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ESSENTIALS of INVESTMENTS bod05175_fm_i-xxvi.indd i 9/3/07 4:09:38 PM The McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate Stephen A Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor FINANCIAL MANAGEMENT Adair Excel Applications for Corporate Finance First Edition Block and Hirt Foundations of Financial Management Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance Ninth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Edition First Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Fifth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Fifth Edition Chew The New Corporate Finance: Where Theory Meets Practice Third Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Helfert Techniques of Financial Analysis: A Guide to Value Creation Eleventh Edition Higgins Analysis for Financial Management Eighth Edition Kester, Ruback, and Tufano Case Problems in Finance Twelfth Edition bod05175_fm_i-xxvi.indd ii Ross, Westerfield and Jaffe Corporate Finance Eighth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications First Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Sixth Edition Ross, Westerfield and Jordan Fundamentals of Corporate Finance Eighth Edition Shefrin Behavioral Corporate Finance: Decisions that Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition INVESTMENTS Adair Excel Applications for investments First Edition Bodie, Kane, and Marcus Essentials of Investments Seventh Edition Bodie, Kane, and Marcus Investments Eighth Edition Hirt and Block Fundamentals of Investment Management Ninth Edition Hirschey and Nofsinger Investments: Analysis and Behavior First Edition Jordan and Miller Fundamentals of Investments: Valuation and Management Fourth Edition FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Seventh Edition Rose and Marquis Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace Tenth Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Sixth Edition Saunders and Cornett Financial Markets and Institutions: An Introduction to the Risk Management Approach Third Edition INTERNATIONAL FINANCE Eun and Resnick International Financial Management Fourth Edition Kuemmerle Case Studies in International Entrepreneurship: Managing and Financing Ventures in the Global Economy First Edition REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Thirteenth Edition Corgel, Ling and Smith Real Estate Perspectives: An Introduction to Real Estate Fourth Edition Ling and Archer Real Estate Principles: A Value Approach Second Edition FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Tenth Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Develop Successful Financial Skills Second Edition Kapoor, Dlabay, and Hughes Personal Finance Eighth Edition 9/3/07 4:09:41 PM ESSENTIALS of INVESTMENTS Seventh Edition ZVI BODIE Boston University ALEX KANE University of California, San Diego ALAN J MARCUS Boston College Boston Burr Ridge, IL Dubuque, IA New York San Francisco St Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto bod05175_fm_i-xxvi.indd iii 9/3/07 4:09:42 PM ESSENTIALS OF INVESTMENTS Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020 Copyright © 2008, 2007, 2004, 2001, 1998, 1995, 1992 by The McGraw-Hill Companies, Inc All rights reserved No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper WCK/WCK ISBN 978-0-07-340517-9 MHID 0-07-340517-5 Executive editor: Michele Janicek Developmental editor II: Christina Kouvelis Marketing manager: Ashley Smith Managing editor: Lori Koetters Lead production supervisor: Michael R McCormick Senior designer: Cara David Lead media project manager: Cathy L Tepper Cover design: Eric Kass, funnel.tv Interior design: Jenny El-Shamy Typeface: 10/12 Times Roman Compositor: Laserwords Private Limited Printer: Quebecor World Versailles Inc Library of Congress Cataloging-in-Publication Data Bodie, Zvi Essentials of investments / Zvi Bodie, Alex Kane, Alan J Marcus —7th ed p cm — (The McGraw-Hill/Irwin series in finance, insurance, and real estate) Includes index ISBN-13: 978-0-07-340517-9 (alk paper) ISBN-10: 0-07-340517-5 (alk paper) Investments I Kane, Alex II Marcus, Alan J III Title HG4521.B563 2008 332.6—dc22 2007027273 www.mhhe.com bod05175_fm_i-xxvi.indd iv 9/3/07 4:09:44 PM To our wives and eight wonderful daughters bod05175_fm_i-xxvi.indd v 9/3/07 4:09:45 PM ABOUT THE AUTHORS Zvi Bodie Boston University Zvi Bodie is Professor of Finance and Economics at Boston University School of Management He holds a PhD from the Massachusetts Institute of Technology and has served on the finance faculty at Harvard Business School and MIT’s Sloan School of Management Professor Bodie has published widely on pension finance and investment strategy in leading professional journals His books include Foundations of Pension Finance, Pensions in the U.S Economy, Issues in Pension Economics, and Financial Aspects of the U.S Pension System His textbook Investments, co-authored with Alex Kane and Alan Marcus, is the market leader and is used in certification programs of the Financial Planning Association and the Society of Actuaries His textbook Finance is co-authored by Nobel Prize–winning economist Robert C Merton Professor Bodie is a member of the Pension Research Council of the Wharton School, University of Pennsylvania His latest book is Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals Alex Kane University of California, San Diego Alex Kane is Professor of Finance and Economics at the Graduate School of International Relations and Pacific Studies at the University of California, San Diego He has been Visiting Professor at the Faculty of Economics, University of Tokyo; Graduate School of Business, Harvard; Kennedy School of Government, Harvard; and Research Associate, National Bureau of Economic Research An author of many articles in finance and management journals, Professor Kane’s research is mainly in corporate finance, portfolio management, and capital markets Alan J Marcus Boston College Alan Marcus is Professor of Finance in the Wallace E Carroll School of Management at Boston College He received his PhD from MIT, has been a Visiting Professor at MIT’s Sloan School of Management and Athens Laboratory of Business Administration, and has served as a Research Fellow at the National Bureau of Economic Research, where he participated in both the Pension Economics and the Financial Markets and Monetary Economics Groups Professor Marcus also spent two years at the Federal Home Loan Mortgage Corporation (Freddie Mac), where he helped to develop mortgage pricing and credit risk models Professor Marcus has published widely in the fields of capital markets and portfolio theory He currently serves on the Research Foundation Advisory Board of the CFA Institute vi bod05175_fm_i-xxvi.indd vi 9/3/07 4:09:45 PM ESSENTIALS of INVESTMENTS bod05175_fm_i-xxvi.indd i 9/3/07 4:09:38 PM BRIEF CONTENTS Part ONE 13 ELEMENTS OF INVESTMENTS Investments: Background and Issues Asset Classes and Financial Instruments 24 Securities Markets 55 Mutual Funds and Other Investment Companies 89 Part TWO PORTFOLIO THEORY 115 Risk and Return: Past and Prologue 116 Efficient Diversification 149 Capital Asset Pricing and Arbitrage Pricing Theory 192 The Efficient Market Hypothesis 231 Behavioral Finance and Technical Analysis 262 Part THREE DEBT SECURITIES 10 11 14 Equity Valuation 401 Financial Statement Analysis 442 Part FIVE DERIVATIVE MARKETS 15 16 17 479 Options Markets 480 Option Valuation 517 Futures Markets and Risk Management 552 Part SIX ACTIVE INVESTMENT MANAGEMENT 587 18 19 20 21 Performance Evaluation and Active Portfolio Management 588 Globalization and International Investing 621 Taxes, Inflation, and Investment Strategy 657 Investors and the Investment Process 681 Appendixes 289 Bond Prices and Yields 290 Managing Bond Portfolios 333 A References B References to CFA Questions Index 701 707 I-1 Part FOUR SECURITY ANALYSIS 12 369 Macroeconomic and Industry Analysis 370 vii bod05175_fm_i-xxvi.indd vii 9/3/07 4:09:46 PM CONTENTS Part ONE ELEMENTS OF INVESTMENTS 1 Investments: Background and Issues 1.1 1.2 1.3 Real Assets versus Financial Assets A Taxonomy of Financial Assets Financial Markets and the Economy The Informational Role of Financial Markets Consumption Timing Allocation of Risk Separation of Ownership and Management Corporate Governance and Corporate Ethics 1.4 The Investment Process 1.5 Markets Are Competitive 10 The Risk-Return Trade-Off 10 Efficient Markets 11 1.6 The Players 12 Financial Intermediaries 12 Investment Bankers 14 1.7 Recent Trends 15 Globalization 15 Securitization 16 Financial Engineering 17 Computer Networks 18 1.8 Outline of the Text 19 Summary 20 2.1 Asset Classes and Financial Instruments 24 The Money Market 25 Treasury Bills 25 Certificates of Deposit 27 Commercial Paper 28 Bankers’ Acceptances 28 Eurodollars 28 Repos and Reverses 28 Brokers’ Calls 29 Federal Funds 29 The LIBOR Market 29 Yields on Money Market Instruments 29 2.2 The Bond Market 30 Treasury Notes and Bonds 30 Inflation-Protected Treasury Bonds 31 Federal Agency Debt 32 International Bonds 32 Municipal Bonds 32 Corporate Bonds 35 Mortgages and Mortgage-Backed Securities 2.3 Equity Securities 37 Common Stock as Ownership Shares 37 Characteristics of Common Stock 38 2.9 Stock Market Listings 38 Preferred Stock 39 Depository Receipts 39 2.4 Stock and Bond Market Indexes 40 Stock Market Indexes 40 Dow Jones Averages 40 Standard & Poor’s Indexes 44 Other U.S Market Value Indexes 45 Equally Weighted Indexes 46 Foreign and International Stock Market Indexes 46 Bond Market Indicators 46 2.5 Derivative Markets 46 Options 46 Futures Contracts 50 Summary 51 3.1 Securities Markets 35 55 How Firms Issue Securities 56 Investment Banking 56 Shelf Registration 57 Private Placements 58 Initial Public Offerings 58 viii bod05175_fm_i-xxvi.indd viii 9/3/07 4:09:46 PM I-10 Index M M2 (Modigliani-squared) measure of performance, 591–592 Macaulay, Frederick, 337 Macaulay’s duration, 336–343, 337 MacBeth, James, 209 MacKinlay, Craig, 242 Macroeconomic analysis business cycles, 379–385, 387–388 covariance and correlation, 152–155 demand and supply shocks, 376–377 domestic economy, 373–374 economic derivatives markets, 506–507 federal government policy, 377–379 financial markets and the economy, 6–10 global economy, 371–373 industry analysis business cycle sensitivity, 387–388 cyclical/defensive industries, 379–381, 390 introduction, 385–386 life cycles, 389–392 NAICS codes, 386–387 sector rotation, 388–389 structure and performance, 393 interest rates, 374, 375–378 Magellan Fund, 108–110, 254, 597–599 Magnitude issue, 240 Maintenance margin, 75, 560 Maksimovic, V., 263n Malkiel, Burton G., 106–107, 251–252, 335–336, 341 Malkiel’s bond-pricing relationships, 335–336 Managed investment companies, 90–94 Management, corporate, 7–8 Managers; see Portfolio managers Marcus, Alan J., 597n, 645 Margin, 74 buying securities, 74–77 futures contracts, 553, 560 marking to market, 560–561 options trading, 484–485 short sales, 78 Market capitalization rate, 405 Market conversion value, 294 Market crash of October 1987, 489, 541, 645–647 Market makers, 67 Market newsletters, 241 Market orders, 62 Market portfolios, 194–196, 200 Market price, 404–405 Market price ratios, 454–455 Market risk, 151, 177 Market timing, 101, 608–611 Market-to-book-value ratio, 454 Market-value-weighted indexes, 44–45 Marking to market, 560–561 Markowitz, Harry, 11, 149, 169 Marsh, Paul, 126n, 140–141 Matrimony, bequest, and intergenerational transfers, 677–678 Maturity stage, 391–392 Mayers, David, 197 Mazuy, Kay, 611 McDonald, Ian, 110n McDonald, R L., 543n McGee, Suzanne, 574n McGrattan, E R., 141 bod05175_ndx_I1-I18.indd I-10 McNichols, M., 251 Mean return, 121 Mean-variance analysis, 124, 159–164 Media reports and stock prices, 233–234, 246–247 Meeker, Mary, 421 Memory bias, 264 Mendelson, Haim, 209, 245 Mendenhall, R., 246n5 Mental accounting, 265–266 Merck, 10 Merrill Lynch, 14, 46, 71, 289, 684 Merton, Robert C., 215–216, 245, 526n, 527, 609 Microsoft Corporation, 402–403, 541–542, 695 Milken, Michael, 313 Miller, Bill, 241, 254 Miller, M., 429 Minor trend, 274 Mobil, 316–317 Model risk, 269 Modern portfolio theory, 11, 115 Modified duration, 339 Modigliani, Franco, 429, 591 Modigliani, Leah, 591 Momentum effect, 242 Monetary policy, 377–379 Money managers; see Portfolio managers Money market funds, 95, 136 Money market mutual funds, 135–136 Money markets, 25; see also Treasury bills bankers’ acceptances, 28 brokers’ calls, 29 certificates of deposit, 27, 29–30 commercial paper, 28 Eurodollars, 28 Federal funds, 29 LIBOR market, 29 overview, 5, 25–26 repurchase agreements, 28–29 yields, 29 Moody’s Investor Services, 35, 293, 313–314, 316–317 Moral hazard, 677 Morey, Matthew R., 110 Morgan Stanley, 421, 467, 591 Morgan Stanley Capital International (MSCI), 46–47, 637, 651 Morningstar, 60, 97, 108–110, 151, 596, 599–600 Mortgage-backed securities, 16–17, 35–37 Mortgage bonds, 316 Mortgages, 35–37, 675–676, 683 Mortgage trusts, 93 Mossin, Jan, 193 Motorola, 458 Moving averages, 277–279 MSCI (Morgan Stanley Capital International), 46–47, 637, 651 Multifactor models, 211–216 Multistage growth models, 412–417 Mumenthaler, Christian, 297 Municipal bonds, 32–35 Mutual funds, 685 classes, 98 closed-end, 91–93, 270–271 costs, 97–101 exchange-traded funds, 45, 103–104, 201, 238 global and international, 95, 635, 637 information sources, 107–110 investment policies, 94–96 8/28/07 6:29:25 PM Index Mutual funds—Cont late trading and market timing, 101–102 managers, 251–255, 597, 601–606 money market, 135–136 performance, 104–107, 251–255, 597, 601; see also Performance evaluation players, 13–14 pricing, 90 as professional investors, 685, 690 rates of return and expenses, 99–101 ratings, 110 reforms, 101–102 return requirement and risk tolerance, 690 sales and marketing, 96–97 tax issues, 102–103 Mutual Fund Sourcebook (Morningstar), 97, 108 Mutual fund theorem, 195 Myers, S C., 271n7 N NAFTA (North American Free Trade Agreement), 386n NAICS codes, 386–387 Naik, Narayan, 601 Naked options, 488–489, 494 Nasdaq 100 Index, 45 Nasdaq Composite Index, 45 Nasdaq (National Association of Securities Dealers Automatic Quotation) System, 1, 64 Nasdaq Stock Market, 66–67 National Association of Securities Dealers (NASD), 45, 64, 73, 80, 319 National Market System, 70–71 National Stock Exchange (India), 73 NAV (net asset value), 90 Neff, John, 254 Neglected-firm effect, 245 Neiman Marcus, 386 Net asset value (NAV), 90 New issues, 56–60 Newsletters, market, 241 New York Stock Exchange (NYSE) block transactions, 68–69 bond trading, 71 globalization and consolidation, 73 orders, 62–64, 69, 573 overview, 67–69 program trading, 573 regulatory roles, 80, 82 settlement, 69 specialists, 65–67 stock market indexes, 45 trading costs, 73–74 Nicoliasen, Donald, 49 Nikkei stock index, 40, 46, 485, 635 Nofsinger, John, 268 “Noisy market hypothesis,” 249–250 No-load funds, 98 Nominal interest rate, 132–133, 375–376, 462 Nondiversifiable risk, 151 Non-life-insurance companies, 687 Nonrecurring items, 464 Nonsystematic risk, 151, 177–178 North American Free Trade Agreement (NAFTA), 386n Notional principal, 577 NYSE-Euronext, 68; see also New York Stock Exchange bod05175_ndx_I1-I18.indd I-11 I-11 O O’Connor, Robert, 489 October 1987 market crash, 489, 541, 645–647 Odean, Terrance, 264, 266, 268, 273 Off-balance-sheet assets and liabilities, 464–465 Official Summary of Security Transactions and Holdings (SEC), 82–83, 248 OneChicago, 556 One Up on Wall Street (Lynch), 392, 420 Open-end funds, 91–93, 92, 271n6 Open interest, 559–560 Open IPOs, 60 Operating earnings, 422 Optimal risky portfolios, 164–167, 165, 170–171 Option Clearing Corporation, 484–485 Option elasticity, 538 Optionlike securities callable bonds, 35, 294, 305–306, 500 collateralized loans, 503–504 convertible securities, 500–502 levered equity and risky debt, 504–505, 534 warrants, 503 Options; see also Call options; Put options American, 484 contracts, 46–49, 480–486 digital, 506–507 European, 484, 527, 533, 535–537 exotic, 505–507 foreign currency, 486 foreign security, 635 futures, 485–486 futures investments versus, 50–51, 556 index, 485 interest rate, 486 markets, 482–485 naked, 488–489, 494 Option Clearing Corporation, 484–485 premium, 51, 481 put/call ratio, 281 stock investments versus, 489–492 values at expiration, 486–489 Option smirk, 543 Option strategies collars, 498 covered calls, 494–495 hedging, 521–522 protective puts, 492–494, 539–540 risk management, 492–493 spreads, 497–499 straddles, 494–497 Option valuation binomial pricing, 520–526 Black-Scholes formula empirical evidence, 542–543 hedge ratios and, 537–538 introduction, 526–533 portfolio insurance, 538–542 put-call parity relationship, 533–536 put option valuation, 536–537 at expiration, 486–489 introduction, 517–520 Order types, 62–64 Oriental Land Company, 296 Original issue discount, 311–312 8/28/07 6:29:25 PM I-12 Index Outlook (Standard & Poor’s), 467 Out of the money, 482 Overconfidence, 264 Over-the-counter (OTC) market, 64 P Paine Webber, 421 Palm, 270 Palmon, Dan, 247 Parity, 269–270 Parmalat, Par value, 291 Passive core strategy, 239, 694 Passive investment strategy, 11, 139, 238 active strategy versus, 238–239, 693–694 bond management cash flow matching and dedication, 349–350 immunization, 343–349, 355–357 capital market line and, 139–141 CAPM and, 195 costs, 141, 637 introduction, 333–334 Passive management, 11 Passive strategy, 139–141 Pass-through securities, 16–17, 36 Patel, Jayendu, 233, 253 Pay-in-kind bonds, 296 Peak, 379 P/E effect, 244 PEG ratio, 420 Pension funds, 344, 685–686, 690 P/E (price-earnings) ratio; see Price-earnings (P/E) multiple or ratio Performance evaluation attribution procedures, 601–606, 649–651 Morningstar risk-adjusted ratings, 599–600 risk-adjusted returns changing portfolio composition and, 594–598 choosing measures of, 592–594 comparison groups, 589 M2 measure of performance, 591–592 methodology, 589–591 style analysis, 598–599, 601 Perold, André, 250n6 Personal trusts, 684–685 Pfizer, 10, 44 PIA (Primary Insurance Amount), 672–673 Pierallini, Fabrizio, 574 Pinkerton, John, 233n Pink Sheets LLC, 66–67 Plowback ratio, 410, 454 PNC Financial, 386 Point and figure charts, 275–277 Political risk, 632–634 Political Risk Services (PRS) Group, 632–635 Pontiff, Jeffrey, 92, 270 Porter, Michael, 393 Portfolio beta, 594, 611 Portfolio insurance, 538–542 Portfolio managers; see also Active investment strategy; Performance evaluation EMH and, 239, 240–241 forecasting by, 264, 430–432, 610 performance, 251–255 bod05175_ndx_I1-I18.indd I-12 Portfolio risk; see also Asset allocation; Diversification asset allocation capital allocation line, 137–138 expected return and risk, 136–137 risk-free assets, 135–136 risk tolerance and, 138–139 risky assets, 134–135 comparison groups, 589 historical returns and, 125–131 mutual funds, 105 risk adjustments with changing portfolio composition, 594–598 Sharpe measure, 124, 127–128 Portfolios; see also Two-risky-assets portfolios active, 613 behavioral finance, 268 complete, 134–138, 166–167, 171 definition and overview, factor, 219 hedge ratios, 537–538 levered complete, 138 market, 194–196 momentum effect, 242 monitoring and revising, 695 optimal risky, 164–167, 170–171 optimization, 612–614 risky, 135, 165 well-diversified, 216–218 Portfolio variance, 157–158 Post-earnings-announcement price drift, 246–247 Poterba, James M., 242 Preferred stock, 39, 295, 407, 500–502 Premium, options, 51, 481 Premium bonds, 305 Present value, 337 Present value of an annuity, 298n Present value of futures price, 567 Present value of growth opportunities (PVGO), 411–412 Presidential futures markets, 557 Price-contingent orders, 62–64 Price continuity, 66 Price-earnings (P/E) multiple or ratio, 417, 455 analysis pitfalls, 422–425 DDM combined with, 425 growth opportunities and, 417–421, 425 introduction, 39 of S&P 500 Index, 422 stock risk and, 421–422 Price risk, 345 Price-to-book ratio, 426, 454 Price-to cash flow ratio, 426 Price-to-sales ratio, 426 Price value of a basis point, 576 Price Waterhouse, 49 Price-weighted average, 40–41 Price-weighted average indexes, 45 Primack, Daniel, Primary Insurance Amount (PIA), 672–673 Primary market, 14–15, 56, 61 Primary trend, 274 Principal Financial Group, 56–57 Private placements, 56, 58 Probability distribution, 121 Procter & Gamble, 289 Producer sentiment, 374 8/28/07 6:29:28 PM Index Product competition, 393 Professional investors, 684–686, 692–693 Profitability measures, 313–314, 447–449 Profit margin, 449–451 Pro forma earnings, 422 Program trades and trading, 69, 82, 573 Progressive tax, 664–668, 665 Property and casualty insurance companies, 687, 691 Prospect theory, 266–267 Prospectus, 56 Protective puts, 492–494, 539–540 Proxy contests, PRS (Political Risk Services) Group, 632–635 Prudent investor rule, 684, 688 Public Accounting Oversight Board, 463 Public offerings, 56 Pure yield pickup swap, 354–355 Put bonds, 294 Put-call parity relationship, 533–536, 534 Put/call ratio, 281 Putnam Funds, 95 Put options, 48, 482 overview, 48–49, 482 portfolio insurance, 538–542 protective, 492–494, 539–540 valuation, 536–537 values at expiration, 482, 488–489 PV factor, 299 PVGO (present value of growth opportunities), 411–412 Q Quality of earnings, 464–465 Quantos, 505–507 “Qubes” (QQQ), 103 Quick ratio, 313, 453 Qwest Communications, R Ramsay, Gordon, 601 Random walk, 232–235 Rate anticipation swap, 354 Rates of return, 117–120; see also Returns Ratings agencies, 35, 293, 313–314 Ratio analysis, 456–457 Ratios; see also Financial statement analysis; Price-earnings ratio bond conversion, 294, 501–502 bond safety, 313–315 book-to-market, 245–246 equity valuation, 410, 420, 422, 426, 430–432 liquidity, 453–454 market price, 454–455 option valuation, 522, 524, 526, 537–538, 540 portfolio construction, 614 reward-to-volatility, 124, 137–138 ROE decomposition, 449–451 summary, 456 technical analysis, 281 turnover, 451–453 Rau, P R., 272 Rauh, J., 463 Real assets, 3–5, Real consumption, 660 Real estate investment trusts (REITs), 93 bod05175_ndx_I1-I18.indd I-13 I-13 Real interest rate, 132, 374–376, 660–661 Realized compound return, 307–308 Realized returns, 201–202 Rebalancing, 347–348 Redeemable preferred stock, 39 Redeemable trust certificates, 91 Red herrings, 56 Redington, F M., 344 Refunding, 294 Regional funds, 95 Registered bonds, 293–294 Regression equation, 173 Regression line, 174 Regret avoidance, 266 Regulation accounting, 423, 463–465 of futures markets, 562 of institutional investors, 688–691 of securities markets, 79–83, 248 Reinganum, Marc R., 245 Reinvestment rate risk, 345 Reinvestment rate risk, 308 REITs (real estate investment trusts), 93 Rekenthaler, John, 151 Relative decline stage, 392 Relative strength, 236, 279–280 Renault, E., 533n Rendleman, R J., 246–247 Replacement cost, 403 Replication, 521–522 Repos, 28–29 Representativeness bias, 265 Repurchase agreements, 28–29 Reserve requirement, 378 Reserving practices, 465 Residual claims, 38 Residual income, 458 Residual standard deviation, 202 Resistance levels, 236 Resource allocation and efficient markets, 239–240 Retirement annuity, 659–660 Retirement plans; see Savings and retirement plans; Tax shelters Return on assets (ROA), 313–314, 447–449 Return on equity (ROE), 313–314, 447–451, 454 Return on sales, 449 Return requirement, 682 Returns; see also Historical returns; Performance evaluation; Risk-return trade-off arithmetic average, 118 asset allocation and, 133–139 dollar-weighted, 119 emerging market investments, 638–639 excess, 123, 172–174 expected, 121, 136–137, 196–202 geometric average, 118–119 holding period, 117–118, 310–311, 320 inflation and, 131–133 mean, 121 over long horizons, 242–243 over multiple periods, 117–119 over short horizons, 242 quoting conventions, 119–120 realized, 201–202 realized compound, 307–308 8/28/07 6:29:29 PM I-14 Index Revenue bonds, 32–33 Revenue recognition, 464 Revenue sharing, 97 Reversal effect, 243 Reverse repos, 29 Reversing trade, 559 Reward-to-volatility ratio, 124, 137–138 Rising yield curve, 319 Risk; see also Interest rate risk; Portfolio risk allocation of, arbitrage, 267–269 basis, 565 bonds, 35–36, 293, 308, 312–318, 345 country-specific, 631–635 diversification and, 151, 170–171, 177–180, 211 emerging market investments, 635–639 exchange rate, 626–631, 640–641 risk premiums and, 120–124 stock, 421–422 Risk Adjusted Rating (Morningstar), 599–600 Risk-adjusted returns changing portfolio composition and, 594–598 choosing measures of, 592–594 comparison groups, 589 EMH and, 243–244 M2 measure of performance, 591–592 methodology, 589–591 Morningstar ratings, 599–600 style analysis, 598–599, 601 Risk aversion, 123, 682 diversification and, 161, 166–168, 171 in individual investors, 682–685 market portfolio and, 193–196 questionnaire for, 684–685 risk premiums and, 123–124, 196 risk tolerance compared, 138n Risk-free assets, 135–136, 164–167 Risk-free interest rate, 522 Risk-free rate of return, 123 Risk management, 492–493 Risk Management Association, 457 Risk premium, 123 of individual securities, 196–198 inefficiencies versus, 248–249 of market portfolio, 194, 196 risk and, 120–124 wealth index and, 129 Risk-return trade-off, 10–11 asset allocation and portfolio risk, 133–139 historical returns, 125–131 inflation and real rates of return, 131–133 passive strategies and capital market line, 139–141 rates of return, 117–120 risk and risk premiums, 120–124 two-risky-assets portfolios, 157–159 Risk tolerance, 682 asset allocation and, 138–139 in individual investors, 682–685 questionnaire for, 684–685 risk aversion and, 138n risk premiums and, 123–124, 196 Risky assets, 134–135, 168–171 Risky debt, 504–505 Rite Aid, Ritter, Jay R., 59n, 60n, 243, 265 bod05175_ndx_I1-I18.indd I-14 Road shows, 58 ROA (return on assets), 313–314, 447–449 Roberts, Harry, 281–282 ROE (return on equity), 313–314, 447–451, 454 Roge, 684 Roll, Richard, 209, 215–216, 645–647 Roll’s critique, 209 Ross, Stephen A., 215–216, 255, 270, 314n, 526n Roth, Brane v., 492–493 Roth IRAs, 667–668 Royal Dutch Shell, 269–270, 458 Rubinstein, Mark, 542–543 Rydqvist, K., 59n S Saitori, 72 Salomon Smith Barney, 46, 71 Sample size neglect, 265 Samuelson, Paul, 254, 432 Samurai bonds, 32, 295 Sanford Bernstein & Co., 61, 357 Sarbanes-Oxley Act, 9, 80–81 Savings and retirement plans; see also Tax shelters accounting for inflation, 660–662 children’s education, 674–675 home ownership, 675–676 household savings, 3–4, 12–13, 375, 658–660, 670–671 large purchases, 674–675 longevity and other uncertainties, 676–677 matrimony, bequest, and intergenerational transfers, 677–678 sheltered versus unsheltered, 670–671 Social Security, 671–674 tax planning, 662–664 Scenario analysis, 121 Schatsky, 684 Scherbina, A., 141 Schleifer, A., 267n Scholes, Myron, 209, 527 Schroders, 201 SCL (security characteristic line), 174, 203 Scudder Kemper Investments Inc., 684 Seasoned equity offerings, 56 Secondary market, 14, 56 Secondary trend, 274 SEC (Securities and Exchange Commission) accounting requirements, 423, 465 EDGAR database, 402 insider trading and, 82–83, 234–236, 248 National Market System, 70–71 new issues and, 56 regulatory roles, 79–83, 248 Sector funds, 95 Sector rotation, 388–389 Sector selection decisions, 603–604 Securities Act of 1933, 79–80 Securities and Exchange Commission; see SEC Securities Exchange Act of 1934, 79–80 Securities Investor Protection Corporation (SIPC), 80 Securities markets; see also specific topic, e.g., options 2003 returns, 627 bonds; see Bond market buying on margin, 74–77 derivatives, 46–51, 479–480, 506–507 forecasting, 264, 430–432, 610 futures; see Futures markets 8/28/07 6:29:30 PM Index Securities markets; see also specific topic, e.g., options—Cont globalization and consolidation, 15–16, 72–73 international, 71–73 money market; see Money markets options, 482–485 primary, 14–15, 56–61 regulation, 79–83, 248 secondary, 14, 56 short sales, 77–79 stocks; see Stock markets trading, 60–66 trading costs, 73–74 trends and corrections, 273–280 types, 61–62 U.S., 66–71 Securitization, 16–17 Security analysis, 10; see also Equity valuation; Financial statement analysis; Macroeconomic analysis Security Analysis (Graham and Dodd), 466–467 Security characteristic line (SCL), 174, 203 Security market line (SML), 198 Security selection, 10, 24, 603–604 Selection bias issue, 240 Self-destructing price patterns, 237 Self-regulatory organizations (SROs), 80 Semistrong-form EMH, 235, 243–247 Senior debt, 316 Sentiment, consumer and producer, 374 Separation property, 171 Serial bonds, 316 Serial correlation, 242 Settlement date, 69, 301 Seyhun, H Nejat, 247–248 Shanken, Jay, 246n4 Shareholders, 7–8, 37–39 Shareholders’ equity, 444 Sharpe, William F., 11, 137, 171, 192–193, 209, 589, 598–600 Sharpe measure, 124, 127–128, 137, 590–591, 608 Shefrin, Hersh, 266 Shelf registration, 57–58 Shell, Shell Transport, 269–270 Shiller, Robert, 243, 272 Shleifer, Andrei, 248, 270 Short hedge, 564 Short interest, 280 Short positions, 554 Short sales, 63, 77–79 Shumway, Tyler, 266 “Siamese Twin” companies, 269–270 Singer, Brian, 598n Single-factor asset market, 171–178 Single-index model, 172–175 Single stock futures, 556 Sinking funds, 315–316 Sinquefield, Rex, 244n SIPC (Securities Investor Protection Corporation), 80 Sloan, Richard G., 246n4 Small-firm effect, 244–245 Smith, Randall, 61n SML (security market line), 198 Social Security, 671–674 Society of the Financial Analysts Federation, 683 Soft dollars, 100–102 Solnik, B., 627, 644n, 645 bod05175_ndx_I1-I18.indd I-15 I-15 Sotheby’s, 421 Sougiannis, Theodore, 463 Specialists, 65–67 Speculating with derivatives, 6, 49 with futures, 563–566 with hedge funds, 93–94 risk premiums and, 123 Speculative grade bonds, 313–314 Speidell, Lawrence S., 465–466 Sperling, Gene, 384n “Spiders” (SPDRs), 103 “Spinning,” 59 Spitzer, Eliot, 82 Spivack, Avia, 677 Spot-futures parity theorem, 566–570, 568–569 Spread, bid-asked, 27, 62, 73–74 Spreads, 497–499, 566, 570–571 SROs (self-regulatory organizations), 80 Stahlman, Mark, 421 Stambaugh, Robert F., 243, 245 Standard deviation, 122, 127, 593 Standard & Poor’s 100 Index, 485, 489 Standard & Poor’s 500 Index dividend yield, 669 earnings per share versus, 373 financial futures trading, 562, 571–572 global lack of diversification, 621–622 historical returns, 10, 610 index funds, 44–45, 96, 139–140, 238, 694 valuation ratios, 422, 426, 430–432 Standard & Poor’s Corporation credit ratings, 35, 293, 313–314 earnings estimates, 463 indexes, 44–45 industry classifications, 387 as information source, 402, 457, 467 Start-up stage, 391 Statement of cash flows, 445–446 Statman, Meir, 151n, 265–266, 268 Staunton, Mike, 126n, 140–141 Stern Stewart, 458 Stiglitz, Joseph E., 234, 605n Stock exchanges, 67–69; see also specific exchange Stockholders, 7–8, 37–39 Stockholders’ equity, 444 Stock index futures, 571–572 Stock market analysts, 250–251 Stock market forecasting, 264, 430–432, 610 Stock market indexes; see also Standard & Poor’s 500 Index calculating yields, 31 Dow Jones, 40–45, 82, 485 equally-weighted, 46 foreign and international, 46 market-value-weighted, 44–45 Nasdaq, 45 Standard & Poor’s, generally, 44–45 Standard & Poor’s 100 Index, 485, 489 value-weighted, 44–45 Wilshire 5000 Index, 45, 105–106, 238 Stock markets ECNs, 64–65, 70, 73 exchanges, 67–69 mechanisms, 64–66 8/28/07 6:29:31 PM I-16 Index Stock markets—Cont Nasdaq, 66–67 National Market System, 70–71 new issues, 14–15, 56–61 order types, 62–64 types, 61–62 Stock options, employee, 464 Stock prices; see also Equity valuation; Financial statement analysis; Industry analysis earnings announcements and, 233–234, 246–247 investment opportunities and, 409–412 Stock risk, 421–422; see also Beta Stocks ADRs, 15, 39, 414n, 635, 637 common, 37–39 dividends, 293n, 316, 518n historical returns, 10, 121, 125–131, 252 newspaper listings, 38–39 option investments versus, 489–492 preferred, 39, 295, 407, 500–502 synthetic positions, 572–573 value, 108, 466–467 Stock selection, 651–652 Stop-buy orders, 63 Stop-loss orders, 63 Stop orders, 63 Stovall, Sam, 390n Straddles, 494–497 Straight bonds, 500 Strebel, Paul J., 245 Street name, 69 Strike price, 46, 481, 483 STRIPS (Separate Trading of Registered Interest and Principal of Securities), 311–312 Strong-form EMH, 235, 247–248 Stub value, 270 Stulz, R., 263n Style analysis, 598–599, 601 Subordination clauses, 316 Substitution swap, 354 Summers, Lawrence H., 242, 267n, 677–678 Sunbeam, 464 Sun Trust, 386 SuperDot system, 69, 573 Suppliers, bargaining power of, 393 Supply shock, 376–377 Support levels, 236 Survivorship bias, 254–255 Swaps, 354–355, 577–579 Swiss Re, 297 Synthetic protective puts, 539–540 Synthetic stock positions, 572–573 Systematic risk, 151, 177–178, 211 T T Rowe Price Associates, Inc., 684 T2(Treynor-Square) measure of performance, 593–594 Targeted-maturity funds, 95 Taxes accounting for, 662–664 capital gains, 32–33, 102–103, 669–670 equivalent taxable yield, 33–35 flat, 662, 665 futures contracts, 562 investment decisions and, 689 mutual fund income, 102–103 bod05175_ndx_I1-I18.indd I-16 Taxes—Cont original-issue discount bonds, 312 progressive, 665–668 Tax shelters, 664 401k and 403b plans, 668–669 benchmark, 664 IRAs, 667–668 risky investments and capital gains, 669–670 sheltered versus unsheltered, 670–671 tax code effects, 664–666 Tax swaps, 355 Tax-timing option, 669 T-bills; see Treasury bills Technical analysis, 235–237 behavioral finance and, 273 breadth, 279 confidence index, 280 Dow theory, 274–275 Elliott wave theory, 275 fundamental analysis compared, 243, 401–402 Kondratieff waves, 275 moving averages, 277–279 point and figure charts, 275–277 put/call ratio, 281 relative strength, 279–280 short interest, 280 trin statistic, 280 warning, 281–282 Templeton, John, 254 Templeton Funds, 254 Term insurance, 686 Term premium, 215 Term repos, 29 Term structure of interest rates, 318–319 Tertiary trend, 274 Thaler, Richard H., 242, 243, 263n, 264, 266, 269n, 270, 272 Thayer, Peter, 489 Thomas, J., 246n5 Thompson, Rex, 92 3Com, 270 Times-interest-earned ratio, 313, 450 Time value of options, 518 Time-weighted average return, 118–119 Timmerman, A., 254 TIPS (Treasury Inflation-Protected Securities), 31–32, 296–298 Titman, Sheridan, 242 Tobin, James, 171, 404 Tobin’s q, 404 Tokyo Disneyland, 296 Tokyo Stock Exchange, 72, 73 Tombstones, 56–57 Total asset turnover (ATO), 449 Toyota, 3, 239, 354 TRACE (Trade Reporting and Compliance Engine) system, 319 Trade-through rule, 70–71 Trading costs, 73–74 Trading halts, 82 Trading mechanisms, 64–66 Traditional IRAs, 667 Trainer, Francis, 357 Treasury bills, 25–27 historical returns, 10, 125–131 pricing and yields, 27, 29–30, 311–312 as risk-free assets, 123, 135–136 Treasury Inflation Protected Securities (TIPS), 31–32, 296–298 8/28/07 6:29:32 PM Index Treasury notes and bonds, 30–31 characteristics, 291–293 historical returns, 125–131 interest rate futures, 574–576 zero-coupon, 311–312 Treasury STRIPS, 311–312 Treynor, Jack, 193, 589, 611 Treynor-Black Model, 611–614, 612 Treynor measure, 591 Treynor-Square (T2) measure, 593–594 Trin statistic, 280 Trough, 379 Trueman, B., 251 Trusts and trustees, 684–685 TSX index, 46 Turnover, 102, 449–453 Tversky, A., 264, 266n 12b-1 fees, 98 $20 bill story, 255 Two-risky-assets portfolios covariance and correlation, 152–155 historical data and, 155–157 mean-variance criterion, 159–164 risk-return trade-offs, 157–159 three rules, 157 Two-stage DDM, 414 Two-state option pricing, 520–526 U UBS Index of Investor Optimism, 268 Unbundling, 17–18 Underwriters, 56–57 Unemployment rate, 374, 506–507 Uniform Securities Act, 80 Unique risk, 151, 177 U.S Department of Commerce, 457 U.S government agency debt, 32, 295 U.S securities markets, 66–71 U.S Treasury Bills; see Treasury bills Unit investment trusts, 91 Universal life policies, 686 Unmanaged trusts, 91 Unsecured bonds, 316 V VA Linux, 58–59 Valuation ratios, 426; see also Equity valuation; Price-earnings ratios Value Line Investment Survey, 110, 387, 412–417, 428–429, 467 Value stocks and investing, 108, 466–467 Value-weighted indexes, 44–45 VanderHoff, Frank, 489 Vanguard Funds, 95–96, 99, 105, 134, 238, 254, 635, 647 Vanguard Group, 684, 693–694 Variable life policies, 686 Variance, 121–122 Vassalou, M., 249n Verizon, 44 Viacom, Vishny, R., 248, 267n Vivendi Universal, Volatility value of options, 518–520 Vonage, 59 Vontobel Ltd., 574 Voting/nonvoting stocks, 37n, 295 Vuolteenaho, Tuomo, 210 bod05175_ndx_I1-I18.indd I-17 I-17 W W R Grace, 464 W R Hambrecht & Co., 60–61 Wage insurance, 677 Waldmann, R., 267n Wallace, A., 209 Wal-Mart, 458 Walt Disney Corporation, 296 Wang, Zhenyu, 210 Warrants, 503 Watson Wyatt, 201 Weak-form EMH, 235, 242–243 Wealth and risk premium, 129 WEBS (World Equity Benchmark Shares), 15, 103, 637 Weinberger, Alfred, 355 Well-diversified portfolios, 216–218 Wermers, R., 254 Westerfield, Randolph W., 314n Weyns, Guy, 467 Whaley, Robert E., 542 White, A., 533n White, H., 254 Whole-life insurance policies, 686 Wiesenberger, 97, 108 Wiggins, J B., 533n Wilhelm, William, 59n Wilshire 5000 Index, 45, 105–106, 238 Winterthur, 296 Wolfers, J., 506n Wolfson, M A., 233 Womack, K L., 251 Workout period, 354 WorldCom, 9, 423 World Equity Benchmark Shares (WEBS), 15, 103, 637 Writing calls, 481, 487, 494–495 Writing puts, 482, 488 Y Yahoo!, 7, 108, 457 Yankee bonds, 32, 295 Yield bank discount method, 27 bond-equivalent, 27, 303 current, 304 effective annual, 303 equivalent taxable, 33–34 on money market instruments, 29 Yield curve, 318–324 Yield to call, 305–306 Yield to maturity, 303 default risk and, 316–318 holding period return versus, 310–311 overview, 303–305 realized compound return versus, 307–308 Z Zeckhauser, Richard, 253 Zero-beta portfolios, 217–218 Zero-coupon bonds, 291, 311–312 Zero sum game, 554 Ziemba, W T., 263n Zurich Financial Services, 297 Zurich Group Inc., 684 8/28/07 6:29:32 PM bod05175_ndx_I1-I18.indd I-18 8/28/07 6:29:33 PM Digital Classroom Solutions Commonly Used Notation Are you looking for a way to spend less time grading and have more flexibility with the problems you assign? ® ™ Try McGraw-Hill’s Homework Manager or Homework Manager Plus for an answer to your classroom needs This Web-based tool for instructors and students delivers and grades end-of-chapter problems and tests, and provides a limitless supply of self-graded practice for students b Retention or plowback ratio C Call option value CF Select end-of-chapter questions are loaded into the program, instructors select the assignments and set the parameters, and students complete the assignments—which are auto-graded and imported back into the instructor’s grade book Algorithmic versions of the problems are also available as well as the Test Bank for additional practice or use as a test /quiz Duration E Exchange rate Futures price e 2.718, the base for the natural logarithm, used for continuous compounding STOCK-TRAK Portfolio Simulations STOCK-TRAK is the most comprehensive online trading simulation featuring stocks, bonds, mutual funds, options, futures, spots, future options, and international stocks, created specifically for classroom use Students receive $500,000 of hypothetical money in a STOCK-TRAK brokerage account with 24/7 access as well as full tech support, if needed No other simulation can offer all of these features! You customize STOCK-TRAK to fit your class by choosing the starting and ending date of their trading period, initial cash balance, and diversification requirements You also have 24/7 access to your students’ ranking and account detail so you can see student progress, and you receive weekly reports of class performance STOCK-TRAK can be used as homework, end-of-course project, class contest, extra credit, or just as a discussion starter in class! ROE Sp t The risk-free rate of interest The rate of return on the market portfolio Return on equity, incremental economic earnings per dollar reinvested in the firm Reward-to-volatility ratio of a portfolio, also called Sharpe’s measure; the excess expected return divided by the standard deviation Time The firm-specific return, also called the residual return, of security i in period t Tp Treynor’s measure for a portfolio, excess expected return divided by beta f Forward rate of interest V g Growth rate of dividends Intrinsic value of a firm, the present value of future dividends per share H Hedge ratio for an option, sometimes called the option’s delta X Exercise price of an option y Yield to maturity ␣ Rate of return beyond the value that would be forecast from the market’s return and the systematic risk of the security ␤ Systematic or market risk of a security For a complete description of these exciting assets, please refer to the Packaging Options section listed in the Preface of this book Give your students a practical application that will last them a lifetime by subscribing to Expected value of random variable x F ei t Are you looking for a way to get your students involved in real-world investing? rM Cash flow D E(x) rf i Inflation rate k Market capitalization rate, the required rate of return on a firm’s stock ln Natural logarithm function M The market portfolio ␳i j Cumulative normal function, the probability that a standard normal random variable will have value less than d Correlation coefficient between returns on securities i and j ␴ Standard deviation N(d) p Probability P Put value PV Present value P/E Price-to-earnings multiple r ␴ Cov(ri , rj) Variance Covariance between returns on securities i and j Rate of return on a security; for fixed-income securities, r may denote the rate of interest for a particular period By entering the Promotional code BK0707 students who sign up using the Bodie/Kane/Marcus text will receive $5.00 off the purchase price of STOCK-TRAK Check out the website at www.stocktrak.com for current pricing, a demo of the product, and more ideas on how to use this simulation in class bod05175_fnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:22:49 AM Front endsheets Color: 2, PMS 539M and PMS139 Pages: 2,3 Digital Classroom Solutions Commonly Used Notation Are you looking for a way to spend less time grading and have more flexibility with the problems you assign? ® ™ Try McGraw-Hill’s Homework Manager or Homework Manager Plus for an answer to your classroom needs This Web-based tool for instructors and students delivers and grades end-of-chapter problems and tests, and provides a limitless supply of self-graded practice for students b Retention or plowback ratio C Call option value CF Select end-of-chapter questions are loaded into the program, instructors select the assignments and set the parameters, and students complete the assignments—which are auto-graded and imported back into the instructor’s grade book Algorithmic versions of the problems are also available as well as the Test Bank for additional practice or use as a test /quiz Duration E Exchange rate Futures price e 2.718, the base for the natural logarithm, used for continuous compounding STOCK-TRAK Portfolio Simulations STOCK-TRAK is the most comprehensive online trading simulation featuring stocks, bonds, mutual funds, options, futures, spots, future options, and international stocks, created specifically for classroom use Students receive $500,000 of hypothetical money in a STOCK-TRAK brokerage account with 24/7 access as well as full tech support, if needed No other simulation can offer all of these features! You customize STOCK-TRAK to fit your class by choosing the starting and ending date of their trading period, initial cash balance, and diversification requirements You also have 24/7 access to your students’ ranking and account detail so you can see student progress, and you receive weekly reports of class performance STOCK-TRAK can be used as homework, end-of-course project, class contest, extra credit, or just as a discussion starter in class! ROE Sp t The risk-free rate of interest The rate of return on the market portfolio Return on equity, incremental economic earnings per dollar reinvested in the firm Reward-to-volatility ratio of a portfolio, also called Sharpe’s measure; the excess expected return divided by the standard deviation Time The firm-specific return, also called the residual return, of security i in period t Tp Treynor’s measure for a portfolio, excess expected return divided by beta f Forward rate of interest V g Growth rate of dividends Intrinsic value of a firm, the present value of future dividends per share H Hedge ratio for an option, sometimes called the option’s delta X Exercise price of an option y Yield to maturity ␣ Rate of return beyond the value that would be forecast from the market’s return and the systematic risk of the security ␤ Systematic or market risk of a security For a complete description of these exciting assets, please refer to the Packaging Options section listed in the Preface of this book Give your students a practical application that will last them a lifetime by subscribing to Expected value of random variable x F ei t Are you looking for a way to get your students involved in real-world investing? rM Cash flow D E(x) rf i Inflation rate k Market capitalization rate, the required rate of return on a firm’s stock ln Natural logarithm function M The market portfolio ␳i j Cumulative normal function, the probability that a standard normal random variable will have value less than d Correlation coefficient between returns on securities i and j ␴ Standard deviation N(d) p Probability P Put value PV Present value P/E Price-to-earnings multiple r ␴ Cov(ri , rj) Variance Covariance between returns on securities i and j Rate of return on a security; for fixed-income securities, r may denote the rate of interest for a particular period By entering the Promotional code BK0707 students who sign up using the Bodie/Kane/Marcus text will receive $5.00 off the purchase price of STOCK-TRAK Check out the website at www.stocktrak.com for current pricing, a demo of the product, and more ideas on how to use this simulation in class bod05175_fnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:22:49 AM Front endsheets Color: 2, PMS 539M and PMS139 Pages: 2,3 Useful Web Sites General business and finance information www.dowjones.com www.economist.com www.wsj.com www.ft.com www.businessweek.com www.euromoney.com www.forbes.com money.cnn.com/magazines/fortune The Economist The Wall Street Journal The Financial Times BusinessWeek Sources of data on individual companies and industries www.mhhe.com/edumarketinsight Available to users of this text with purchase of a new book, a source of extensive financial statement data as well as stock price histories www.bloomberg.com finance.yahoo.com Stock price and company information money.cnn.com www.hoovers.com www.annualreports.com Annual reports www.sec.gov Annual reports and other financial statements from the EDGAR database Macroeconomic data www.bea.gov www.federalreserve.gov www.fms.treas.gov stats.bls.gov Bureau of Economic Analysis Board of Governors of the Federal Reserve System Links to publications of the Treasury Department Bureau of Labor Statistics Sites with links to other resources www.financewise.com www.investorlinks.com www.finpipe.com www.corpfinet.com www.ceoexpress.com www.cob.ohio-state.edu/fin/journal/jofsites.htm (site maintained by Ohio State University College of Business) bod05175_fnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:22:49 AM Front endsheets Color: 2, PMS 539M and PMS139 Pages: Useful Formulas Equity Analysis Constant growth dividend discount model: Sustainable growth rate of dividends: Measures of Risk ∑ p(s)[r(s) Ϫ E(r)]2 Variance of returns: ␴2 ϭ ␴ϭ Standard deviation: ␤i ϭ ∑ p(s)[ri(s) Ϫ E(ri)] [rj (s) Ϫ E(rj)] Cov(ri , rM) Var (rM) g ϭ ROE ϫ b 1Ϫ b k Ϫ ROE ϫ b Debt   ROE ϭ (1 Ϫ Tax rate)  ROA ϩ (ROA Ϫ Interest rate ) Equity   Derivative Assets Put-call parity: E(rp) ϭ Variance of portfolio rate of return: ␴ 2p ϭ ∑ Spot-futures parity: F0 ϭ S0(1 ϩ r Ϫ d )T Interest rate parity:  ϩ rUS  F0 ϭ E0    ϩ rforeign  Market Equilibrium E(ri) ϭ rf ϩ ␤i[E(rM) Ϫ rf] Fixed-Income Analysis ln (S /X ) ϩ (r Ϫ ␦ ϩ ␴ /22 )T ␴ T d2 ϭ d1 Ϫ ␴ T n ∑ ∑ wj wi Cov(ri, rj) j ϭ1 i ϭ1 C ϭ SeϪ␦T N (d1 ) Ϫ XeϪrT N (d2 ) d1 ϭ wi E(ri) i ϭ1 n P ϭ C Ϫ S0 ϩ PV(X ϩ dividends) Black-Scholes formula: n Expected rate of return on a portfolio with weights wi in each security: T Performance Evaluation Present value of $1: Discrete period compounding: Continuous compounding: r ϭ Sharpe’s measure: Sp ϭ Treynor’s measure: Tp ϭ PV ϭ 1/(1 ϩ r)T PV ϭ eϪrT Forward rate of interest for period T: Real interest rate: D1 kϪg s Portfolio Theory The security market line: P /E ϭ ␴2 Covariance between returns: Cov(ri , rj) ϭ Beta of security i: Price/earnings multiple: s V0 ϭ fT ϭ (1 ϩ yT )T Ϫ1 (1 ϩ yT Ϫ1 )T Ϫ1 1ϩ R Ϫ1 1ϩi rp Ϫ rf ␴p rP Ϫ rf ␤p Jensen’s measure, or alpha: ␣p ϭ rp Ϫ [rf ϩ ␤p(rM Ϫ rf)] Geometric average return: rG ϭ [(1 ϩ r1)(1 ϩ r2) (1 ϩ rT)]1/T Ϫ where R is the nominal interest rate and i is the inflation rate T Duration of a security: D ϭ CF ∑ t ϫ (1 ϩ ty)t /Price t ϭ1 Modified duration: D* ϭ D/(1 ϩ y) bod05175_bnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:25:13 AM Back endsheets Color: PMS 539M and PMS139 Pages: 6,7 Useful Formulas Equity Analysis Constant growth dividend discount model: Sustainable growth rate of dividends: Measures of Risk ∑ p(s)[r(s) Ϫ E(r)]2 Variance of returns: ␴2 ϭ ␴ϭ Standard deviation: ␤i ϭ ∑ p(s)[ri(s) Ϫ E(ri)] [rj (s) Ϫ E(rj)] Cov(ri , rM) Var (rM) g ϭ ROE ϫ b 1Ϫ b k Ϫ ROE ϫ b Debt   ROE ϭ (1 Ϫ Tax rate)  ROA ϩ (ROA Ϫ Interest rate ) Equity   Derivative Assets Put-call parity: E(rp) ϭ Variance of portfolio rate of return: ␴ 2p ϭ ∑ Spot-futures parity: F0 ϭ S0(1 ϩ r Ϫ d )T Interest rate parity:  ϩ rUS  F0 ϭ E0    ϩ rforeign  Market Equilibrium E(ri) ϭ rf ϩ ␤i[E(rM) Ϫ rf] Fixed-Income Analysis ln (S /X ) ϩ (r Ϫ ␦ ϩ ␴ /22 )T ␴ T d2 ϭ d1 Ϫ ␴ T n ∑ ∑ wj wi Cov(ri, rj) j ϭ1 i ϭ1 C ϭ SeϪ␦T N (d1 ) Ϫ XeϪrT N (d2 ) d1 ϭ wi E(ri) i ϭ1 n P ϭ C Ϫ S0 ϩ PV(X ϩ dividends) Black-Scholes formula: n Expected rate of return on a portfolio with weights wi in each security: T Performance Evaluation Present value of $1: Discrete period compounding: Continuous compounding: r ϭ Sharpe’s measure: Sp ϭ Treynor’s measure: Tp ϭ PV ϭ 1/(1 ϩ r)T PV ϭ eϪrT Forward rate of interest for period T: Real interest rate: D1 kϪg s Portfolio Theory The security market line: P /E ϭ ␴2 Covariance between returns: Cov(ri , rj) ϭ Beta of security i: Price/earnings multiple: s V0 ϭ fT ϭ (1 ϩ yT )T Ϫ1 (1 ϩ yT Ϫ1 )T Ϫ1 1ϩ R Ϫ1 1ϩi rp Ϫ rf ␴p rP Ϫ rf ␤p Jensen’s measure, or alpha: ␣p ϭ rp Ϫ [rf ϩ ␤p(rM Ϫ rf)] Geometric average return: rG ϭ [(1 ϩ r1)(1 ϩ r2) (1 ϩ rT)]1/T Ϫ where R is the nominal interest rate and i is the inflation rate T Duration of a security: D ϭ CF ∑ t ϫ (1 ϩ ty)t /Price t ϭ1 Modified duration: D* ϭ D/(1 ϩ y) bod05175_bnshts.indd ISBN: 0073405175 Author: Zvi Bodie Title: Essentials of Investments, 7/e 8/13/07 9:25:13 AM Back endsheets Color: PMS 539M and PMS139 Pages: 6,7 ... across broad asset classes security selection Choice of specific securities within each asset class security analysis Analysis of the value of securities Elements of Investments 1.5 MARKETS ARE... Elements of Investments TABLE 1.4 Balance sheet of nonfinancial U .S business Assets $ Billion Real assets Equipment and software Real estate Inventories Total real assets Financial assets Deposits... agreements Other Total liabilities Financial assets Cash Investment securities Loans and Leases Other financial assets Total financial assets Other assets Intangible assets Other Total other assets