonds; see also Municipal bonds; U.S Treasury bills; U.S Treasury bonds; U.S Treasury notes agency securities, 314–316, 636–637 auctions, 304, 634–636 basics, 628 historical returns, 7–14, 15, 18t, 21e, 22f, 27t intermediate-term, 22f, 27t long-term, 7–14, 15, 18t, 21e, 22f, 27t open market operations, 669–670 prices bonds and notes, 631–633 STRIPS, 629–631 TIPS, 320–322, 633–634, 635 Government National Mortgage Association (GNMA), 118, 315–316, 636 Government-sponsored enterprises (GSEs), 636 Great Atlantic & Pacific Tea Co., 566 Greece, 312 Gross domestic product (GDP), 661–662 Gross margin ratio, 584, 593, 599 Groupon, 83 Growth and income funds, 115 Growth funds, 115 Growth models constant perpetual, 181–183, 194–195, 197–198 nonconstant, 190–192, 195 two-stage dividend, 188–193, 601–602 Growth stocks, 25, 119, 199–200, 432 GSEs (government-sponsored enterprises), 636 Guggenheim Investments, 130 Gymboree, 408 H H-model, 192 Harley-Davidson, 2–4, 412, 413t Harrah’s Entertainment, 147 Harvard Business School, 552 Head and shoulders pattern, 280, 281f Hedge funds, 133–135, 145–146, 455, 458–459 Hedgers, 476 Hedging with futures contracts, 475–479, 487–489 interest rate risk, 488–489 with stock index options, 561–563 stock market risk, 487–488 with stock options, 559–561 Hedging strategies, 476–478, 479, 487–489 Hemline indicator, 285 Herding, 269 Herzfeld Caribbean Basin Fund, 117 Heuristics, 269 Hewlett-Packard, 272 HIBOR, 304 High-yield bonds, 617, 645–649 High-yield funds, 118 Historical perspective futures trading, 469–470 growth rates, 183–185 inflation rates, 12f interest rates, 299–301 Historical returns average returns, 15, 25 corporate bonds, 7–14, 18t, 22f, 27t government bonds, 7–14, 15, 18t, 21e, 22f, 27t growth stocks, 25 S&P 500 Index, 1, 7, 12–14 stock markets, 1–2, 7–14, 23–24 Treasury bills, 7–14, 15, 27t Historical variance, 19–21 Holding period, Home Depot, 55, 283 Honda Motor Company, 271 Hong Kong Investment Funds Association, 455 Horizon, 42–45, 66 “Hot-hand” fallacy, 267–268 House margin requirement, 54 House money, 261–262 Hurricane Katrina, 626, 642 Hybrid bonds, 640–641 Hybrid market, 154 Hypothecation, 57 I IBM, 82, 102, 155, 413, 500, 504, 552 ICE (IntercontinentalExchange), 470 Illusion of knowledge, 263 ImClone, 230 IMM (International Monetary Market), 469 Immunization, 360–362 Implementation costs, 272 Implied standard deviation (ISD), 563–565 Implied volatility (IVOL), 563 Imputed interest, 628 In-the-money bond, 623 In-the-money options, 511–512 Income, 582 Income funds, 119 Income statement, 580, 582–583, 587–588, 595–597 Indenture summary, 617 Index arbitrage, 486–487 Index divisor, 169 Index funds alpha and, 445 ETFs compared with, 128–130 overview, 116–117 passive investment strategy and, 233 Value-at-Risk, 455–457 Index options, 506–509, 561–563 Index staleness, 170 Indexes; see S&P 500 Index; Stock market indexes Individual retirement accounts (IRAs), 58–59 Industry analysis Porter’s five forces, 674–675 sectors, 671–674 Industry life cycle, 673–674 Inefficient portfolios, 389–390 Inflation CPI and, 667–668 Fisher hypothesis, 320, 324 historical rates, 8f, 12f, 14, 15, 22f, 27t, 320, 321f monetary policy and, 668–670 real GDP and, 661, 667–668 Inflation-indexed Treasury securities (TIPS), 320–322, 633–634, 635 Inflation premium, 326, 327f Information effect on price event studies, 226–228 news and announcements, 226–228, 241, 407–409 past returns as predictor of future, 225–226 Information ratio, 447–448 Information sources, 282–283, 579–580, 585 Informed traders, 229 Initial margin, 53–54, 480 Initial public offerings (IPOs), 147–150 Innovation, 408 Inside quotes, 161 Insider trading, 229–230 Institutional investors, 239 Insured funds, 118 Insured municipal bonds, 641 Intangible assets, 580–581 Intel Corporation, 5, 84f, 161, 201–202, 226, 409, 501 IntercontinentalExchange (ICE), 470 Interest accrued, 344 bond (coupon), 79, 338–341, 584, 616, 625–626 imputed, 628 short, 63 simple, 309 Interest-bearing assets fixed-income securities, 79–82 money market instruments, 78–79 Interest rate futures, 473–474 Interest rate risk definition, 326, 348 hedging with futures, 488–489 Malkiel’s theorems, 349–351 maturity and, 349 realized yield and, 348–349 Interest rate risk premium, 326 Interest rates; see also Money market interest rates; Term structure of interest rates APR, 309–311, 339 basis points and, 305 bellwether, 301 call money, 52, 303 callable versus noncallable bonds, 619 changes in, 359–362 coupon rate, 79, 338–339, 341–342, 344, 625–626 discount rate, 192–193, 303, 669 EAR, 6–7, 309–311, 339 Federal funds, 302, 669 Fisher hypothesis, 320, 324 fixed-income securities, 311–316 forward, 323–324 history, 299–301 LIBOR, 304 nominal, 319–321, 324, 326–328 prime, 301 real, 319–321, 326–327 simple, 309 Intermediate-term government bonds, 22f, 27t Intermediate-term mutual funds, 118 Internal rate of return (IRR), 30 Internal Revenue Service (IRS), 2n, 58, 107, 272 International equity, 388 International funds, 115 International Monetary Market (IMM), 469 International Paper, 86f International Securities Exchange, 503 International stock markets, 15–16 Intrinsic bond value, 624 Intrinsic value, 509–512, 541 Subject Index 701 Inverse floaters, 627 Inverted market, 483 Inverted yield curve, 313 Investment banking firms, 148 Investment cash flow, 584 Investment companies, 104–105, 107; see also Mutual funds Investment fraud, 51, 52 Investment horizon, 42–45, 66 Investment management, 47, 66 Investment objectives, 42 Investment opportunity set, 389–390 Investment policy statement (IPS), 42–48, 66–67 Investment portfolios, 65–68 Investment process; see also Margin accounts cash accounts, 52 introduction, 41 long positions, 59 portfolio formation, 65–68 professional management, 49–52, 103, 234–236, 239, 261 retirement accounts, 58–59 short positions, 59–65 Investment professionals, 49–52, 103, 234–236, 239, 261 Investment risk management, 454–459 Investment Technologies Inc., 43 Investment value, 624 Investor protection, 50–51 Investors biases of, 260, 268, 269–270 constraints of, 42–46, 66 irrationality of, 222–223, 258 noise traders, 271 risk-averse, 42, 259 Invoice price, 344 iPath ETNs, 132, 530 IPOs (initial public offerings), 147–150 IPS (investment policy statement), 42–48, 66–67 IRAs (individual retirement accounts), 58–59 IRR (internal rate of return), 30 Irrationality of investors, 222–223, 258 IRS (Internal Revenue Service), 2n, 58, 107, 272 ISD (implied standard deviation), 563–565 iShares ETFs, 128 ISO, 626 Italy Index, 128 IVOL (implied volatility), 563 J J P Morgan Chase, 81, 519 Jack Russell Corp., 616–617 January effect, 237–240 Japanese stock market, 245–246 Jensen’s alpha, 443–444, 449, 450 Johnson & Johnson, 6–7 JPMorgan Chase & Co., 81, 519 Junk bonds, 617, 645–649 Jupiter Investment Management Group, 381 K Kamp Re, 626 Kansas City Board of Trade (KCBT), 469, 473 Knowledge illusion, 263 Kraft Foods, 152 702 Subject Index L Labor force participation rate, 666–667 Labor market indicators, 666–667 Landon Air, 198 Large-cap mutual funds, 115 Large-company (large-cap) stocks average returns, 15, 18t, 27–29, 238–239 historical returns, 7–14, 21e, 22f, 25 return variability, 18–19, 23 risk premium, 18t risk-return trade-off, 31f Law of small numbers, 268 LBO (leveraged buyout), 147 Leading economic indicators, 664 Leap year bond equivalent yield, 309 Legal insider trading, 230 Lehman Brothers, 248, 518 Lehman Brothers Holdings Inc., 113, 301 Level load, 108 Leverage, 55, 130–131, 132, 518 Leveraged buyout (LBO), 147 Liabilities, 581 LIBOR (London Interbank Offered Rate), 304 Life-cycle funds, 119 Life-cycle investing, 381 Limit orders, 157, 160 Limit-up/limit-down system, 159 Limited tax bonds, 640 Limits to arbitrage, 271–272 LinkedIn, 83 Lipper Inc., 27 Liquidity, 45, 66 Liquidity preference theory, 324n Liquidity premium, 324n, 327–328 Load funds, 108 Lockheed Martin, 117 London Interbank Offered Rate (LIBOR), 304 Long hedge, 478–479 Long positions, 59, 474 Long-short funds, 134 Long-Term Capital Management, 455 Long-term corporate bonds, 7–14, 18t, 22f, 27t Long-term debt, 581 Long-term government bonds, 7–14, 15, 18t, 21e, 22f, 27t Long-term mutual funds stock and bond funds, 118–119 stock funds, 114–116 taxable and municipal bond funds, 116–118 Lorillard, 117 Loss aversion, 260–261, 270–271 Lowe’s Companies, Inc., 6, 286 Lundquist College of Business, 64 M Macaulay duration, 352–356 MACD (moving average convergence divergence), 283, 284f Macroeconomic activity; see Global macroeconomic activity Mad Money (TV show), 269 Maintenance margin, 54–55, 480 Make-whole call price, 346–347 Make-whole call provision, 618, 619–620 Make-whole premium, 620 Malkiel’s theorems, 349–351 Management fees, 109 Margin, 53 Margin accounts account equity, 53 call money rate, 52, 303 critical price, 56, 62 definition, 52 futures trading in, 479–481 history, 241 hypothecation, 57 initial margin, 53–54, 480 leverage and, 55 maintenance margin, 54–55 margin call, 54–55, 62, 480 returns in, 55, 56–57 short sales, 59–65 street name registration, 57–58 Margin call, 54–55, 62, 480 Margin purchase, 52 Market anomalies, 237–241 Market-book ratio, 200–201 Market capitalization definition and introduction, Fama-French three-factor model, 430–432 mutual fund objectives and, 119 worldwide, 16t, 661–662 Market efficiency anomalies, 237–241 “beating the market,” 222 bubbles and crashes, 241–248 driving forces, 224–225 efficient markets hypothesis, 222 forms of, 223–224, 226, 229 foundations of, 222–223 implications, 225–229, 233 informed traders, 229 insider trading, 229–230 introduction, 222 money manager performance and, 231–233, 234–236, 239 testing, 231–233 Market index, 429 Market makers, 153–154, 156, 161 Market neutral strategy, 134 Market orders, 156 Market portfolios, 420 Market risk, 409, 411, 456, 487–488 Market risk premium, 420 Market segmentation theory, 325 Market sentiment, 274–275 Market timing, 29–30, 47, 66, 135, 233 Marketocracy Masters 100 Fund, 117 Marking-to-market, 480 Markit, 519 Markowitz efficient frontier, 392–394, 451–452 Martha Stewart Living Omnimedia, Inc., 230 Material nonpublic information, 229, 579–580 Maturity, 349, 352–356, 624–625; see also Yield to maturity Maturity preference theory, 324–325, 326 Maturity premium, 324 MBIA Inc., 642 MBSs (mortgage-backed securities), 519, 645 McDonald’s, 102, 117 McGraw-Hill Companies, 484 Medifast, 373 Mental accounting, 261–262 Merrill Lynch, 49, 106, 313, 552 Mezzanine-level financing, 146 Microsoft, 5, 102, 161, 163, 229, 265, 282, 284, 408, 413t, 428 MidAmerica Commodity Exchange, 469 MidAmerican Energy, 232 Midcap mutual funds, 115 Middle-market companies, 146–147 Minimum variance portfolio, 389–391, 393 Minneapolis Grain Exchange (MPLS), 469, 473 MMDAs (money market deposit accounts), 114 MMMFs (money market mutual funds), 111–114 Modern portfolio theory, 381, 450 Modern term structure theories, 326–328 Modified duration, 353, 355 Molson Coors, 117 Monetary policy, 668–670 Monetta Young Investor Fund, 117 Money creation, 669–670 Money flow, 283–284 Money illusion, 262 Money managers, 49–52, 103, 231–236, 239, 261 Money market deposit accounts (MMDAs), 114 Money market instruments; see also U.S Treasury bills banker’s acceptance, 303–304 certificates of deposit, 303 commercial paper, 303 definition and introduction, 78–79 Eurodollars, 304 as pure discount securities, 305 Money market interest rates APR and EAR, 6–7, 309–311, 339 bank discount basis, 305–306 banker’s acceptance, 304 basis points and, 305 bellwether rate, 301 bond equivalent yield, 308–309 call money rate, 303 certificates of deposit, 303 commercial paper, 303 discount rate, 192–193, 303, 669 Eurodollars, 304 Federal funds rate, 302, 669 LIBOR, 304 prime rate, 301 Treasury bills, 306–308 Money market mutual funds (MMMFs), 111–114 Money multiplier, 670 Monster Beverage Corporation, 93–94 Moody’s Investors Service, 80, 519, 617, 643–644, 645 Moral obligation bonds, 640–641 Morgan Stanley, 81, 519, 648 Morgan Stanley Smith Barney, 132 Morningstar, 114, 121, 122n5 Mortgage-backed securities (MBSs), 519, 645 Mortgage funds, 118 Moving average convergence divergence (MACD), 283, 284f Moving averages, 280–282 Multi-period binomial option pricing model, 549–551 Municipal bond funds, 116–118 Municipal bonds basics, 628, 637–639 credit ratings of, 643–649 equivalent taxable yield, 641–643 features of, 639–640 general obligation, 316, 638, 640, 641 hybrid, 640–641 insurance on, 641 maturity structure of, 639 prices, 639 putable, 338, 621, 640 revenue, 316, 640 tax treatment of, 316, 327–328, 638 taxable, 643 Mutual funds actively managed, 234–236 advantages and drawbacks of, 103–104 annual reports on, 107 behavioral finance and, 261, 265, 268 bond funds, 116–118 closed-end, 104–105, 125–127 costs and fees, 107–111 definition and introduction, 102–103 ETFs compared with, 129 exchange-traded funds, 127–133 hedge funds, 133–135, 145–146, 455, 458–459 index, 234–236 net asset value, 105–106 objectives of, 119–121 open-end, 104–105 organization and creation of, 106–107 performance of, 122–126 prospectuses, 107 short-term, 111–114 stock and bond funds, 118–119 stock funds, 114–116 taxation of, 107 turnover of, 109 unusual, 117 Myopic loss aversion, 262 N Nabisco, 408 Naissance Capital, 117 NASCAR indicator, 285–287 NASDAQ Capital Market, 161 NASDAQ Global Market, 161 NASDAQ Global Select Market, 161 NASDAQ 100 Index, 128, 563 NASDAQ 100 Volatility Index (VXN), 564 NASDAQ stock market competitors, 153, 155, 162–164 ECNs and, 161 Facebook IPO, 152 individual stock circuit breakers, 245 inside quotes, 161 October 1987 crash, 244 operations, 161 Pink Sheets trading volume compared with, 163 stock ticker, 86 trading volume, 160 NASDAQ stock market indexes, 164, 167f National debt, 670–671 National Football Conference, 285–286 National Indemnity Cos., 232 National Stock Exchange, 153 Neckline support pattern, 280 Ned Kelley Hedge Fund, 458–459 Negative convexity, 619, 620 Negative correlation, 385 Negative covenants, 626–627 Negative pledge clause, 618 Net asset value, 105–106 Net profit margin, 186 Netflix, 431 New York Board of Trade (NYBOT), 470 New York Coffee Exchange, 469 New York Cotton Exchange (NYCE), 469–470 New York Futures Exchange (NYFE), 469, 470 New York Mercantile Exchange, 469, 473, 476, 484 New York Mets, 51, 52 New York Stock Exchange (NYSE) circuit breakers, 158–159, 244–245 competitors of, 161, 162–164 crashes, 158, 242, 244 exchange members, 153 floor activity, 156–157 floor brokers, 154 historical returns, history, 144, 153 hybrid market, 154 indexes, 164, 167f license holders, 153 listed stocks, 155 maintenance margin requirement, 54 market makers, 153–154, 156, 161 order types, 156–157, 159, 160 participants, 153–154 program trading, 244, 487 trading on, 153, 156 uptick rule, 63–64 News and announcements, 226–228, 241, 407–409 News Corp., 485 Nike Inc., 91–93 Nikkei Index crash, 245–246 No-load funds, 108 Noise traders, 271 Nominal GDP, 661–662 Nominal interest rates, 319–321, 324, 326–328 Noncash items, 583 Nonconstant growth, 190–192, 195 Nondiversifiable risk, 382, 411 Nordstrom, Inc., 85, 160, 413t Normal distribution, 22–23, 25, 454 Northwestern University, 271 Nucor Corp., 86f, 87 NYBOT (New York Board of Trade), 470 NYCE (New York Cotton Exchange), 469–470 NYFE (New York Futures Exchange), 469, 470 NYSE; see New York Stock Exchange NYSE Arca, 503 NYSE circuit breakers, 158–159, 244–245 NYSE Euronext, 144, 153, 155, 579 NYSE exchange members, 153 NYSE license holders, 153 NYSE uptick rule, 63–64 Subject Index 703 O OCC (Options Clearing Corporation), 503–504 Odd-lot indicator, 285 OEX (S&P 100 Index options), 506, 508 OHLC (open-high-low-close) charts, 280 OIC (Options Industry Council), 504 One-period binomial option pricing model, 542–545 OneChicago, 483 Online brokers, 50 Open-end funds, 104–105 Open-high-low-close (OHLC) charts, 280 Open market operations, 669–670 Open Outcry, 471 Operating cash flow, 583, 584 Operating margin ratio, 584, 593, 599 Option chain, 502 Option contracts, 90–91, 500–503 Option premium, 91 Option time value, 510–511 Option valuation Black-Scholes-Merton pricing model, 566–568 Black-Scholes pricing model, 551–554, 557–559, 563, 567 delta, 543–545, 547–548, 557–559 employee stock options, 565–568 fractional shares of stock, 543–545, 547–548 hedging portfolios with index options, 561–563 hedging stock with stock options, 559–561 implied standard deviations, 563–565 introduction, 540 multi-period binomial option pricing model, 549–551 one-period binomial option pricing model, 542–545 price trees, 542, 543, 546–547, 549–550 simple model, 541 stock price change impact on option prices, 557–559 two-period binomial option pricing model, 545–549 varying option price input values, 554–557 Option writing, 513 OptionMONSTER, 530 Options; see also Call options; European options; Option valuation; Put options American-style, 91, 500, 506, 510–511, 523–525 arbitrage, 523–525 at-the-money, 511–512 basics, 500–501 combinations, 522–523 on common stock, 500–503 employee stock, 565–568 exchanges, 501 exercise price, 91, 500 exercise style, 91, 500 expiration, 91, 500, 501 futures contracts versus, 91 gains and losses on, 93–94, 513–515 in-the-money, 511–512 intrinsic value, 509–512 last trading day, 91 out-of-the-money, 511–512 704 Subject Index payoff diagrams, 513–515 premium, 513 price quotes, 91–93, 501–503, 507–509 profit diagrams, 515–516 put-call parity, 526–529 risk management, 517–520 settlement, 501, 506 spreads, 521–522 stock index, 506–509 stock investments versus, 93, 504–506 strategies, 517–520, 520–523 strike price, 91, 500 synthetic, 529–530 time value, 510–511 trading, 520–523 underwater, 565–566 writing, 513 Options Clearing Corporation (OCC), 503–504 Options Industry Council (OIC), 504 Order flow, 155 Original-issue junk, 646 Out-of-the-money bond, 623 Out-of-the-money options, 511–512 Over-the-Counter Bulletin Board (OTCBB), 163 Over-the-counter (OTC) market, 161 Overreaction and correction, 226, 227f, 275 P Pacific Investment Management Co., 312 PacificCorp, 232 Palm, 272, 273f Par bonds, 341–342, 354 Par value, 346, 616 Parity, put-call, 526–529 Parnassus Fund, 116 Passive investment strategy, 48 Payout ratio, 185, 188 P/B (price-book) ratio, 200–201, 586 P/CF (price-cash flow) ratio, 200, 201, 586 P/E (price-earnings) ratio, 199–200, 201, 203, 586, 667 PEG ratio, 200 Penny stocks, 163 Pension funds, 358 Pension Research Institute, 455 Pep Boys, 84f PepsiCo, Inc., 55–56, 189–190, 279 Percentage of sales approach, 587 Percentage payout, 588 Percentage return, 4–7, 24 Performance evaluation alpha calculation, 445–447 comparing measures of, 449–454 definition and introduction, 441–442 information ratio, 447–448 Jensen’s alpha, 443–444, 449, 450 measuring, 442–443 R-squared, 448 Sharpe-optimal portfolios, 451–454, 459 Sharpe ratio, 443, 449–450, 455 Treynor ratio, 443–444, 449, 450 Performance ratios, 584–586 Petco Animal Supplies Inc., 648 Pfizer, 53, 84f Philadelphia Stock Exchange, 153, 503 Pierced neckline, 280 Pimco Total Return fund, 106 Pink Sheets, 163 Pittsburgh Steelers, 286 Plain vanilla bonds, 616 Plowback ratio, 588 Ponzi schemes, 51, 52 Porter’s five forces, 674–675 Portfolio betas, 414–415 Portfolio return and beta, 415–418 Portfolio risk diversification and, 379–384, 386–388 expected returns and, 377–378, 415–418 Markowitz efficient frontier, 392–394 standard deviations, 379–384 three assets, 377–378, 387, 392–393 two-asset portfolios, 386–387 Portfolio variance, 378–379, 386–391, 393 Portfolio weight, 376–378 Portfolios; see also Performance evaluation; Two-asset portfolios bond, 357–360, 488–489 dedicated, 358, 360–362 definition, 376 efficient/inefficient, 389–390, 392–394 hedging with stock index options, 561–563 hedging with stock options, 559–561 market, 420 put-call parity, 526–529 riskless, 378 three-asset, 377–378, 387, 392–393 Positive convexity, 619 Positive correlation, 23–24, 385 Positive covenants, 627 PowerShares ETFs, 431, 485 Preferred habitat theory, 325 Preferred stock, 82–84 Premium option, 513 risk, 15–16, 18, 193, 406, 415–416 yield, 646–647 Premium bonds, 341–342 Present value, 300, 317 Present value of an annuity, 339, 358 Price-book (P/B) ratio, 200–201, 586 Price-cash flow (P/CF) ratio, 200, 201, 586 Price channel, 280, 281f Price-earnings (P/E) ratio, 199–200, 201, 203, 586, 667 Price ratio, 586 Price ratio analysis, 199–203, 207–208 Price risk, 360, 475–476 Price-sales (P/S) ratio, 200, 201 Price-weighted indexes, 165–169 Primary assets, 87 Primary market, 147–150 Prime rate, 301 Primitive assets, 87 Principal, 616 Principal strips, 629 Principle of diversification, 382 Private activity bonds, 643 Private equity, 145–147 Private placement, 617, 618 Pro forma balance sheet, 588–591, 592t, 597–599, 600t Pro forma financial statements, 586–587 Pro forma income statement, 587–588, 595–597 Procter & Gamble, 158 Procter & Gamble valuation dividend discount model, 205 introduction, 203–205 price ratio analysis, 207–208 residual income model, 205–207 Professional management, 49–52, 103, 234– 236, 239, 261 Profit diagrams, 515–516 Profit motive, 224–225 Profitability ratios, 186, 584–586, 593 Program trading, 244, 487 Projected risk premium, 374–375 Promised yield, 339, 348–349 Prospect theory, 258–262 Prospectus, 107, 149–150, 617 Protective covenants, 626–627 Protective put strategies, 517–519 Prudent investment guidelines, 645 P/S (price-sales) ratio, 200, 201 Pure discount securities, 305 Put bonds, 338, 621, 640 Put-call parity, 526–529 Put option intrinsic value, 510 Put options; see also Option valuation definition and overview, 90, 500 gains and losses, 94 hedging stock with, 560–561 intrinsic value, 510, 512 payoff diagrams, 514–515 prices, 92f, 523–525 profit diagrams, 515–516 protective, 517–519 put-call parity, 526–529 stock investment versus, 94, 505–506 strategies, 92, 93 Put writers, 513 Q QQQQ (Cubes), 128 Quaker State Corporation, 347 Qwest, R R-squared, 448 Random walk, 225–226 Rate of return, Ratio analysis, 584–586, 599–600 Ratios; see also Earnings per share book-to-market, 430–432 book value per share, 586, 593, 599 capital intensity, 588 cash flow per share, 200, 586, 593 conversion, 621 enterprise value, 202–203 gross margin, 584, 593, 599 information, 447–448 operating margin, 584, 593, 599 payout, 185, 188 PEG, 200 price-book, 200–201, 586 price-cash flow, 200, 201, 586 price-earnings, 199–200, 201, 203, 586, 667 price-sales, 200, 201 profitability, 186, 584–586, 593 retention, 185, 588 return on assets, 584–586, 593, 599 return on equity, 185, 186–188, 584–586, 593, 599 reward-to-risk, 416, 418–420, 443 Sortino, 443, 450, 455 Treynor, 416n, 443–444, 449, 450 Raw return, 442–443 Raytheon, 117 Real estate investment trusts (REITs), 67 Real GDP, 661–662, 663f, 667–668 Real interest rates, 319–321, 326–327 Realized yield, 348–349 Recency bias, 268 Red herring, 150 Redemption fees, 109 Redemption value, 628 Reduced Value index options, 506–507 Refunding provision, 619 Regret aversion, 262 Regulation FD (Fair Disclosure), 579–580 Reinsurance, 626 Reinvestment rate risk, 359–360 REITs (real estate investment trusts), 67 Relative strength, 279 Relevant information problem, 231 Representativeness heuristic, 265 Required earnings per share (REPS), 194 Research in Motion, 84f Reserve Primary Fund, 112, 113 Residual income, 194 Residual income model (RIM), 193–195, 205–207 Resistance level, 276 Resolution Trust Funding Corporation, 636 Resources as investor constraint, 42, 66 Retained earnings, 185 Retalix, 265 Retention ratio, 185, 588 Retirement accounts, 58–59 Retirement plans, 58, 103, 259 Return on assets (ROA), 584–586, 593, 599 Return on equity (ROE), 185, 186–188, 584–586, 593, 599 Return variability frequency distributions and, 18–19 historical returns, 21–22 historical variance and standard deviation, 19–21 normal distribution, 22–23 positive correlation with risk, 23–24 Returns; see also Average returns; Expected returns; Performance evaluation abnormal, 228 annualizing, 6–7, 56–57 capital gain or loss as, 2–3 dollar, 2–4, 29–31 excess, 15, 222 margin account, 55, 56–57 percentage, 4–7, 24 S&P 500 Index, 1, 7, 12–14 S&P 500 sectors, 672 systematic and unsystematic components, 410 Revenue bonds, 316, 640 Reversal patterns, 280 Reverse trade, 480–481 Reward-to-risk ratio, 416, 418–420, 443 Rights offer, 147–148 RIM (residual income model), 193–195, 205–207 Risk; see also Interest rate risk; Systematic risk asset-specific, 409, 411 counterparty, 503, 518 default, 638, 641 diversifiable, 382, 411 diversifiable/nondiversifiable, 382, 411 exchange rate, 665–666 firm-specific, 271 market, 409, 411, 456, 487–488 mutual funds, 104 price, 360, 475–476 reinvestment rate, 359–360 sentiment-based, 271–272 total, 411–412, 414, 443 unique, 409, 411 unsystematic, 409–410, 424 Risk-adjustment problem, 231 Risk and return; see also Beta; Risk and return history; Systematic risk announcements and news, 226–228, 241, 407–409 capital asset pricing model, 420–421, 429–432 correlation and, 390–391 diversification and risk, 411 expected and unexpected returns, 407 expected returns and variances, 373–376 Fama-French three-factor model, 430–432 introduction, 406–407 investment objectives, 42 positive correlation with risk, 23–24 reward-to-risk ratio, 416–420, 422t risk premium, 18 security market line, 420–421 summary, 422t total return, 407 total risk, 411–412, 414, 443 trade-offs, 31–32, 390–391 with two assets, 390–391 Risk and return history APR and EAR, 6–7 average returns, 14–18, 26–31 dollar returns, 2–4 frequency distributions and, 18–19 historical record, 21–22 historical returns, 7–14 historical variance and standard deviation, 19–21 introduction, 1–2 normal distribution, 22–23 percentage returns, 4–7 Risk-averse investors, 42 Risk-free rate, 15 Risk management, 454–459, 517–520 Risk premium beta and, 415–416 definition and introduction, 15–18, 406 U.S stock market, 193 world stock market capitalization, 16 Risk-taking behavior, 258 Risk tolerance, 42, 43–45, 65–66, 456 Riskless investments, 192, 526–529 Riskless portfolios, 378 Subject Index 705 ROA (return on assets), 584–586, 593, 599 Robeco, 430, 431 ROE (return on equity), 185, 186–188, 584–586, 593, 599 Rotational investing, 671–674 Roth IRAs, 58–59 Royal Dutch, 272–273 Royal Swedish Academy of Sciences, 552 Russell 1000 Index, 116 Rydex, 130 S Sales charges, 108, 111 Salomon Smith Barney, 563 Samson Capital Advisors, 642 Santa Clara University, 456 Scheduled sinking fund redemption, 625 Schwab Funds, 116, 132 SDBK (Super Display Book system), 154 Seasoned equity offering (SEO), 147 Second-stage financing, 146 Secondary market, 147, 150 Secondary offering, 147 Sector funds, 115–116 Sectors, 661, 664, 671–674 Securities and Exchange Commission (SEC) bond regulation, 617–618 employee stock options, 567 ETF registration, 128 as financial information source, 579 hedge fund regulation, 133 insider trading regulation, 229, 230 IPO regulation, 149–150 money market regulation, 113 mutual fund regulation, 108 OCC regulation, 504 uptick rule repeal, 63–64 Securities Exchange Act of 1934, 53 Securities Investor Protection Corporation (SIPC), 51 Security classification; see also specific types derivatives futures contracts, 87–90 option contracts, 90–94 equities common stock, 82–87 preferred stock, 82–84 interest-bearing assets fixed-income securities, 79–82 money market instruments, 78–79 introduction, 77–78 Security market line (SML), 420–421 Security selection, 48, 66, 233 Segmentation theory, 325 Self-attribution bias, 268 Semistrong form of market efficiency, 223–224, 226 Senior debentures, 618 Sentiment-based risk, 271–272, 274–275 SEO (seasoned equity offering), 147 Separate Trading of Registered Interest and Principal of Securities (STRIPS), 316–319, 324, 326, 360, 629–631 Serial bonds, 624–625, 639 Settlement, 471, 486, 490, 501, 506 Shareholder equity, 581, 586 SharesPost, 152 706 Subject Index Sharpe-optimal portfolios, 451–454, 459 Sharpe ratio, 443, 449–450, 455 Shell, 272–273, 286 Short hedge, 476–478, 479 Short interest, 63 Short positions, 59, 474 Short sales, 59–63, 63–64, 135, 159 Short straddle, 522 Short-term mutual funds, 111–114, 118 Simple interest, 309 Simple moving average, 281–282 Single-state funds, 112, 118 Sinking fund, 624–625, 639 SIPC (Securities Investor Protection Corporation), 51 Sirius XM Radio, 84f SLP (supplemental liquidity provider), 154 Small-company mutual funds, 115 Small-company (small-cap) stocks average returns, 15, 18t, 25, 27t as growth stocks, 25 historical returns, 7–14, 21–22 January effect and, 237–240 risk premium, 18t risk-return trade-off, 31f SML (security market line), 420–421 Snakebite effect, 264–265 Social conscience funds, 116 Society for Neuroeconomics, 270 Soft dollars, 109 Sony, 117 Sortino ratio, 443, 450, 455 Southern Copper, 86f Southwest Airlines, 413 S&P 100 Index options (OEX), 506, 508 S&P 100 Volatility Index (VXO), 564 S&P 500 Index as benchmark, 164, 429 dot-com bubble and crash, 246, 247f ETFs representing, 128, 130 futures contracts on, 471, 486–488 heat map, 671–674 hedging, 506, 508, 561–563 historical returns, 1, 7, 12–14 January effect and, 239–240 market index mutual funds, 234–236 NYSE circuit breakers and, 244 price quotes, 89 sectors, 671–674 time diversification fallacy, 383–384 as value-weighted index, 170 S&P 500 Index funds, 116, 445, 455–457 S&P 500 Index options (SPX), 506, 508, 561–563 S&P 500 Volatility Index (VIX), 564 S&P sectors, 671–674 SPDR (Standard & Poor’s Depositary Receipt), 128 Special circumstances as constraint, 66 Specialists, 153–154 Speculation with futures contracts, 474–475 Speculator, 474 Spider (SPDR) ETF, 128, 431 Spot market, 481 Spot-futures parity, 483–485 Spot price, 481 Spreads bid-ask, 150, 632 credit, 645–646, 647 interest rate, 52 option, 521–522 Sprint Nextel, 84f SPX (S&P 500 Index options), 506, 508, 561–563 Standard & Poor’s Corporation credit ratings by, 80, 617, 642, 643–644, 645, 648 sector identification by, 671–674 as WSJ article source, 484 Standard & Poor’s Depositary Receipt (SPDR), 128 Standard & Poor’s indexes, 164, 167f, 168 Standard & Poor’s Low Volatility Index, 430–431 Standard deviation asset allocation and, 388–390 correlation coefficient, 385–386, 390–391 definition and introduction, 19–21 historical variance and, 19–21 implied, 563–565 Markowitz efficient portfolios and, 393–394 normal distribution, 22–23 portfolio diversification, 379–384, 387–388 variance of expected return, 375, 378–379 Standardized contracts, 88, 91, 469, 470, 500 Stanford Graduate School of Business, 552 Stanford University, 455 Stanley Black & Decker, 287 Starbucks, 161, 199, 200, 236, 413t, 414, 502, 565 Starbucks financial statement analysis analyst estimates, 595–596 balance sheet, 594t income statement, 595t introduction, 593–595 market perspective, 602–603 pro forma balance sheet, 597–599, 600t pro forma income statement, 595–597 ratio analysis, 599–600 two-stage dividend growth model, 601–602 Status quo bias, 260 Steel Dynamics, 86f Sterling Equities, 52 Stock and bond funds, 118–119 Stock funds, 114–116 Stock index futures, 486–488 Stock index options, 506–509, 561–563 Stock market indexes; see also Dow Jones Industrial Average; S&P 500 Index futures contracts on, 486–488 NASDAQ, 164, 167f NYSE, 167f overview, 164–170 price-weighted, 165–169 Standard & Poor’s, 167f value-weighted, 165–169 volatility measures, 430–431, 563, 564 Stock markets; see also Bubbles and crashes; NASDAQ; New York Stock Exchange dealers and brokers, 150–153 global economy correlation with, 664–665 global returns, 15–16 hedging risk with futures, 487–488 historical returns, 1–2, 7–14, 23–24 indexes, 164–170 introduction, 144–145 investor sentiment and, 274–275 leading economic indicators and, 664 market timers, 29–30 primary, 147–150 private equity, 145–147 risk premium for, 193 secondary, 147, 150 volatility measures, 25, 430–431, 563, 564 Stock options; see Option valuation; Options Stock price behavior anomalies, 237–241 bubbles and crashes, 241–248 event studies, 226–228 news and announcements, 226–228, 241, 407–409 past returns as predictor of future, 225–226 random walk and, 225–226 Stock screening, 585 Stock splits, 168–169 StockCar Stocks Index Fund, 117 Stocks; see also Common stock asset allocation, 388–390 blue chip, 122n6 fractional shares, 543–545, 547–548 global economy and return correlations, 380–381, 388, 664–665 growth, 25, 119, 199–200, 432 hedging with stock options, 559–561 NYSE-listed, 155 option contracts versus, 93, 504–506 order types, 156–157, 159, 160 penny, 163 preferred, 82–84 ticker symbols, ticker tape, 86 value, 119, 199–200, 430–432 Stop-buy orders, 157 Stop-limit orders, 159 Stop-loss orders, 157 Stop orders, 157 Stop-out bid, 635 Stop-sell orders, 157 Straddle, 522–523 Straight bond value, 624 Straight bonds, 338, 339–344 Strategic allocation, 67 Strategies and policies, 47–48, 66–67 Street name, 57–58 Strike price, 91, 500 Strips, 629 STRIPS (Separate Trading of Registered Interest and Principal of Securities), 316–319, 324, 326, 360, 629–631 Strong form of market efficiency, 223–224, 229 Subordinated debentures, 618 Subprime mortgages, 247 Subsector (industry) differences, 674 Sun Microsystems, 280 Sunk cost fallacy, 262 Super Bowl indicator, 285–286 Super Display Book system (SDBK), 154 SuperDOT system, 154 Supernormal growth, 191–192 Supplemental liquidity provider (SLP), 154 Support level, 276 Surprises, 408 Sustainable growth rate, 185–186 Swiss Re, 626 Syndicate, 148 Synthetic options, 529–530 Systematic risk beta and, 412–415, 424 CAPM and, 420–421 components of return, 410 definition, 409–410 diversification and, 411 expected return and, 412, 419–420 measuring, 412–414 security market line and, 420–421 Treynor ratio, 443–444, 449, 450 Systematic risk principle, 412 T T-bills; see U.S Treasury bills Tactical asset allocation, 67 Target, 117 Target date, 358, 361 Target date funds, 119 Tax-exempt market, 638 Tax-exempt money market instruments, 112–113 Tax-loss selling, 239 Tax-managed funds, 116 Tax Reform Act of 1986, 643 Taxable and municipal bond funds, 116–118 Taxable municipal bonds, 643 Taxation of investment companies, 107 Taxes aftertax yield, 642–643 critical marginal tax rate, 643 equivalent taxable yield, 641–642 as investor constraint, 45–46, 66 money market funds and, 112–113 on mutual fund investments, 104 Technical analysis advance/decline line, 276–278 block trades, 278 charting, 279–284 Closing Arms (TRIN), 278 Daytona 500 indicator, 286–287 definition, 274 Dow theory, 275 Elliott wave theory, 275–276 Fibonacci numbers, 285 hemline indicator, 285 market sentiment, 271–272, 274–275 odd-lot indicator, 285 popularity of, 274–275 relative strength, 279 Super Bowl indicator, 285–286 support and resistance levels, 276 volume indicators, 278 weak-form market efficiency and, 224 Tel Aviv Stock Exchange, 552 Telemet, 413 Templeton Global Income Fund, 126 Tender offer bonds, 640 10K reports, 579 Tennessee Valley Authority (TVA), 314, 636 10Q reports, 579 Term bonds, 624–625 Term structure of interest rates definition, 316 expectations theory, 323–324, 325 market segmentation theory, 325 maturity preference theory, 324–325, 326 modern theories, 326–328 traditional theories, 323–325 Treasury STRIPS, 316–319, 324, 326 Terminal dividend, 181 Teucrium, 485 Themis Trading, 158 Third market, 162 Three-asset portfolios, 377–378, 387, 392–393, 526 3Com, 272, 273f 3M Company, 53, 80, 155 TIAA-CREF, 43 Ticker symbols, Ticker tape, 86 Time diversification fallacy, 382–384 Time horizon, 382–384 Time value of money, 31, 192, 300 Time value of options, 510–511 Timing the market, 29–30, 47, 66, 135, 233 Timothy Plan Aggressive Growth Fund, 117 Tippees, 229 Tippers, 229 TIPS (inflation-indexed Treasury securities), 320–322, 633–634, 635 Tombstones, 150, 151f Top-down analysis, 660–661 Total dollar return, Total market capitalization, Total percent return, 4–7 Total return, 407 Total risk, 411–412, 414, 443 TPC Group, 287 TPG funds, 147 Tracking error, 447–448 Trade Reporting and Compliance Engine (TRACE), 80–81 Trading accounts, 49 Trading costs, 109 Trading frequency, 262–263 Trading volume, 278 Traditional fixed-price call provision, 618–619 Traditional term structure theories, 323–325 Treasury yield curve, 312–313, 314 Trees, price, 542, 543, 546–547, 549–550 Treynor ratio, 416n, 443–444, 449, 450 Triple witching hour, 487 Trust Indenture Act, 617–618 Turn-of-the-month effect, 240 Turn-of-the-year effect, 240 Turnover, 109 TVA (Tennessee Valley Authority), 314, 636 12b-1 fees, 108, 111 Two-asset portfolios asset allocation, 388–390, 392–393 correlation, 385–386, 388, 390 expected return, 377–380, 452 portfolio risk, 386–387 risk-return trade-off, 390–391 Two-period binomial option pricing model, 545–549 Two-stage dividend growth model, 188–193, 601–602 Two-stage residual income model, 195 Two states of the economy, 373–374, 377–378 TXU, 147 Subject Index 707 U UBS, 132 Underlying asset, 476 Underwater assets, 270–271, 565–566 Underwrite, 148 Underwriter spread, 148 Underwriting types, 148–149 Unemployment rate, 666–667 Unexpected returns, 407, 423–424 Uniform price auction, 149 Unique circumstances as constraint, 46 Unique risk, 409, 411 U.S government agency bonds, 314–316, 636–637 U.S Oil Fund, 484–485 U.S Savings Bonds, 628 U.S Treasury, 628 U.S Treasury bills definition, 304 historical returns, 7–14, 15, 18t, 22f, 27t, 321f interest rates, 301, 304 overview, 79, 628 prices and yields, 306–310 put-call parity and, 526 real interest rates and, 320 risk-return trade-off, 31f as riskless benchmark, 192–193 U.S Treasury bonds as benchmark, 183 coupon rate, 628 futures contracts on, 470, 480 historical returns, 12 overview, 628 prices, 88–90, 343 prices and yields, 631–633 risk-return trade-off, 31f as straight bonds, 338 U.S Treasury notes coupon rate, 628–629 futures contracts on, 470, 489 overview, 79, 628 price quotes, 88–90 prices and yields, 631–633 U.S Treasury securities auctions, 304, 634–636 inflation-indexed, 320–322, 633–634, 635 interest rates, 299 tax status, 327–328 yield curve, 312–313, 314 yields, 301, 360 U.S Treasury STRIPS, 316–319, 324, 326, 360, 629–631 University of California, Berkeley, 270 University of Oregon, 64 University of Rochester, 552 Unlimited tax bonds, 640 Unseasoned equity offering, 147 Unsecured debt, 617 Unsystematic risk, 409–411, 424 UPS, 152 Uptick rule, 63–64 V Valuation; see Common stock valuation; Financial statements analysis; Option valuation; Procter & Gamble valuation 708 Subject Index Value-at-Risk (VaR), 454–459 Value Line Investment Survey, 122n5, 203–206, 412–413, 428, 429 Value of a basis point, 356 Value stocks, 119, 199–200, 430–432 Value-weighted indexes, 165–169 Vanguard 500 Index Fund, 234–236 Vanguard Group, 129 Vanguard Inflation Protected Securities Fund, 635 Vanguard Investors, 27, 106, 116 Vanguard REIT ETF, 128 Vanguard Small Cap ETF, 128 VaR (Value-at-Risk), 454–459 Variance asset allocation and, 388–390 calculating, 457 correlation and, 390–391 definition and introduction, 19–21 expected returns and, 373–376, 378–379 historical, 19–21 minimum, 391 portfolio, 378–379, 386–391, 393 three-asset portfolios, 387 Velocity of money, 670 Venture capital (VC), 145, 146 Verizon Communications, 84f, 287 Vesting period, 565, 566 Vestra Wealth, 381 Vice Fund, 117 Visa, 152 VIX (S&P 500 Volatility Index), 564 Volatility, 25, 430–431, 563, 564 Volume indicators, 278 VXN (NASDAQ 100 Volatility Index), 564 VXO (S&P 100 Volatility Index), 564 W Wall Street Journal, The agency securities, 636–637 annual reports service, 579 credit markets, 311–312 Dow as editor of, 275 EPS reporting, 199 futures contract prices, 471–473 Market Diaries, 277 money rates, 299, 301–302 municipal bonds, 639 mutual fund information, 119, 120, 121, 122 options contract prices, 501, 507–509 stock market information, 164 TIPS, 321–322, 633–634 Treasury bonds and notes, 317, 318f, 631–632 Walmart, 56, 413t Walt Disney Corporation, 49, 117, 202, 674 Weak form of market efficiency, 223–224, 226 Wealth and time diversification fallacy, 382–384 Weisenberger, 122n5 Wells Fargo, 81, 519 William E Simon Business School, 552 Wishful thinking bias, 268 Women’s Leadership Fund, 117 World Bank, 636 World funds, 118 World stock markets, 15–16 World Wrestling Federation Entertainment, Inc., 151f X Xerox Corp., 60 Y Yahoo!, 63, 77, 161, 413t, 414 Yahoo! Finance, 5, 85, 428, 502, 564, 595–596, 647 Yankee bonds, 315 Yield aftertax, 642–643 bond, 339 bond equivalent, 307–311 calculating, 345–348 capital gains, 4, current, 79, 338–339, 344 definition, 305 discount, 305–306, 308–309 dividend, 4, earnings, 199 equivalent taxable, 641–642 money market funds, 112 price relationship with, 339, 349, 350, 627, 632–633 realized, 348–349 relationship among, 344 Treasury STRIPS, 317–319, 324, 326 Yield curve slope of, 313, 323–324 traditional theories, 323–325 Treasury, 312–313, 314 zero coupon, 316 Yield premium, 646–647 Yield spread, 645–646, 647 Yield to call (YTC), 346–348, 347–348 Yield to maturity (YTM) bond prices and, 339–344, 632–633 calculating, 345–346 definition, 339 dollar value of an 01 and, 356 interest rate risk and, 348–349 Malkiel’s theorems, 349–351 realized yield compared with, 348–349 TIPS, 633–634 Treasury STRIPS, 317–319, 629–631 yield to call compared with, 347 zero coupon bonds, 629–631 Yield value of a 32nd, 357 Z Zero correlation, 385 Zero coupon bonds definition, 316, 629–631 duration, 353, 356 reinvestment rate risk and, 359–360 Zero coupon yield curve, 316 Zillow, 83 Zurich Financial Services, 626 Zynga, 83, 84f ... Returns 20 09 20 13 20 09 20 13 20 09 20 13 30 Annual return % 30 20 10 Ϫ10 30 20 10 Ϫ10 Year 20 10 20 09 20 10 20 11 20 12 20 13 Ϫ10 20 09 20 10 20 11 20 12 20 13 20 09 20 10 20 11 20 12 20 13 Annual... 80 2. 20 (2. 02) 2. 18 0 324 Boom 20 70 (2. 02) 72 5184 (1) State of Economy (5) Product (2) (4) Starcents 025 92 10368 S2 129 60 Jpod Recession 80 30 26 04 0016 Boom 20 10 26 2. 16 025 6 00 128 005 12. .. Average wealth Standard deviation of wealth 10 15 20 25 30 35 40 $1,118 $1,6 92 $3, 026 $4, 923 $7,896 $ 12, 2 52 $18, 121 $26 ,0 42 $44,890 $20 2 $ 620 $1,433 $2, 751 $4, 622 $7,131 $9,057 $9,7 42 $ 12, 161 Chapter