Frank reilly s investment analysis and portfolio management (10th edition)

WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Investment Analysis & Portfolio Management TENTH EDITION FRANK K REILLY University of Notre Dame KEITH C BROWN University of Texas at Austin Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM This is an electronic version of the print textbook Due to electronic rights restrictions, some third party content may be suppressed Editorial review has deemed that any suppressed content does not materially affect the overall learning experience The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Investment Analysis & Portfolio Management, Tenth Edition Frank K Reilly and Keith C Brown Vice President of Editorial, Business: Jack W Calhoun Editor-in-Chief: Joe Sabatino Executive Editor: Mike Reynolds © 2012, 2009 South-Western, Cengage Learning ALL RIGHTS RESERVED No part of this work covered by the copyright herein may be reproduced, transmitted, stored, or used in any form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, web distribution, information networks, or information storage and retrieval systems, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the publisher Development Editor: Margaret Kubale For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706 Sr Editorial Assistant: Adele Scholtz Marketing Manager: Nathan Anderson 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Edition Package ISBN 10: 0-538-48238-9 Student Edition ISBN 13: 978-0-538-48210-3 Student Edition ISBN 10: 0-538-48210-9 South-Western Cengage Learning 5191 Natorp Boulevard Mason, OH 45040 USA Cengage Learning products are represented in Canada by Nelson Education, Ltd For your course and learning solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.cengagebrain.com Printed in the United States of America 15 14 13 12 11 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM To my best friend & wife, Therese, and the greatest gifts and sources of our happiness, Frank K III, Charlotte, and Lauren Clarence R II, Michelle, Sophie, and Cara Therese B and Denise Z Edgar B., Lisa, Kayleigh, Madison J T., Francesca, and Alessandra —F K R To Sheryl, Alexander, and Andrew, who make it all worthwhile —K C B WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Brief Contents Preface xiii Acknowledgments xvii About the Authors xxi PART 1 CHAPTER The Investment Setting CHAPTER The Asset Allocation Decision CHAPTER Selecting Investments in a Global Market 63 CHAPTER Organization and Functioning of Securities Markets 95 CHAPTER Security-Market Indexes PART 33 123 Efficient Capital Markets 149 CHAPTER An Introduction to Portfolio Management CHAPTER An Introduction to Asset Pricing Models CHAPTER Multifactor Models of Risk and Return 10 Analysis of Financial Statements 271 CHAPTER 11 An Introduction to Security Valuation 181 207 241 269 Valuation Principles and Practices CHAPTER PART 147 Developments in Investment Theory CHAPTER PART 327 Analysis and Management of Common Stocks 365 CHAPTER 12 Macroanalysis and Microvaluation of the Stock Market 367 CHAPTER 13 Industry Analysis CHAPTER 14 Company Analysis and Stock Valuation CHAPTER 15 Technical Analysis CHAPTER 16 Equity Portfolio Management Strategies 549 PART iv The Investment Background 413 459 525 Analysis and Management of Bonds CHAPTER 17 Bond Fundamentals CHAPTER 18 The Analysis and Valuation of Bonds CHAPTER 19 Bond Portfolio Management Strategies 591 623 691 589 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Brief Contents PART Derivative Security Analysis 739 CHAPTER 20 An Introduction to Derivative Markets and Securities CHAPTER 21 Forward and Futures Contracts CHAPTER 22 Option Contracts CHAPTER 23 Swap Contracts, Convertible Securities, and Other Embedded Derivatives 867 PART Specification and Evaluation of Asset Management 741 781 821 909 CHAPTER 24 Professional Money Management, Alternative Assets, and Industry Ethics 911 CHAPTER 25 Evaluation of Portfolio Performance Appendixes A-D 1009 Comprehensive References List Glossary 1032 Index 1045 1017 959 v WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Contents Preface xiii Acknowledgments xvii About the Authors xxi PART The Investment Background CHAPTER The Investment Setting What Is an Investment? Investment Defined Measures of Return and Risk Measures of Historical Rates of Return 5, Computing Mean Historical Returns 7, Calculating Expected Rates of Return 9, Measuring the Risk of Expected Rates of Return 12, Risk Measures for Historical Returns 14 Determinants of Required Rates of Return 14 The Real Risk-Free Rate 15, Factors Influencing the Nominal Risk-Free Rate (NRFR) 15, Risk Premium 17, Risk Premium and Portfolio Theory 20, Fundamental Risk versus Systematic Risk 20, Summary of Required Rate of Return 20 The Importance of Asset Allocation 49 Investment Returns after Taxes and Inflation 51, Returns and Risks of Different Asset Classes 52, Asset Allocation Summary 53 Chapter Appendix: Objectives and Constraints of Institutional Investors 58 CHAPTER Selecting Investments in a Global Market 63 The Case for Global Investments 64 Relative Size of U.S Financial Markets 65, Rates of Return on U.S and Foreign Securities 66, Risk of Combined Country Investments 66 Global Investment Choices 71 Fixed-Income Investments 72, International Bond Investing 75, Equity Instruments 76, Special Equity Instruments: Options 78, Futures Contracts 78, Investment Companies 79, Real Estate 81, Low-Liquidity Investments 82 Historical Risk-Returns on Alternative Investments 83 World Portfolio Performance 83, Art and Antiques 87, Real Estate 87 Relationship between Risk and Return 21 Movements along the SML 22, Changes in the Slope of the SML 22, Changes in Capital Market Conditions or Expected Inflation 24, Summary of Changes in the Required Rate of Return 24 CHAPTER Chapter Appendix: Computation of Variance and Standard Deviation 30 Organization and Functioning of Securities Markets 95 CHAPTER The Asset Allocation Decision 33 Individual Investor Life Cycle 34 The Preliminaries 34, Investment Strategies over an Investor’s Lifetime 35, Life Cycle Investment Goals 37 The Portfolio Management Process 37 The Need for a Policy Statement 38 Understand and Articulate Realistic Investor Goals 38, Standards for Evaluating Portfolio Performance 39, Other Benefits 40 Input to the Policy Statement 41 Investment Objectives 41, Investment Constraints 45 Constructing the Policy Statement 49 General Guidelines 49, Some Common Mistakes 49 vi Chapter Appendix: Covariance 93 What Is a Market? 96 Characteristics of a Good Market 96, Decimal Pricing 97, Organization of the Securities Market 98 Primary Capital Markets 98 Government Bond Issues 98, Municipal Bond Issues 98, Corporate Bond Issues 99, Corporate Stock Issues 99, Private Placements and Rule 144A 101 Secondary Financial Markets 101 Why Secondary Markets Are Important 101, Secondary Bond Markets 102, Financial Futures 102, Secondary Equity Markets 102 Classification of U.S Secondary Equity Markets 105 Primary Listing Markets 105, Regional Stock Exchanges 109, The Third Market 109, The Significant Transition of the U.S Equity Markets 109 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Contents Alternative Types of Orders Available 112 Market Orders 112, Limit Orders 112, Special Orders 113, Margin Transactions 113, Short Sales 115, Exchange Market-Makers 117, New Trading Systems 117, Exchange Merger Mania 118 CHAPTER Security Market Indexes 123 Uses of Security-Market Indexes 124 Differentiating Factors in Constructing Market Indexes 125 The Sample 125, Weighting Sample Members 125, Computational Procedure 125 Stock-Market Indexes 125 Price-Weighted Index 126, Value-Weighted Index 127, Unweighted Index 129, Fundamental Weighted Index 130, Style Indexes 130, Global Equity Indexes 131 Bond-Market Indexes 133 U.S Investment-Grade Bond Indexes 135, High-Yield Bond Indexes 135, Global Government Bond Indexes 135 Composite Stock-Bond Indexes 137 Comparison of Indexes over Time 138 Correlations between Monthly Equity Price Changes 138, Correlations between Monthly Bond Index Returns 139, Mean Annual Security Returns and Risk 139 Chapter Appendix: Stock-Market Indexes PART 144 Developments in Investment Theory 147 CHAPTER Efficient Capital Markets 149 Why Should Capital Markets Be Efficient? 150 Alternative Efficient Market Hypotheses 151 Weak-Form Efficient Market Hypothesis 151, Semistrong-Form Efficient Market Hypothesis 152, Strong-Form Efficient Market Hypothesis 152 Tests and Results of Efficient Market Hypotheses 152 Weak-Form Hypothesis: Tests and Results 152, Semistrong-Form Hypothesis: Tests and Results 155, Strong-Form Hypothesis: Tests and Results 165 Behavioral Finance 169 Explaining Biases 170, Fusion Investing 171 Implications of Efficient Capital Markets 171 Efficient Markets and Technical Analysis 171, Efficient Markets and Fundamental Analysis 172, Efficient Markets and Portfolio Management 174 vii CHAPTER An Introduction to Portfolio Management 181 Some Background Assumptions 181 Risk Aversion 182, Definition of Risk 182 Markowitz Portfolio Theory 182 Alternative Measures of Risk 183, Expected Rates of Return 183, Variance (Standard Deviation) of Returns for an Individual Investment 184, Variance (Standard Deviation) of Returns for a Portfolio 185, Standard Deviation of a Portfolio 190, A Three-Asset Portfolio 197, Estimation Issues 198, The Efficient Frontier 198, The Efficient Frontier and Investor Utility 200 Chapter Appendix: A Proof That Minimum Portfolio Variance Occurs with Equal Weights When Securities Have Equal Variance 205 B Derivation of Weights That Will Give Zero Variance When Correlation Equals −1.00 205 CHAPTER An Introduction to Asset Pricing Models 207 Capital Market Theory: An Overview 207 Background for Capital Market Theory 208, Developing the Capital Market Line 208, Risk, Diversification, and the Market Portfolio 212, Investing with the CML: An Example 215 The Capital Asset Pricing Model 216 A Conceptual Development of the CAPM 217, The Security Market Line 218 Relaxing the Assumptions 225 Differential Borrowing and Lending Rates 225, Zero-Beta Model 226, Transaction Costs 227, Heterogeneous Expectations and Planning Periods 228, Taxes 228 Additional Empirical Tests of the CAPM 229 Stability of Beta 229, Relationship between Systematic Risk and Return 229, Summary of CAPM Risk-Return Empirical Results 231 The Market Portfolio: Theory versus Practice 232 CHAPTER Multifactor Models of Risk and Return 241 Arbitrage Pricing Theory 242 Using the APT 244, Security Valuation with the APT: An Example 245, Empirical Tests of the APT 247 Multifactor Models and Risk Estimation 250 Multifactor Models in Practice 250, Estimating Risk in a Multifactor Setting: Examples 256 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM viii Contents PART Valuation Principles and Practices 269 CHAPTER 10 Analysis of Financial Statements 271 Major Financial Statements 272 Generally Accepted Accounting Principles 272, Balance Sheet 273, Income Statement 273, Statement of Cash Flows 273, Measures of Cash Flow 275, Purpose of Financial Statement Analysis 277 Analysis of Financial Ratios 277 Importance of Relative Financial Ratios 278 Computation of Financial Ratios Common Size Statements 279 279 Evaluating Internal Liquidity 279 Internal Liquidity Ratios 280, Inventory Turnover 283 Evaluating Operating Performance 284 Operating Efficiency Ratios 285, Operating Profitability Ratios 287 Risk Analysis 293 Business Risk 294, Financial Risk 295, External Market Liquidity Risk 303 Analysis of Growth Potential 304 Importance of Growth Analysis 304, Determinants of Growth 305 Comparative Analysis of Ratios 307 Internal Liquidity 307, Operating Performance 307, Risk Analysis 309, Growth Analysis 309 Analysis of Non-U.S Financial Statements 309 The Quality of Financial Statements 309 Balance Sheet 309, Income Statement 310, Footnotes 310 The Value of Financial Statement Analysis 310 Specific Uses of Financial Ratios 311 Stock Valuation Models 311, Estimating the Ratings on Bonds 312, Predicting Insolvency (Bankruptcy) 313, Limitations of Financial Ratios 313 CHAPTER 11 An Introduction to Security Valuation 327 An Overview of the Valuation Process 329 Why a Three-Step Valuation Process? 329 General Economic Influences 329, Industry Influences 331, Company Analysis 332, Does the Three-Step Process Work? 332 Theory of Valuation 333 Stream of Expected Returns (Cash Flows) 333, Required Rate of Return 333, Investment Decision Process: A Comparison of Estimated Values and Market Prices 334 Valuation of Alternative Investments 334 Valuation of Bonds 334, Valuation of Preferred Stock 335, Approaches to the Valuation of Common Stock 336, Why and When to Use the Discounted Cash Flow Valuation Approach 337, Why and When to Use the Relative Valuation Techniques 338, Discounted Cash Flow Valuation Techniques 339, Infinite Period DDM and Growth Companies 343, Valuation with Temporary Supernormal Growth 344, Present Value of Operating Free Cash Flows 346, Present Value of Free Cash Flows to Equity 347 Relative Valuation Techniques 347 Earnings Multiplier Model 347, The Price/Cash Flow Ratio 350, The Price/Book Value Ratio 350, The Price/ Sales Ratio 351, Implementing the Relative Valuation Technique 351 Estimating the Inputs: The Required Rate of Return and the Expected Growth Rate of Valuation Variables 352 Required Rate of Return (k) 352, Estimating the Required Return for Foreign Securities 354, Expected Growth Rates 356, Estimating Dividend Growth for Foreign Stocks 359 Chapter 11 Appendix: Derivation of Constant Growth Dividend Discount Model (DDM) 364 PART Analysis and Management of Common Stocks 365 CHAPTER 12 Macroanalysis and Microvaluation of the Stock Market 367 The Components of Market Analysis 367 Macromarket Analysis 368 Economic Activity and Security Markets 368, Economic Series and Stock Prices 369, The Cyclical Indicator Approach 369, Monetary Variables, the Economy, and Stock Prices 372, Money Supply and the Economy 372, Money Supply and Stock Prices 373, Monetary Policy and Stock Returns 373, Inflation, Interest Rates, and Security Prices 374, Analysis of World Security Markets 376 Microvaluation Analysis 377 Applying the DDM Valuation Model to the Market 377, Market Valuation Using the Free Cash Flow to Equity (FCFE) Model 384 Valuation Using the Earnings Multiplier Approach 387 Two-Part Valuation Procedure 387, Importance of Both Components of Value 387 Estimating Expected Earnings per Share 390 Estimating Gross Domestic Product 390, Estimating Sales per Share for a Market Series 391, Alternative Estimates of Corporate Net Profits 392, Estimating Aggregate Operating Profit Margin 393, Estimating Interest Expense 396, WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1038 Glossary In the money An option that has positive intrinsic value Incentive compensations A scheme for paying investment managers according to the performance of the portfolio, often based on the level of assets under management Income bonds Debentures that stipulate interest payments only if the issuer earns the income to make the payments by specified dates Income statement A financial statement that shows the flow of the firm’s sales, expenses, and earnings over a period of time Indenture The legal agreement that lists the obligations of the issuer of a bond to the bondholder, including payment schedules, call provisions, and sinking funds Indexing A passive bond portfolio management strategy that seeks to match the composition, and therefore the performance, of a selected market index Industry life cycle analysis An analysis that focuses on the industry’s stage of development Information An attribute of a good market that includes providing buyers and sellers with timely, accurate information on the volume and prices of past transactions and on all currently outstanding bids and offers Information ratio Statistic used to measure a portfolio’s average return in excess of a comparison, benchmark portfolio divided by the standard deviation of this excess return Informationally efficient market A more technical term for an efficient capital market that emphasizes the role of information in setting the market price Initial public offering (IPO) existing public market A new issue by a firm that has no Interest rate anticipation An active bond portfolio management strategy designed to preserve capital or take advantage of capital gains opportunities by predicting interest rates and their effects on bond prices Interest rate collar The combination of a long position in a cap agreement and a short position in a floor agreement, or vice versa; it is equivalent to a series of range forward positions Interest rate parity The relationship that must exist in an efficient market between the spot and forward foreign exchange rates between two countries and the interest rates in those countries Interest rate risk The uncertainty of returns on an investment due to possible changes in interest rates over time Interest rate swap An agreement calling for the periodic exchange of cash flows, one based on an interest rate that remains fixed for the life of the contract and the other that is linked to a variable-rate index Interest-on-interest payments Bond income from reinvestment of coupon Intrinsic value The portion of a call option’s total value equal to the greater of either zero or the difference between the current value of the underlying asset and the exercise price; for a put option, intrinsic value is the greater of either zero or the exercise price less the underlying asset price; for a stock, it is the value derived from fundamental analysis of the stock’s expected returns or cash flows Investment The current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for the time the funds are committed, the expected rate of inflation, and the uncertainty of future payments Investment company A firm that sells shares of the company and uses the proceeds to buy portfolios of stock, bonds, or other financial instruments Investment decision process Estimation of intrinsic value for comparison with market price to determine whether or not to invest Investment horizon The time period used for planning and forecasting purposes or the future time at which the investor requires the invested funds Investment management company A company separate from the investment company that manages the portfolio and performs administrative functions Investment strategy A decision by a portfolio manager regarding how he or she will manage the portfolio to meet the goals and objectives of the client This will include either active or passive management and, if active, what style in terms of top-down or buttom-up or fundamental versus technical J January effect A frequent empirical anomaly where risk-adjusted stock returns in the month of January are significantly larger than those occurring in any other month of the year J-curve effect The tendency for the returns to private equity funds to be negative initially and then positive in later years as the more profitable investments are realized Jensen measure An absolute measure of a portfolio’s risk-adjusted performance, computed as the intercept in a regression equation where the excess returns to a manager’s portfolio and the market index are, respectively, the dependent and independent variables L Lagging indicators A set of economic variables whose values reach peaks and troughs after the aggregate economy Leading indicators A set of economic variables whose values reach peaks and troughs in advance of the aggregate economy Limit order An order that lasts for a specified time to buy or sell a security when and if it trades at a specified price Intermarket Trading System (ITS) A computerized system that connects competing exchanges and dealers who trade stocks listed on an exchange Its purpose is to help customers find the best market for these stocks at a point in time Limited partnership A business organization with one or more general partners who manage the business and assume legal debts and obligations, and one or more limited partners who are liable only to the extent of their investments Internal liquidity (solvency) ratios Financial ratios that measure the ability of the firm to meet future short-term financial obligations Liquid Term used to describe an asset that can be quickly converted to cash at a price close to fair market value Internal rate of return (IRR) The discount rate at which cash outflows of an investment equal cash inflows Liquidity The ability to buy or sell an asset quickly and at a reasonable price based on information International domestic bonds Bonds issued by a foreign firm, denominated in the firm’s native currency, and sold within its own country Liquidity preference hypothesis One of the alternative explanations for the different shapes of the term structure of interest rates This hypothesis holds that long-term securities should provide WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Glossary higher promised yields than short-term securities because of the higher price volatility of long-maturity (high duration) bonds Liquidity risk Uncertainty due to the ability to buy or sell an investment in the secondary market Long hedge A long position in a forward or futures contract used to offset the price volatility of a short position in the underlying asset Long position The buyer of a commodity or security or, for a forward contract, the counterparty who will be the eventual buyer of the underlying asset Long-term, high-priority goal A long-term financial investment goal of personal importance that typically includes achieving financial independence, such as being able to retire at a certain age Lower-priority goal A financial investment goal of lesser personal importance, such as taking a luxurious vacation or buying a car every few years Low-load fund A mutual fund that imposes a moderate front-end sales charge when the investor buys the fund, typically to percent M Macaulay duration A measure of the time flow of cash from a bond where cash flows are weighted by present values discounted by the yield to maturity Maintenance margin The required proportion that the investor’s equity value must be to the total market value of the stock If the proportion drops below this percent, the investor will receive a margin call Management and advisory firm A firm that provides a range of services from standard banking transactions (savings accounts, personal loans) to advising individual and institutional investors on structuring their portfolios and managing investment funds Management effect A combination of the interest rate anticipation effect, the analysis effect, and the trading effect Management fee The compensation an investment company pays to the investment management company for its services The average annual fee is about 0.5 percent of fund assets Margin The percent of cost a buyer pays in cash for a security, borrowing the balance from the broker This introduces leverage, which increases the risk of the transaction Margin account The collateral posted with the futures exchange clearinghouse by an outside counterparty to insure its eventual performance; the initial margin is the deposit required at contract origination while the maintenance margin is the minimum collateral necessary at all times Margin call A request by an investor’s broker for additional capital for a security bought on margin if the investor’s equity value declines below the required maintenance margin Marginal tax rate The part of each additional dollar in income that is paid as tax Marked to market The settlement process used to adjust the margin account of a futures contract for daily changes in the price of the underlying asset Market The means through which buyers and sellers are brought together to aid in the transfer of goods and/or services Market order An order to buy or sell a security immediately at the best price available Market portfolio The portfolio that includes all risky assets with relative weights equal to their proportional market values 1039 Market risk premium The amount of return above the risk-free rate that investors expect from the market in general as compensation for systematic risk Market value added (MVA) External management performance measure to compare the market value of the company’s debt and equity with the total capital invested in the firm Maturity strategy A portfolio management strategy employed to reduce the interest rate risk of a bond portfolio by matching the maturity of the portfolio with its investment horizon For example, if the investment horizon is 10 years, the portfolio manager would construct a portfolio that will mature in 10 years Mean rates of return The average of an investment’s returns over an extended period of time Modified duration A measure of Macaulay duration divided by one plus the bond’s periodic yield used to approximate the bond’s price volatility Money market The market for short-term debt securities with maturities of less than one year Money market fund A fund that invests in short-term securities sold in the money market (Large companies, banks, and other institutions also invest their surplus cash in the money market for short periods of time.) In the entire investment spectrum, these are generally the safest, most stable securities available They include Treasury bills, certificates of deposit of large banks, and commercial paper (short-term IOUs of large corporations) Money-weighted return The discount rate that sets the present value of a future set of cash flows equal to the investment’s current value; also known as the internal rate of return Mortgage bonds Bonds that pledge specific assets such as buildings and equipment The proceeds from the sale of these assets are used to pay off bondholders in case of bankruptcy Moving average The continually recalculating average of security prices for a period, often 200 days, to serve as an indication of the general trend of prices and also as a benchmark price Multifactor model An empirical version of the APT where the investor chooses the exact number and identity of the common risk factors used to describe an asset’s risk-return relationship Risk factors are often designated as macroeconomic variables (e.g., inflation, changes in gross domestic product) or microeconomic variables (e.g., security-specific characteristics like firm size or book-to-market ratios) Municipal bond insurance See Bond insurance Mutual fund An investment company that pools money from shareholders and invests in a variety of securities, including stocks, bonds, and money market securities A mutual fund ordinarily stands ready to buy back (redeem) its shares at their current net asset value, which depends on the market value of the fund’s portfolio of securities at the time Mutual funds generally continuously offer new shares to investors N Nasdaq InterMarket A trading system that includes Nasdaq market makers and ECNs that quote and trade stocks listed on the NYSE and the AMEX It involves dealers from the Nasdaq market and the Intermarket Trading System (ITS) In many ways, this has become what had been labeled the third market National Association of Securities Dealers Automated Quotation (Nasdaq) system An electronic system for providing bid-ask quotes on OTC securities WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1040 Glossary Near-term, high-priority goal A short-term financial investment goal of personal importance, such as accumulating funds for making a house down payment or buying a car Negotiated sales An underwriting arrangement wherein the sale of a security issue by an issuing entity (governmental body or a corporation) is done using an investment banking firm that maintains an ongoing relationship with the issuer The characteristics of the security issue are determined by the issuer in consultation with the investment banker Net asset value (NAV) per share The market value of an investment company’s assets (securities, cash, and any accrued earnings) after deducting liabilities, divided by the number of shares outstanding Net present value (NPV) A measure of the excess cash flows expected from an investment proposal It is equal to the present value of the cash inflows from an investment proposal, discounted at the required rate of return for the investment, minus the present value of the cash outflows required by the investment, also discounted at the investment’s required rate of return If the derived net present value is a positive value (i.e., there is an excess net present value), the investment should be acquired since it will provide a rate of return above its required returns New issue Common stocks or bonds offered by companies for public sale No-load fund A mutual fund that sells its shares at net asset value without adding sales charges Nominal yield A bond’s yield as measured by its coupon rate Normal portfolio A specialized or customized benchmark constructed to evaluate a specific manager’s investment style or philosophy Notes Intermediate-term debt securities with maturities longer than year but less than 10 years Notional principal The principal value of a swap transaction, which is not exchanged but is used as a scale factor to translate interest rate differentials into cash settlement payments O Objectives The investor’s goals expressed in terms of risk and return and included in the policy statement Offensive competitive strategy A strategy whereby a firm attempts to use its strengths to affect the competitive forces in the industry and, in so doing, improves the firm’s relative position in the industry 130/30 strategy An active equity portfolio management approach that allows short positions up to a certain percentage (e.g., 30) of capital and an equal percentage of leveraged long positions Open-end investment company The more formal name for a mutual fund, which derives from the fact that it continuously offers new shares to investors and redeems them (buys them back) on demand Operating efficiency ratios Financial ratios intended to indicate how efficiently management is utilizing the firm’s assets in terms of dollar sales generated per dollar of assets Primary examples would be: total asset turnover, fixed asset turnover, or equity turnover Operating leverage The use of fixed-production costs in the firm’s operating cost structure The effect of fixed costs is to magnify the effect of a change in sales on operating profits Operating profitability ratios Financial ratios intended to indicate how profitable the firm is in terms of the percent of profit generated from sales Alternative measures would include operating profit (EBIT)/net sales, pretax profit (EBT)/net sales, and net profit/ sales Optimal portfolio The portfolio on the efficient frontier that has the highest utility for a given investor It lies at the point of tangency between the efficient frontier and the curve with the investor’s highest possible utility Option-adjusted duration An estimate of the duration of a bond that specifically adjusts for the existence of an embedded put and/or call option in the bond It can be envisioned as the duration of a noncallable bond minus the duration of an embedded call option or plus the duration of an embedded put option Options Clearing Corporation (OCC) A company designed to guarantee, monitor margin accounts, and settle exchange-traded option transactions Option contract An agreement that grants the owner the right, but not the obligation, to make a future transaction in an underlying commodity or security at a fixed price and within a predetermined time in the future Option premium The initial price that the option buyer must pay to the option seller to acquire the contract Option-adjusted spread A type of yield spread that considers changes in the term structure and alternative estimates of the volatility of interest rates It is spread after adjusting for embedded options Options Clearing Corporation (OCC) A company designed to guarantee, monitor margin accounts, and settle exchange-traded option transactions OTC Electronic Bulletin Board (OTCBB) A regulated quotation service that displays real-time quotes, last-sale prices, and volume information for a specified set of over-the-counter (OTC) securities that are not traded on the formal Nasdaq market Out of the money An option that has no intrinsic value Overfunded plan A defined benefit pension plan in which the present value of the pension liabilities is less than market value of the plan’s assets Overweighted A condition in which a portfolio, for whatever reason, includes more of a class of securities than the relative market value alone would justify P Par value See Principal Payback The time required for the added income from the convertible security relative to the stock to offset the conversion premium Peak The culmination of a bull market when prices stop rising and begin declining Peer group comparison A method of measuring portfolio performance by collecting the returns produced by a representative universe of investors over a specific period of time Performance presentation standards (PPS) A comprehensive set of reporting guidelines created by the Association for Investment Management and Research (AIMR) (now the CFA Institute), in an effort to fulfill the call for uniform, accurate, and consistent performance reporting WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Glossary Perpetuity An investment without any maturity date It provides returns to its owner indefinitely Personal trust An amount of money set aside by a grantor and often managed by a third party, the trustee Often constructed so one party receives income from the trust’s investments and another party receives the residual value of the trust after the income beneficiaries’ death Policy effect The difference in performance of a bond portfolio from that of a chosen index due to differences in duration, which result from a fund’s investment policy Policy statement A statement in which the investor specifies investment goals, constraints, and risk preferences Portfolio A group of investments Ideally, the investments should have different patterns of returns over time Portfolio turnover The total dollar value of securities sold from a portfolio in a year divided by the average assets under management for the fund during the same period Preferred stock An equity investment that stipulates the dividend payment either as a coupon or a stated dollar amount The firm’s directors may withhold dividend payments Premium A bond selling at a price above par value due to capital market conditions Price continuity A feature of a liquid market in which there are small price changes from one transaction to the next due to the depth of the market Price momentum A portfolio strategy in which you acquire stocks that have enjoyed above-market stock price increases Price risk The component of interest rate risk due to the uncertainty of the market price of a bond caused by changes in market interest rates Price/earnings (P/E) ratio The number by which expected earnings per share is multiplied to estimate a stock’s value; also called the earnings multiplier Price-weighted index An index calculated as an arithmetic mean of the current prices of the sampled securities Price-yield curve Created by plotting the set of computed prices for a specific bond against an alternative set of potential yields It generally shows the convexity of the curve Primary market The market in which newly issued securities are sold by their issuers, who receive the proceeds Principal (par value) The original value of the debt underlying a bond that is payable at maturity Private equity An ownership interest in a company or collection of assets that is not publicly traded on an exchange or in the over-thecounter market Private placement A new issue sold directly to a small group of investors, usually institutions Promised yield to call (YTC) A bond’s yield if held until the first available call date, with reinvestment of all coupon payments at the yield-to-call rate Promised yield to maturity (YTM) The most widely used measure of a bond’s yield that states the fully compounded rate of return on a bond bought at market price and held to maturity with reinvestment of all coupon payments at the yield to maturity rate Protective put A trading strategy in which a put option is purchased as a supplement to a long position in an underlying asset or portfolio of assets; the most straightforward form of portfolio insurance 1041 Public bond A long-term, fixed-obligation debt security in a convenient, affordable denomination for sale to individuals and financial institutions Pure auction market A trading system in which interested buyers and sellers submit bid and ask prices for given stocks to a central location where the orders are matched by a broker who does not own the stock but acts as a facilitating agent In the current environment the facilitator can be a computer as well as an individual Pure cash-matched dedicated portfolio A conservative dedicated portfolio management technique aimed at developing a bond portfolio that will provide cash payments that exactly match the specified liability schedules Put options Options to sell a security (stock or bond) within a certain period at a specified price Put-call parity The relationship that must exist in an efficient market between the prices for put and call options having the same underlying asset, exercise price, and expiration date Q Quadratic optimization A technique that relies on historical correlations in order to construct a portfolio that seeks to minimize tracking error with an index Quality financial statements Financial statements that most knowledgeable observers (analysts, portfolio managers) would consider conservatively prepared in terms of sales, expenses, earnings, and asset valuations The results reported would reflect reasonable estimates and indicate what truly happened during the period and the legitimate value of assets and liabilities on the balance sheet R Range forward A trading strategy based on a variation of the putcall parity model where, for the same underlying asset but different exercise prices, a call option is purchased and a put option is sold (or vice versa) Rate anticipation effect The difference in return because of changing the duration of the portfolio during a period as compared with the portfolio’s long-term policy duration Real estate investment trusts (REITs) Investment funds that hold portfolios of real estate investments Real options Options embedded in a firm’s real assets that give managers valuable decision-making flexibility, such as the right to either undertake or abandon an investment project Real risk-free rate (RRFR) The basic interest rate with no accommodation for inflation or uncertainty; the pure time value of money Realized capital gains Capital gains that result when an appreciated asset is sold; realized capital gains are taxable Realized yield The expected compounded yield on a bond that is sold before it matures assuming the reinvestment of all cash flows at an explicit rate Also called horizon yield for the yield realized during an investment horizon period Refunding issue Bonds that provide funds to prematurely retire another bond issue These bonds can be either a junior or senior issue Registered bond A bond for which ownership is registered with the issuer The holder receives interest payments by check directly from the issuer WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1042 Glossary Registered competitive market makers (RCMMs) Members of an exchange who are allowed to use their memberships to buy or sell for their own account within the specific trading obligations set down by the exchange Registered traders Members of the stock exchange who are allowed to use their memberships to buy and sell for their own account, which means they save commissions on their trading but they provide liquidity to the market, and they abide by exchange regulations on how they can trade Relative-strength (RS) ratio The ratio of a stock price or an industry index value to a market indicator series, indicating the stock’s or the industry’s performance relative to the overall market Required rate of return The return that compensates investors for their time, the expected rate of inflation, and the uncertainty of the return Resistance level A price at which a technician would expect a substantial increase in the supply of a stock to reverse a rising trend Return prediction studies Studies wherein investigations attempt to predict the time series of future rates of return using public information An example would be predicting above-average returns for the stock market based on the aggregate dividend yield—for example, a high dividend yield indicates above average future market returns Revenue bond A bond that is serviced by the income generated from specific revenue-producing projects of the municipality such as toll roads or athletic stadiums Rising trend channel The range defined by security prices as they move progressively higher Risk The uncertainty that an investment will earn its expected rate of return Security market index An index created as a statistical measure of the performance of an entire market or segment of a market based on a sample of securities from the market or segment of a market Security market indicator series An index created as a statistical measure of the performance of an entire market or segment of a market based on a sample of securities from the market or segment of a market Security market line (SML) The line that reflects the combination of risk and return of alternative investments In CAPM, risk is measured by systematic risk (beta) SelectNet An order-routing and trade-execution system for institutional investors (brokers and dealers) that allows communication through the Nasdaq system rather than by phone Semistrong-form efficient market hypothesis The belief that security prices fully reflect all publicly available information, including information from security transactions and company, economic, and political news Separation theorem The proposition that the investment decision, which involves investing in the market portfolio on the capital market line, is separate from the financing decision, which targets a specific point on the CML based on the investor’s risk preference Serial obligation bond A bond issue that has a series of maturity dates Typical for municipal bonds Settlement price The price determined by the exchange clearinghouse with which futures contract margin accounts are marked to market Sharpe measure A relative measure of a portfolio’s benefit-to-risk ratio, calculated as its average return in excess of the risk-free rate divided by the standard deviation of portfolio returns Risk averse The assumption about investors that they will choose the least risky alternative, all else being equal Short hedge A short position in a forward or futures contract used to offset the price volatility of a long position in the underlying asset Risk premium (RP) The increase over the nominal risk-free rate that investors demand as compensation for an investment’s uncertainty Short position The seller of a commodity or security or, for a forward contract, the counterparty who will be the eventual seller of the underlying asset Risk-free asset An asset with returns that exhibit zero variance Risky asset An asset with uncertain future returns Runs test A test of the weak-form efficient market hypothesis that checks for trends that persist longer in terms of positive or negative price changes than one would expect for a random series S Sampling A technique for constructing a passive index portfolio in which the portfolio manager buys a representative sample of stocks that comprise the benchmark index Seasoned equity issues New equity shares offered by firms that already have stock outstanding Secondary market The market in which outstanding securities are bought and sold by owners other than the issuers Purpose is to provide liquidity for investors Sector rotation strategy An active strategy that involves purchasing stocks in specific industries or stocks with specific characteristics (low P/E, growth, value) that are anticipated to rise in value more than the overall market Secured (senior) bond assets of the issuer A bond backed by a legal claim on specified Short sale The sale of borrowed securities with the intention of repurchasing them later at a lower price and earning the difference Sinking fund Bond provision that requires the issuer to redeem some or all of the bond systematically over the term of the bond rather than in full at maturity Small-firm effect A frequent empirical anomaly where riskadjusted stock returns for companies with low market capitalization (i.e., share price multiplied by number of outstanding shares) are significantly larger than those generated by high market capitalization (large cap) firms Small-Order Execution System (SOES) A quotation and execution system for retail (nonprofessional) investors who place orders with brokers who must honor their prevailing bid-ask for automatic excution up to 1,000 shares Soft dollars A form of compensation to a money manager generated when the manager commits the investor to paying higher brokerage fees in exchange for the manager receiving additional services (e.g., stock research) from the broker Sortino measure A relative measure of a portfolio’s performance, calculated as its average return in excess of minimum acceptable return threshold, divided by its downside risk coefficient WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Glossary 1043 Specialist The major market maker on U.S stock exchanges who acts as a broker or dealer to ensure the liquidity and smooth functions of the secondary stock market Support level A price at which a technician would expect a substantial increase in price and volume for a stock to reverse a declining trend that was due to profit taking Speculative company A firm with a great degree of business and/ or financial risk, with commensurate high earnings potential Sustainable growth potential A measure of how fast a firm can grow using internal equity and debt financing and a constant capital structure; equal to retention rate × ROE Swap spread A measure of the risk premium for an interest rate swap, calculated as the difference between the agreement’s fixed rate and the yield on a Treasury bond with the same maturity Speculative stock A stock that appears to be highly overpriced compared to its intrinsic valuation Spending phase Phase in the investment life cycle during which individuals’ earning years end as they retire They pay for expenses with income from social security and returns from prior investments and invest to protect against inflation Spot rate The required yield for a cash flow to be received at some specific date in the future—for example, the spot rate for a flow to be received in one year, for a cash flow in two years, and so on Spread A trading strategy where long and short positions in two call (or two put) option contracts having the same underlying asset but different exercise prices or expiration dates are combined to create a customized return distribution Standard deviation A measure of variability equal to the square root of the variance Statement of cash flows A financial statement that shows the effects on the firm’s cash flow of income flows and changes in its balance sheet Static yield spread Yield spreads over the total term structure Stock index arbitrage A trading strategy involving a long position in a stock portfolio and a short position in a stock index futures contract (or vice versa) designed to exploit a mispricing in the futures contract relative to the underlying index Straddle A trading strategy requiring the simultaneous purchase of a call option and a put option having the same exercise price, underlying asset, and expiration date Variations of this theme include strips, straps, strangles, and chooser options Strong-form efficient market hypothesis The belief that security prices fully reflect all information from both public and private sources Structural change Economic trend occurring when the economy is undergoing a major change in organization or in how it functions Structured note A bond with an embedded derivative designed to create a payoff distribution that satisfies the needs of a specific investor clientele Style analysis An attempt to explain the variability in the observed returns to a security portfolio in terms of the movements in the returns to a series of benchmark portfolios designed to capture the essence of a particular security characteristic such as size, value, and growth Style grid A graph used to classify and display the investment style that best defines the nature of a security portfolio Subordinate (junior) bonds Debentures that, in case of default, entitle holders to claims on the issuer’s assets only after the claims of holders of senior debentures and mortgage bonds are satisfied Superior analyst An individual who consistently is able to identify undervalued and overvalued securities that will provide excess riskadjusted returns This requires two attributes: the first is being correct regarding estimates of major valuation variables; the second is being different from most other analysts and investors The result is the prediction of significant “surprises” related to the securities involved SWOT analysis An examination of a firm’s Strengths, Weaknesses, Opportunities, and Threats This analysis helps an analyst evaluate a firm’s strategies to exploit its competitive advantages or defend against its weaknesses Systematic risk The variability of returns that is due to macroeconomic factors that affect all risky assets Because it affects all risky assets, it cannot be eliminated by diversification T Tactical asset allocation An investment strategy that adjusts the investor’s mix of stocks and bonds by increasing the allocation to the asset class that is relatively undervalued Tax cost ratio Based on the ratio of the portfolio’s tax-adjusted and pretax returns, the measure indicates the average annual percentage of a taxable investor’s assets that have been consumed by taxes over the measurement period Tax efficiency The extent to which the investor controls the tax consequences of the security trades in a portfolio by balancing capital gains and capital losses Technical analysis Estimation of future security price movements based on past price and volume movements Term bond A bond that has a single maturity date Term premium See Liquidity preference hypothesis Term structure of interest rates The relationship between term to maturity and yield to maturity for a sample of comparable bonds at a given time Popularly known as the yield curve Term to maturity Specifies the date or the number of years before a bond matures or expires Third market exchange Over-the-counter trading of securities listed on an Tick The minimum price movement for the asset underlying a forward or futures contract; for Treasury bonds, one tick equals 1/32 of percent of par value Time premium The difference between an option’s total market value and its intrinsic value Time-series analysis An examination of a firm’s performance data over a period of time Time-weighted return The geometric average of (one plus) the holding period yields to an investment portfolio Total return A return objective in which the investor wants to increase the portfolio value to meet a future need by both capital gains and current income reinvestment Total return swap An agreement providing for the periodic exchange of cash flows based on a floating-rate index and the total return (i.e., interest plus capital gain or loss) to a predetermined reference entity, usually a specific bond or bond index WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1044 Glossary Tracking error The standard deviation of the difference in returns between an active investment portfolio and its benchmark portfolio; also called tracking error volatility Trading effect The difference in performance of a bond portfolio from that of a chosen index due to short-run changes in the composition of the portfolio Trading rule A formula for deciding on current transactions based on historical data Trading turnover The percentage of outstanding shares traded during a period of time Transaction cost The cost of executing a trade Low costs characterize an operationally efficient market Treasury bill A negotiable U.S government security with a maturity of less than one year that pays no periodic interest but yields the difference between its par value and its discounted purchase price Treasury bond A U.S government security with a maturity of more than 10 years that pays interest periodically Treasury inflation-protected securities (TIPS) Treasury bonds backed by the faith and credit of the Treasury that provide a promised yield in real terms—that is, the principal and interest payments are indexed to the Consumer Price Index (CPI) published by the Bureau of Labor Statistics Treasury note A U.S government security with maturities of to 10 years that pays interest periodically Treynor composite measure A relative measure of a portfolio’s performance calculated as its average return in excess of the risk-free rate divided by its beta coefficient Trough The culmination of a bear market at which prices stop declining and begin rising 12b-1 plan A fee charged by some funds, named after the SEC rule that permits it Such fees pay for distribution costs, such as advertising, or for brokers’ commissions The fund’s prospectus details any 12b-1 charges that apply V Valuation analysis An active bond portfolio management strategy designed to capitalize on expected price increases in temporarily undervalued issues Valuation process Part of the investment decision process in which you estimate the value of a security Value stocks Stocks that appear to be undervalued for reasons besides earnings growth potential These stocks are usually identified based on high dividend yields, low P/E ratios, or low price-to-book ratios Value-weighted index An index calculated as the total market value of the securities in the sample Market value is equal to the number of shares or bonds outstanding times the market price of the security Variable-rate note A debt security for which the interest rate changes to follow some specified short-term rate, for example, the T-bill rate; see Floating rate note Variable principal redemption (VPR) A class of debt securities whose principal redemption at maturity is not fixed but tied to changes in the value of another economic entity, such as a stock index or commodity price Variance A measure of variability equal to the sum of the squares of a return’s deviation from the mean, divided by the total number of returns Volatility index (VIX) A measure of investor expectations of nearterm volatility in the stock market calculated as a weighted average of the implied volatilities estimated from Standard and Poor’s 500 option contracts W Warrant An instrument that allows the holder to purchase a specified number of shares of the firm’s common stock from the firm at a specified price for a given period of time Weak-form efficient market hypothesis The belief that security prices fully reflect all security market information U Y Underfunded plan A defined benefit pension plan in which the present value of the fund’s liabilities to employees exceeds the value of the fund’s assets Yankee bonds Bonds sold in the United States and denominated in U.S dollars but issued by a foreign firm or government Yield The promised rate of return on an investment under certain assumptions Yield illusion The erroneous expectation that a bond will provide its stated yield to maturity without recognizing the implicit reinvestment assumption related to coupon payments Underweighted A condition in which a portfolio, for whatever reason, includes less of a class of securities than the relative market value alone would justify Unrealized capital gains Capital gains that reflect the price appreciation of currently held unsold assets Unsecured bonds Bonds that promise payments of interest and principal but pledge no specific assets Holders have first claim on the issuer’s income and unpledged assets Also known as debentures Unsystematic risk Risk that is unique to an asset, derived from its particular characteristics It can be eliminated in a diversified portfolio Unweighted index An indicator series affected equally by the performance of each security in the sample regardless of price or market value Also referred to as an equal-weighted series Unwind The negotiated termination of a forward or futures position before contract maturity Yield spread The difference between the promised yields of alternative bond issues or market segments at a given time relative to yields on Treasury issues of equal maturity Yield to worst Given a bond with multiple potential maturity dates and prices due to embedded call options, the practice is to calculate a yield to maturity for each of the call dates and prices and select the lowest yield (the most conservative possible yield) as yield to worst Z Zero coupon bond A bond that pays its par value at maturity but no periodic interest payments Its yield is determined by the difference between its par value and its discounted purchase price Also called original issue discount (OID) bonds WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index A Abnormal returns market overreaction investment strategies, 562–563 semistrong-form EMH, 155 ABSs (asset-backed securities), 608–609 Accounting change announcements, semistrong-form EMH, 164–165 Accumulation phase, investor life cycle, 35–36 Active bond portfolio management, 697–711 credit analysis, 700–705 example of, 709–711 implementing transactions, 705–709 interest rate anticipation, 698–699 overview, 697–698 valuation analysis, 700 yield spread analysis, 705 Active equity portfolio management, 550, 558–569 anomalies and attributes, 563–565 fundamental analysis, 559–562 momentum-based stock portfolios, 565–568 overview, 558–559 passive versus, 550–551 tax efficiency and, 568–569 technical analysis, 562–563 Actuarial rate of return, 58 Add-on yield (AY), 820 ADRs (American Depository Receipts), 77 Advisory firms See Investment, management, and advisory firms Agency bonds, 596 Eurozone, 604 Japan, 604 overview, 596, 602 price quotes, 617–619 United Kingdom, 604 United States, 73, 602–604 Agency conflict, 946 Aggregate market analysis, efficient capital markets, 172 Aggregate operating profit margin, 393–396 analysis of effects, 395–396 capacity utilization rate, 393–394 foreign competition, 395 overview, 393 rate of inflation, 395 unit labor cost, 394–395 Algorithmic trading (AT), 110–112 Alpha, 931 Alternative asset classes, 929–945 defined, 929 hedge funds, 931–935 overview, 929–931 private equity funds, 938–945 risk arbitrage investing, 935–936 Alternative investment valuation, 334–352 bonds, 334–335 common stock, 336–337 discounted cash flow valuation techniques, 337–347 preferred stock, 335–336 relative valuation techniques, 338, 347–352 AM (arithmetic mean), 7–9, 129–130 American (direct) quotation method, 806 American Depository Receipts (ADRs), 77 American options, 748 American shares, 77 American Stock Exchange (AMEX), 105–107 American-style options, 847–848 Analysis effect, portfolio performance, 995 Analysts and managers analysis of, 173 conflicts of interest, 514 corporate insider trading, 166–167 influence of efficient markets on, 513 overview, 513 paralysis of, 514 performance of, 39–40, 167–169 superior, 174–175 transitioning between, 40 Anchoring, 170 Antiques, 82, 87 APT See Arbitrage pricing theory (APT) Arbitrage, 742, 760–766 Arbitrage-based hedge fund strategies, 934 Arbitrage pricing theory (APT), 242–249 alternative testing techniques, 249 capital asset pricing model versus, 242–244, 249–250 empirical tests of, 247–249 multifactor models, 250–261 overview, 241–244 security valuation with, 245–247 using, 244–245 Arithmetic mean (AM), 7–9, 129–130 Art, 82, 87 Asset allocation, 33–61, 577–583 defined, 33 effect on returns, 50–51 importance of, 49–55 insured, 582–583 integrated, 578–580 investor life cycle, 34–37 overview, 33–34, 577–578 policy statements, 38–49 portfolio management process, 37–38 selecting method of, 583 strategic, 580–581 tactical, 581–582 Asset allocation (flexible portfolio) funds, 924 Asset-backed securities (ABSs), 608–609 Asset classes See also Asset allocation alternative, 929–945 defined, 33 performance attribution analysis, 987 returns and risks of different, 52–53 Asset-liability management, 713 Asset management firms See Investment, management, and advisory firms Asset pricing models, 207–240 arbitrage pricing theory, 242–249, 250–261 capital asset pricing model, 216–225, 229–232 capital market theory, 207–216, 225–229 overview, 207 Assets under management (AUM) approach, 912–915 ASX (Australian Stock Exchange), 119 AT (algorithmic trading), 110–112 At the money, 748 Attribution analysis, 986–989 bond performance, 994–996 example of, 986–988 extensions, 988–989 overview, 986 Auction-rate securities, 609–610 AUM (assets under management) approach, 912–915 Australian Stock Exchange (ASX), 119 Autocorrelation tests, 153 Automobile insurance, purpose of, 34 Average tax rates, 46 AY (add-on yield), 820 B Backwardated markets, 791 Balanced funds, 80, 924 Balance sheets, 273–274 proportion of debt ratios, 298–300 quality of, 309–310 Bankruptcy (insolvency), predicting, 313 Bar charting, 538 Barclays Capital bond indexes, 51–52, 53, 185, 187–189, 696 Barclay’s Global Investors (BGI), 81 Barra characteristic-based risk factors, 254–255 Basis defined, 46, 786 defining, 786–787 hedging and, 786 Basis risk, 787 Bearer bonds, 592 Bear money spreads, 857–858 Behavioral finance, 169–171 defined, 169 explaining biases, 170–171 fusion investing, 171 insights from, 176 overview, 169–170 Belief perseverance, 170 BE/ME (book-to-market equity ratio), 161–162, 231 Benchmark errors, 232, 990 1045 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1046 Index Benchmark portfolio, 40, 968–969 Benchmarks problems with, 990–992 required characteristics of, 992–993 security-market indexes, 124 Best-efforts basis, 100 Beta coefficient defined, 216 stability of, 229 zero-beta model, 226–227 BGI (Barclay’s Global Investors), 81 Bid-ask spread, 749 Binomial option pricing model, 837–839 forecasting price changes, 837–838 generalizing, 838–839 overview, 837 Black-Scholes valuation model, 839–842, 848–850 estimating volatility, 842–844 example of, 841–842 foreign currency options, 849–850 futures options, 850 overview, 839–840, 848 problems with, 844 properties of, 840–841 stock index options, 848–849 Bond analysis and valuation, 334–335, 623–690 calculating future prices, 632–636 computing yields, 627–632 fundamentals of, 624–627 interest rates, 638–647 overview, 623–624 price volatility, 654–678 spot rates, 636–638, 647–649 term-structure theories, 650–654 yield spreads with embedded options, 678–681 Bond books (yield books), 636 Bond funds, 80 Bond ladders, 694–695 Bond-market indexes, 133–137 global government, 135, 137 high-yield, 135 overview, 133–134 U.S investment-grade, 135 yields and returns for, 137 Bond market line, 994–996 Bond markets overview, 594–595 participating investors, 597 participating issuers, 596–597 secondary, 102 technical analysis of, 542–544 Bond portfolio management, 691–738 active, 697–711 contingent and structured, 724–729 core-plus, 711–713 matched-funding, 713–724 overview, 691 passive, 694–696 performance, style, and strategy, 691–694 Bond price volatility, 654–657 callable bonds, 667–670 convexity, 662–667 duration measures, 657–662, 670–678 overview, 654–657 trading strategies, 657 Bonds, 591–622 See also names of specific types of bonds corporate, 606–613 domestic government, 599–602 features of, 591–594 government agency, 602–604 interest rates and prices of, 375 international, 613–614 market structure, 594–598 municipal, 604–606 overview, 591 portfolio performance, 993–996 price information, 614–620 rating of, 14, 23–24, 312, 597–599 Bond swaps overview, 706 pure yield pickup, 706–707 substitution, 706–708 tax, 707–709 Book-to-market equity ratio (BE/ME), 161–162, 231 Book value/market value (BV/MV) ratio See Price/book value (P/BV) ratio Bootstrapping, 645 Borsa Italiana, 118 Break-even time (payback), 889 Brinson Global Security Market Index (GSMI), 84–86, 138 Brokerage accounts credit balances in, 531 debit balances in, 533 Brokers, 100, 117 Buffett, Warren, 467 Bulldog bonds, 76, 614 Bull money spreads, 857–858 Business cycle industry sectors and, 417–419 macroeconomic-based risk factor models, 251–252 stock market and, 418, 560 Business risk, 294–295 adjusting volatility measures for growth, 295 defined, 18 industry analysis, 426 operating leverage, 295 overview, 294 relationship to financial risk, 296 required return for foreign securities, 355 sales variability, 294–295 Butterfly spreads, 858–859 Buy-and-hold strategy, bond portfolio management, 694–695 Buyouts, 941 BV/MV (book value/market value) ratio See Price/book value (P/BV) ratio C Calendar (time) spreads, 857 Calendar effects, 158 Callable bonds convexity of, 670 option-adjusted duration, 669–670 overview, 667–669 Call markets, 104–105 Call money rate, 113 Call options, 78, 742–743 covered, 850, 852–853 defined, 747 payoff and profit diagrams for, 755–758 Call premium, 593 Call provisions, 74 Candlestick charts, 538, 540 Capacity utilization rate, 393–394 Cap agreements, 875–876 Cap-floor-swap parity, 877–878 Capital appreciation, 44 Capital asset pricing model (CAPM), 216–225, 229–232 See also Arbitrage pricing theory (APT); Capital market theory arbitrage pricing theory versus, 242–244, 249–250 conceptual development of, 217 market portfolio, 232 overview, 207, 216–217, 229 relationship between systematic risk and return, 229–231 relaxing assumptions, 225–229 security market line, 218–225 stability of beta, 229 Capital gains, 46, 501 Capital market instruments, 72–74 corporate bonds, 73–74 municipal bonds, 73 overview, 72–73 U.S government agency securities, 73 U.S Treasury securities, 73 Capital market line (CML), 208–212 combining risk-free asset with risky portfolio, 209–210 comparative Sharpe measures, 965–966 covariance with risk-free asset, 209 example of investing with, 215–216 hedge fund performance, 938 overview, 208–209, 210–211 relaxing CAPM assumptions, 226–229 risk measure for, 214–215 risk-return possibilities with leverage, 211–212 separation theorem and, 214 Capital markets effect on nominal risk-free rate, 16–17 effect on risk-return relationship, 24 efficient, 149–180 primary, 98–101 secondary, 101–105 Capital market theory, 207–216 assumptions of, 208 capital market line, 208–212 development of, 208 overview, 207–208 practice versus, 232–234 risk, diversification, and market portfolio, 212–215 Capital preservation, 44 CAPM See Arbitrage pricing theory (APT); Capital asset pricing model (CAPM); Capital market theory CARs (certificates for automobile receivables), 609 Cash conversion cycle, 283–284 Cash flow discounted valuation techniques, 339–346 from financing activities, 276 free, 276–277, 303 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index free to equity, 277, 338, 384–387, 433–435, 472–474 free to the firm, 277, 474–477 from investing activities, 276 measures of, 275–277 from operating activities, 276 from operations, 303 price/cash flow ratio, 350, 406–407, 449–450, 496 security valuation theory, 333 statements of, 273–275, 276 traditional, 275–276 Cash flow coverage ratio, 301–302 Cash flow-outstanding debt ratios, 302–303 Cash ratio, liquidity, 281–282 Cash reserves, 34 CBOE (Chicago Board Options Exchange), 531–532, 823 CBOT (Chicago Board of Trade), 79, 102, 118, 792–793 CDOs (collateralized debt obligations), 610 CDs See Certificates of deposit (CDs) CDS (credit default swaps), 882–883 Centralized transactions, 109 Certificates for automobile receivables (CARs), 609 Certificates of deposit (CDs) money market funds, 80 overview, 72 taxation, 48 CFA Institute, 997, 999–1000 Change in wealth, Characteristic-based risk factor models extensions of, 254–256 macroeconomic-based, 251–253 microeconomic-based, 253–254 Characteristic line defined, 221 Treynor’s composite performance measure, 963 Characteristic selectivity (CS) performance measure, 984–985 Chicago Board of Trade (CBOT), 79, 102, 118, 792–793 Chicago Board Options Exchange (CBOE), 531–532, 823 Chicago Mercantile Exchange (CME), 79, 102, 118 Chooser options, 856 CI (Confidence Index), 532–533 Classical immunization application of, 720–722 interest rate risk and, 716 Closed-end funds, 79 Closed-end investment companies, 920–923 CME (Chicago Mercantile Exchange), 79, 102, 118 CML See Capital market line (CML) CMOs (collateralized mortgage obligations), 607–608 Code of Ethics and Standards of Professional Conduct, 948–949 Coefficient of variation (CV), 13 Coincident indicators, 369–371 Coins, 83 Collar agreements, 771–772, 876–878 Collateralized debt obligations (CDOs), 610 Collateralized issues, 596 Collateralized mortgage obligations (CMOs), 607–608 Collateral trust bonds, 74, 607 Commingled Real Estate Funds (CREFs), 86–87 Commodity-linked bull and bear bonds, 894–896 Common effect, 17 Common size statements, 279, 280–281, 288 Common stock empirical duration for, 677–678 funds of, 80 overview, 76 valuation of, 336–337 Company analysis, 459–515 competitive strategies, 464–466, 483–487 earnings multipliers, 487–494 earnings per share, 480–482 economic influences on, 462–463 global, 514–515 growth company analysis, 499–504 influences on, 462–463 influences on analysts, 513–514 intrinsic value, 467–479 lessons from Peter Lynch, 466 measures of relative value, 494–499 measures of value added, 504–512 overview, 459–460 security valuation, 332 site visits and interviews, 512 stock valuation versus, 460–462 structural influences on, 463 SWOT analysis, 466 tenets of Warren Buffett, 467 when to sell, 512–513 Competition, in industry analysis, 423–425 Competitive bid sales, 98–99 Competitive environment, 424 Competitive strategy, 423–424 Completely diversified portfolio, 212–213, 215 Completeness funds, 552 Composite leading indicator index, 370 Composite stock-bond indexes, 137–138 Compound annual rate of return, Comptroller of the Currency, 61 Confidence Index (CI), 532–533 Confidence risk, 251–252 Confirmation bias, 170 Consolidated quotations, 109 Consolidation phase, investor life cycle, 35–36 Constant growth FCFE model, 385–386, 433–434 Constant-mix asset allocation, 580 Constant proportion strategy, 583 Construction and development trusts, 81 Consumer sentiment, business cycle and, 419 Contango markets, 790 Contingent, deferred sales loads, 923 Contingent immunization, 724–729 Continual monitoring, 37–38 Continuous markets, 96–97, 104–105 Contract price, forward, 743 Contrarian investment strategy, 562, 581 Contrary-opinion rules, 530–532 Convenience yield, 790 Conversion factors, 793 1047 Conversion parity price, 886 Conversion premium, 886 Conversion ratio, 885–886 Conversion value, 885 Convertible bonds, 74–75, 886–890 Convertible preferred stock, 885–886 Convertible securities, 883–890 convertible bonds, 74–75, 886–890 convertible preferred stock, 885–886 overview, 883, 885 Convexity, bond callable bonds, 670 computation of, 666–667 desirability of, 664–665 determinants of, 665–666 modified-duration-convexity effects, 666 overview, 662 price-yield relationship for bonds, 662–664 Core-plus bond portfolio management, 711–713 Corporate bond markets, 102–103 Corporate bonds, 73–74, 99, 596–597 covered bonds, 608–611 high-yield bonds, 611–613 overview, 596–597, 606 price quotes, 615–617 promised yields, 14–15 United States, 606–608 Corporate events, semistrong-form EMH, 165 Corporate insider trading, 48, 166–167 Corporate net profits, estimating, 392–393 Corporate stock issues, 99–100 Correlation coefficients, 68–70, 93–94 standard deviation of returns for portfolios, 188–190 between stock and bond indexes, 139 Country risk (CR; political risk) defined, 19 global company and stock analysis, 515 industry analysis, 427 required return for foreign securities, 356 Coupon reinvestment risk, 715 Covariance of returns, portfolio analysis, 185–188 Cover basis, 787 Covered bonds asset-backed securities, 608–609 auction-rate securities, 609–610 certificates for automobile receivables, 609 collateralized debt obligations, 610 credit card–backed securities, 609 deep discount bonds, 610–611 overview, 608 variable-rate notes, 610 zero-coupon bonds, 610–611 Covered call options, 850, 852–853 Covered interest arbitrage, 809–811 CR See Country risk (CR; political risk) Credit analysis, 697, 700–705 of high-yield bonds, 700–701 investing in defaulted debt, 701 models of, 701–705 overview, 700 Credit card–backed securities, 609 Credit default swaps (CDS), 882–883 Credit quality, 692 Credit-related swaps, 879–883 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1048 Index CREFs (Commingled Real Estate Funds), 86–87 Cross hedges, 788 Crossover price, 631 Crossover yield, 631 Cross-sectional analysis, 278 Cross-sectional return predictions, semistrongform EMH, 158–161 book value/market value ratio, 161 neglected firms and trading activity, 160–161 overview, 158–159 price-earnings/growth rate ratios, 159 price/earnings ratios, 159 size effect, 159–160 Cross-section distribution, 155 CS (characteristic selectivity) performance measure, 984–985 Currency forwards and futures, 806–812 calculating implied world investment rates, 811–812 interest rate parity and covered interest arbitrage, 809–811 mechanics of, 806–809 overview, 806 Currency sensitivity, 255 Current income, 44 Current ratio, 280–281 Current yield, 628 Cushion bonds, 699 Cushion spread, 725–726 CV (coefficient of variation), 13 Cyclical changes, 417 Cyclical companies, 461–462 Cyclical indicator approach, 369–372 analytical measures of performance, 370–371 categories, 369–370 comparison with previous cycles, 371 composite series and ratio of series, 370 international leading indicator series, 372 leading employment index, 372 leading inflation index, 372 limitations of, 372 long-leading index, 372 overview, 369 surveys of sentiment and expectations, 372 Cyclical stocks, 461–462 D DDM See Dividend discount model (DDM) Dealer market (quote-driven market) system, 104–105 Dealers, 117 Debentures (unsecured bonds), 74–75, 593 Debt-equity ratio, 299 Decimal pricing, 97–98, 110–111 Declining trend channel, 530 Declining yield curves, 644 Dedicated portfolios, 713–715 Dedication with reinvestment, 714 Deep discount bonds, 610–611 Defaulted debt, 701 Default spread, 157 Defensive companies, 461 Defensive competitive strategies, 464 Defensive stocks, 461 Deferred call provision, 593 Defined benefit pension plans, 58 Defined contribution pension plans, 58 Delta, 841 Demographics, alternative industries and, 420 Depth, of markets, 97 Derivative markets and securities, 741–779 defined, 741 forward and futures markets, 743–744 futures price quotations, 744–747 investing with, 750–760 option markets, 747–748 option price quotations, 748–750 overview, 741–743 relationship between forward and option contracts, 760–767 use of derivatives in portfolio management, 767–772 Designated market makers (DMM), 117 Deutsche Borse (German Stock Exchange), 118 Diamonds, 83 Differential borrowing and lending rates, 225–226 Differentiation strategy, 464 Diffusion indexes, 370–371 Direct (American) quotation method, 806 Direct real estate investment, 81 Disability insurance, purpose of, 34 Discount bond pricing, 626 Discounted cash flow valuation techniques dividend discount model, 339–346 overview, 339 present value of free cash flows to equity, 347 present value of operating free cash flows, 346–347 using, 337–338 Discretionary accounts, 48 Display Book, 117 Diversification elimination of unsystematic risk, 213–214 measuring, 213 Dividend-bearing securities, 845–847 Dividend discount model (DDM) combining estimates, 384 current estimate of risk premium and required rate of return, 380 derivation of constant growth, 364 discounted cash flow valuation approach, 337–338 dividend growth rate, 380–384 equity risk premium, 378–380 infinite period model, 342–344 multiple-year holding period, 341–342 one-year holding period, 340–341 overview, 339–340, 377–378 present value of dividends model, 468–472 reduced form, 378, 426–433 temporary supernormal growth, 344–346 Dividend/payout ratio company analysis, 488 industry analysis, 445 stock analysis, 401–402 Dividend yield, 255 DJIA See Dow Jones Industrial Average (DJIA) Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 785, 822, 946–948 Dollar-weighted (value-weighted) mean rate of return, Domestic diversification, 70 Domestic government bonds Eurozone, 602 Japan, 601 United Kingdom, 601–602 United States, 599–601 Dow Jones Industrial Average (DJIA), 126–127, 131 bearish sentiment index, 531–532 beta estimates for, 990–991 declines in, 39 industry group performance, 415 Dow Jones Total Stock Market Index, 139, 185–189 Dow Jones Wilshire Global Indexes, 133, 134 Downside risk (DR), 980–982 Dow Theory, 534 Dual currency bonds, 891–892 DuPont System extended, 291–293 overview, 289–291 Duration approach to hedging, 793–794 effective, 671–676 Macaulay, 657–660, 670–678 modified, 657, 661–662, 670–678 negative effective, 674–678 overview, 657–658, 670–671 yield to maturity and, 659–660 Dynamic true growth model, 503–504 E Earnings and cash flow coverage ratios, 300–302 Earnings before interest, taxes, depreciation, and amortization (EBITDA) measure of cash flow, 277, 287 Earnings before interest and taxes (EBIT), 287, 291–292, 300, 393 Earnings momentum strategy, 563–564, 565–568 Earnings multiplier alternative investment valuation, 347–350 company analysis, 487–492, 494 industry analysis, 435–446 microvaluation analysis, 387–404 Earnings per share company profit margin, 482 company sales forecast, 480–482 computing, 485 industry analysis, 435–438 overview, 480 stock management and analysis, 390–399 Earnings retention rate, 428 Earnings surprises, 157, 173, 566 Earnings variability, 255 Earnings yield, 255 EBIT (earnings before interest and taxes), 287, 291–292, 300, 393 EBITDA (earnings before interest, taxes, depreciation, and amortization) measure of cash flow, 277, 287 ECNs (electronic communications networks), 110–111 Economic series, stock prices and, 369–370 Economic value added (EVA) alternative measure of, 507 overview, 505–506 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index relationship between MVA and, 507 return on capital, 506 Effective duration, 658, 675–676 greater than maturity, 674 negative, 674–678 overview, 671–673 putable bonds, 673–674 Efficient capital markets, 149–180 behavioral finance, 169–171 defined, 149 implications of, 171–176 overview, 149–150 reasons for, 150–151 semistrong-form efficient market hypothesis, 155–165 strong-form efficient market hypothesis, 165–169 weak-form efficient market hypothesis, 152–155 Efficient frontier defined, 198 investor utility and, 200 overview, 198–199 Efficient market hypothesis (EMH), 151, 528–529 semistrong form, 155–165 strong form, 165–169 weak form, 152–155 Electronic communications networks (ECNs), 110–111 Embedded options, bonds with, 667–668 Emerging market bonds, 597 EMH See Efficient market hypothesis (EMH) Empirical duration, 658 for common stock, 677–678 overview, 674–677 Employee Retirement and Income Security Act (ERISA) of 1974, 59, 946–947 Employer-sponsored retirement plans, 49 Ending-wealth value, 629 Enhanced indexing, 711 Equal-weighted indexes, 125 Equipment trust certificates, 74, 607 Equity-based hedge fund strategies, 934 Equity-index linked notes, 892–894 Equity-index-linked swaps (equity swaps), 878–879 Equity instruments, 76–78 acquiring foreign, 77–78 common stock classifications, 76 overview, 76 Equity markets, 102–112 Equity options, 823–825 Equity portfolio management, 549–587 active, 558–569 asset allocation, 577–583 overview, 549 passive, 551–558 style analysis, 573–577 value versus growth investing, 569–573 Equity swaps (equity-index-linked swaps), 878–879 Equity trusts, 81 Equity turnover, 286–287 Equivalent taxable yield (ETY), 635–636 ERISA (Employee Retirement and Income Security Act) of 1974, 59, 946–947 ERR See Exchange rate risk (ERR) Escalation bias, 170–171 ETFs See Exchange-traded funds (ETFs) Eurobonds, 75–76, 613–614 Eurodollar bonds contract mechanics, 796–797 creating synthetic fixed-rate funding, 797–799 market, 614 T-bill/Eurodollar yield spread, 533 European (indirect) quotation method, 806 European options, 748 European-style put options, 845, 847–848 Euroyen bonds, 76, 614 Eurozone agency bonds, 604 domestic government bonds, 602 international bonds, 614 international stock index, 132 EVA See Economic value added (EVA) Event studies, semistrong-form EMH, 155–156, 161–165 announcements of accounting changes, 164–165 corporate events, 165 exchange listing, 163 initial public offerings, 163 overview, 161–162 stock split studies, 162 unexpected world events and economic news, 163–164 Exchange clearinghouses, 782 Exchange listing, semistrong-form EMH, 163 Exchange market-makers, 117 Exchange mergers, 118–119 Exchange rate risk (ERR) defined, 18–19 global company and stock analysis, 515 industry analysis, 427 required return for foreign securities, 356 Exchange-traded funds (ETFs), 77–79, 81 index options, 825–828 origin of, 124 passive equity portfolio management, 555–558 portfolio management, 175–176 purchase or sale of, 77–78 Exercise (striking) price, 78, 747 Expansion model, 502–503 Expectations hypothesis, 650–652 Expected earnings per share, 390–399 aggregate operating profit margin, 393–396 alternative estimates of corporate net profits, 392–393 example of, 398–399 gross domestic product, 390 interest expense, 396–398 overview, 390 sales per share for market series, 391–392 tax rate, 398 Expected growth rate (g) breakdown of ROE, 357–358 company analysis, 490–492 dividend discount model, 380–384 of dividends, 400–401 estimating based on history, 358–359 estimating from fundamentals, 356–357 1049 for foreign stocks, 359–360 industry analysis, 445–446 overview, 356 of returns, 333 Expected rate of inflation effect on nominal risk-free rate, 17 effect on risk-return relationship, 24–25 overview, 353 Expected rate of return, 183–184 calculating, 9–12 risk of, 12–14 for risky assets, 218–219 semistrong-form EMH, 156 Expense ratio, 569 Expiration (maturity) date, 743 External (informational) efficiency, 97 External liquidity, 61 External market liquidity risk, 303–304 External market measure of risk, 20 F Fair game model, 151 Fama-French models, 253–254, 256 Fama portfolio performance measure, 979–980 Fannie Mae (Federal National Mortgage Association), 73, 603 FASB (Financial Accounting Standards Board), 272 Fat finger events, 111–112 FCFE See Free cash flow to equity (FCFE) FCFF (free cash flow to the firm), 277, 474–477 Federal Deposit Insurance Corporation (FDIC), 61 Federal Home Loan Bank (FHLB), 73 Federal Home Loan Mortgage Corporation (FHLMC; Freddie Mac), 73, 603 Federal Housing Administration (FHA), 73 Federal Land Banks (FLBs), 73 Federal National Mortgage Association (FNMA; Fannie Mae), 73, 603 Federal Reserve Board, 61 FHA (Federal Housing Administration), 73 FHLB (Federal Home Loan Bank), 73 FHLMC (Federal Home Loan Mortgage Corporation), 73, 603 Fidelity Investments, 43 FIFO (first-in, first-out) inventory method, 165 Financial Accounting Standards Board (FASB), 272 Financial assets, defined, 72 Financial futures, 79, 102 Financial Industry Regulatory Authority (FINRA), 947–948 Financial leverage See Financial risk (financial leverage) Financial ratios, 277–310 See also names of specific ratios computation of, 279 growth analysis, 309 growth potential, 304–307 importance of relative, 278–279 internal liquidity, 279–284, 307 limitations of, 313 operating performance, 284–293, 307–308 overview, 277–278 risk analysis, 293–304, 309 specific uses of, 311–313 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1050 Index Financial risk (financial leverage), 295–298, 308 capitalizing operating leases, 296–298 defined, 18 industry analysis, 427 lease obligations, 296 overview, 295–296 relationship to business risk, 296 required return for foreign securities, 355 Financial statements, 271–325 See also Financial ratios balance sheets, 273, 309–310 footnotes, 310 generally accepted accounting principles, 272 income statements, 273, 310 measures of cash flow, 275–277 non-U.S., 309 overview, 271–272 purpose of, 277 quality of, 309–310 statements of cash flow, 273–275 value of analyzing, 310–311 Financial Times Stock Exchange (FTSE) indexes, 84, 86 FINRA (Financial Industry Regulatory Authority), 947–948 First-in, first-out (FIFO) inventory method, 165 Fixed-income investments, 72–75 capital market instruments, 72–74 income bonds, 74–75 preferred stock, 75 savings accounts, 72 subordinated bonds, 74 Flash Crashes, 112 Flat trend channel, 530 Flat yield curves, 644 FLBs (Federal Land Banks), 73 Flexible (range) forwards, 859–861 Flexible portfolio (asset allocation) funds, 924 Floating-rate notes (FRNs), 869–870, 873–874 Floor agreements, 875–876 FNMA (Federal National Mortgage Association), 73, 603 Footnotes, financial statement, 310 Forcing conversion, 888 Foreign bonds, 613 Foreign competition, 395 Foreign currency exchange warrants, 884–885 Foreign currency options, 828–829, 849–850 Foreign exchange (FX) transactions, 806–810 Foreign exchange rates, technical analysis of, 542 Foreign government bonds, 596 Foreign markets, technical analysis of, 541–542 Foreign securities, required rate of return for, 354–356 Foreign shares, purchase or sale of, 77 Foreign stock market indexes, technical analysis of, 541–542 Forward-based interest rate contracts, 868–875 forward rate agreements, 868–869 interest rate swaps, 869–875 Forward contracts, 742–743, 781–820 currency forwards, 806–812 defined, 743 futures contracts versus, 785 hedging with, 786–788 interest rate forwards, 792 overview, 781–783 paying to acquire, 750–753 payoff and profit diagrams for, 754–755 relationship between option contracts and, 760–767 relationship between spot and forward prices, 790–791 use of in portfolio management, 767–768 valuation concepts, 788–791 Forward discount, 808 Forward markets, 743–744 Forward premium, 808 Forward rate agreements (FRAs), 792, 868–872 Forward rates, 647–649 401(k) plans, 47–48 Franchise factor concept, 507–508 FRAs (forward rate agreements), 792, 868–872 Freddie Mac (Federal Home Loan Mortgage Corporation), 73, 603 Free cash flow, 276–277, 303 Free cash flow to equity (FCFE), 277, 338 constant growth model, 385–386, 433–434 industry analysis, 433–435 overview, 384 present value of, 347, 472–474 two-stage growth model, 386–387, 434–435 Free cash flow to the firm (FCFF), 277, 474–477 Freely callable provision, 593 FRNs (floating-rate notes), 869–870, 873–874 FTEY (fully taxable equivalent yield), 635–636 FT/S&P-Actuaries World Indexes, 132–133 FTSE (Financial Times Stock Exchange) indexes, 84, 86 Full replication bond portfolios, 695 equity portfolios, 552 Fundamental analysis active equity portfolio management, 559–562 efficient capital markets, 172–174 Fundamental risk, 19–20 Fundamental weighted indexes, 130 Fusion investing, 171 Future consumption, Futures commission merchants, 782 Futures contracts, 78–79, 742–743, 781–820 currency futures, 806–812 defined, 744 financial futures, 79 forward contracts versus, 785 hedging with, 786–788 interest rate futures, 792–800 mechanics of, 783–785 options on, 828–830, 850 overview, 78–79, 781–783 popular, 745 stock index futures, 800–806 valuation concepts, 788–791 Futures markets, 743–744 defined, 744 leading by trading volume, 783 popular, 745 Futures options, 828–830 Futures prices, 744–747 FX (foreign exchange) transactions, 806–810 G G See Expected growth rate (g) GDP (gross domestic product), estimating, 390 Generally accepted accounting principles (GAAP), 272 General obligation bonds (GOs), 73, 604 Geometric Brownian motion, 839 Geometric mean (GM), 7–9, 129–130 German Stock Exchange (Deutsche Borse), 118 GICs (guaranteed insurance contracts), 60 Gifting phase, investor life cycle, 35–36 Gilt-edge securities, 599 Ginnie Mae (Government National Mortgage Association), 73, 602 GIPS (Global Investment Performance Standards), 999 Glass-Steagall Act, 61 Global bond market returns, 66 risks, 68–69 Global company and stock analysis, 514–515 Global equity indexes comparison of world stock indexes, 133 Dow Jones Wilshire Global Indexes, 133–134 FT/S&P-Actuaries World Indexes, 132–133 Morgan Stanley Capital International Indexes, 133 overview, 131–132 Global equity market returns, 66 risks, 69–70 Global funds (international funds), 927 Global government bond indexes, 136 Global investment companies, 927 Global Investment Performance Standards (GIPS), 999 Global investments, 63–94 case for, 64–71 choices, 71–83 historical risk-returns on alternative, 83–88 overview, 63–64 total investable assets in global capital market, 65 Global mutual funds, 77–78 Global stock indexes, 106–107, 132 GM (geometric mean), 7–9, 129–130 GNMA (Government National Mortgage Association), 73, 602 Gold futures contracts, 783 GOs (general obligation bonds), 73, 604 Government bonds domestic, 599–602 foreign, 596 global, 66 issues, 98 promised yields, 14–15 quasi, 73, 596, 602–604, 617–619 secondary markets for, 102 Government National Mortgage Association (GNMA; Ginnie Mae), 73, 602 Government-sponsored enterprises (GSEs), 602–603 Grinblatt-Titman (GT) portfolio performance measure, 982–985 Gross domestic product (GDP), estimating, 390 Gross profit margin, 287 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM Index Growth analysis, 304–305, 308–309 Growth companies, 460–461 actual returns above required returns, 500 alternative growth models, 501 defined, 343, 500 growth stocks versus, 500 long-run growth models, 501–504 no-growth firm, 501 overview, 499–500 the real world, 504 Growth duration model alternative use of T, 510–511 computation of, 508–510 factors to consider, 511–512 intraindustry analysis, 510 overview, 508 Growth investing, 462, 569–573 Growth mutual funds, 570 Growth potential, 304–307 determinants of growth, 305–307 importance of growth analysis, 304–305 Growth rate See Expected growth rate (g) Growth stocks, 130–131, 460–461, 500 GSEs (government-sponsored enterprises), 602–603 GSMI (Brinson Global Security Market Index), 84–86, 138 GT (Grinblatt-Titman) portfolio performance measure, 982–985 Guaranteed insurance contracts (GICs), 60 H Harbor Capital Appreciation (HACAX) mutual fund, 571–572, 576–577 Health insurance, purpose of, 34 Hedge funds, 931–939 characteristics of, 932–933 development of industry, 932 performance of, 936–939 strategies, 933–935 Hedging, 742 duration-based approach to, 793–794 with forward and futures contracts, 786–788 future funding commitments, 794–795 Hedging pressure theory (segmented market hypothesis), 652–653 Heterogeneous expectations and planning periods, 228 High-frequency trading (HFT), 111 High minus low (HML), 253–254, 256–258 High-yield (HY) bonds, 80, 597 credit analysis of, 700–702 distribution of ratings, 612 history of market, 611–612 indexes of, 136 overview, 597, 611 ownership of, 612–613 Hindsight bias, 170 Historical rate of return overview, 5–7 portfolio of investments, risk measures for, 14 single investment, 7–9 HML (high minus low), 253–254, 256–258 Holding period, Holding period returns (HPRs), 6–9 Holding period yields (HPYs), 6–9, 14, 19 Holdings-based performance measurement, 982–985 characteristic selectivity, 984–985 Grinblatt-Titman, 982–984 overview, 982 Home insurance, purpose of, 34 Home purchases, 81 Homogeneity, futures contracts, 744 Horizon matching, 723–724 Horizon yield See Realized (horizon) yield HPRs (holding period returns), 6–9 HPYs (holding period yields), 6–9, 14, 19 Humped yield curves, 644 HY bonds See High-yield (HY) bonds I Immunization strategies, 715–722 alternative view of, 718–720 application of, 720–722 contingent immunization, 724–729 interest rate risk, 715–716 mechanics of, 716–718 overview, 715 Implied volatility, 843 Income bonds, 74–75 Income statements, 273, 275, 310 Indenture provisions, 73–74, 593 Index arbitrage, 800–803 Index-based factor models, 254 Index funds, 80 origin of, 124 passive equity portfolio management, 555 portfolio management, 175–176 Indexing strategy, 694–695, 711 Index mutual funds, 555 Indirect (European) quotation method, 806 Individual retirement accounts (IRAs), 47–48 Industry analysis, 413–457 business cycle and industry sectors, 417–419 competition, 423–425 differences in industry risk, 416 efficient capital markets, 172–173 global, 451–452 industry life cycle, 422–423 overview, 413–414 process of, 417 rates of return, 425–435 reasons for using, 415–416 relative valuation approach, 435–451 structural economic changes and alternative industries, 420–421 summary of research on, 417 Industry-economy relationships, 436 Industry life cycle analysis, 422–423 Industry risk, 416 Inflation aggregate operating profit margin and rate of, 395 business cycle and industry sectors, 419 expected rate of, 17, 24–25, 353 foreign securities and, 354–355 macroeconomic-based risk factor models, 251–252 overview, 374–375 after returns, 51–52 stock prices and, 376 Informational (external) efficiency, 97 1051 Informationally efficient markets, 150 See also Efficient capital markets Information ratio (IR) portfolio performance measure, 968–972, 975–976, 978 Initial basis, 786 Initial public offerings (IPOs), 99–100, 163–164 Input-output analysis, 436 Insider trading, 48, 166–167 Insolvency (bankruptcy), predicting, 313 Institutional theory (segmented market hypothesis), 652–653 Insurance investor life cycle, 34 municipal bonds, 605–606 Insured asset allocation, 582–583 Integrated asset allocation, 578–580 Interest coverage ratio, 300–301 Interest expense aggregate operating profit margin and, 396–398 industry analysis, 439–442 Interest-on-interest, 628 Interest rate anticipation, 697–699 Interest rate collars, 876–877 Interest rate forwards, 792 Interest rate futures, 792 long term, 792–796 short term, 796–800 Interest rate parity, 809–811 Interest rate risk, 715–716 Interest rates bonds and, 375, 638–647 business cycle and industry sectors, 419 overview, 374–375 stocks and, 376 Interest rate sensitivity, 692 Interest rate swaps, 792, 869–875 Intermarket Trading System (ITS), 109–110 Internal efficiency, 97 Internal liquidity, 61 Internal liquidity (solvency) ratios, 279–284, 308 cash ratio, 281–282 compared to other ratios, 307 current ratio, 280–281 inventory turnover, 283–284 overview, 279–280 quick ratio, 281 receivables turnover, 282–283 Internal performance, 483–485 Internal rate of return (IRR), 627, 944–945 International bonds domestic, 76 Eurozone, 614 investing in, 75–76 Japan, 614 overview, 613–614 United Kingdom, 614 United States, 614 International diversification, 70 International domestic bonds, 76 International economics, business cycle and, 419 International funds (global funds), 927 International leading indicator series, 372 International Swap and Derivatives Association, 822, 879–880 WWW.YAZDANPRESS.COM WWW.YAZDANPRESS.COM 1052 Index Interviews, 512 In the money, 748 Intrinsic value defined, 748 estimates of, 492 overview, 467–468 present value of dividends, 468–472 present value of free cash flow to equity, 472–474 present value of operating free cash flow, 474–477 relative valuation ratio techniques, 477–479 Inventory turnover, 283–284 Investment, defined, Investment, management, and advisory firms, 79–81, 911–957 balanced funds, 80 bond funds, 80 common stock funds, 80 ethics and regulation in, 946–950 exchange-traded funds, 81 index funds, 80 money market funds, 79–80 operating structures of, 912–913 organization and management of, 919–929 overview, 79, 911–912 private firms, 916–919 services of, 912 structure and evolution of, 912–916 Investment Advisers Act of 1940, 946–947 Investment advisory opinions, 531 Investment bankers, relationships with, 100 Investment Company Act of 1940, 946–947 Investment horizon, 715 Investment risk, Investments benefits of early, 35–36 constraints, 45–48 defined, 3–5 goals, 38–39 objectives of, 41–45 overview of process, 329–333 Investment strategy, 37–38, 41, 44–48 Investor analysis, 173 Investor life cycle, 34–37 goals, 37 overview, 34 phases of, 35–36 preliminaries, 34 IPOs (initial public offerings), 99–100, 163–164 IR (information ratio) portfolio performance measure, 968–972, 975–976, 978 IRAs (individual retirement accounts), 47–48 IRR (internal rate of return), 627, 944–945 IShares, 81, 555, 696 ITS (Intermarket Trading System), 109–110 J January anomaly (January effect), 158, 249 Japan agency bonds, 604 domestic government bonds, 601 international bonds, 614 J-curve effect, 944–945 Jensen’s alpha (α) portfolio performance measure, 967–968, 973–978 bond portfolio performance, 993–994 characteristic selectivity versus, 985 compared to other measures, 970–972 demonstration of, 968 overview, 967–968 Junior (subordinate) debentures, 593 Junk bonds, 700–702 K K See Required rate of return (k) L Lagging indicators, 369–371 Land development, 82 Large-cap stocks, 565 Last-in, first-out (LIFO) inventory method, 165 LB (Lehman Brothers) bond indexes, 84, 86 Leading employment index, 372 Leading indicators, 369–372 Leading inflation index, 372 LEAPS (Long-Term Equity Anticipation Securities), 825–826 Leases capitalizing, 296–298 consideration of obligations, 296 Lehman Brothers (LB) bond indexes, 84, 86 Leverage Barra characteristic-based risk factor, 255 financial risk, 295–298, 308 option contracts and, 759–760 LIBOR (London Interbank Offer Rate), 796–800, 820, 868–881, 897–898 Life insurance, as component of financial plan, 34 Lifestyle, alternative industries and, 420 LIFO (last-in, first-out) inventory method, 165 Limited partnerships, 929 Limit orders, 112–113, 117 Liquidity defined, 45 market orders, 112 of markets, 96 needs, 45 of secondary markets, 101 Liquidity preference (term premium) hypothesis, 652 Liquidity risk defined, 18 external market, 303–304 global company and stock analysis, 515 industry analysis, 427 required return for foreign securities, 355 Load open-end funds, 922–923 London Interbank Offer Rate (LIBOR), 796–800, 820, 868–881, 897–898 London Stock Exchange (LSE), 106, 118 Long hedges, 786 Long-leading index, 372 Long position, 743 Long-run growth models capital gain component, 503 dynamic true, 503–504 expansion, 502–503 negative growth, 503 overview, 501 simple growth, 501–502 Long-run real growth rate of economy, 15 Long straddle position, 853–856 Long strangle position, 856 Long strap position, 855 Long strip position, 855 Long-term, high-priority goals, 37 Long-term-care insurance, 34 Long-term debt-total capital ratio, 300 Long-Term Equity Anticipation Securities (LEAPS), 825–826 Long-term interest rate futures, 792–796 duration-based approach to hedging, 793–794 hedging future funding commitments, 794–795 “Notes over Bond” spread, 795–796 T-bond/T-note contract mechanics, 792–793 Low-cost strategy, 464 Lower-priority goals, 37 Low-liquidity investments, 82–83 antiques, 82, 87 art, 82, 87 coins and stamps, 83 defined, 72 diamonds, 83 overview, 82 Low-load funds, 923 LSE (London Stock Exchange), 106, 118 Lynch, Peter, 466 M MA (moving-average) lines, 536–538 Macaulay duration, 657 characteristics of, 658–660 limitations of, 670–678 overview, 658 Macroeconomic-based risk factor models, 250–253 Macromarket analysis, 368–377 company analysis, 487 cyclical indicator approach, 369–372 economic activity and security markets, 368 economic series and stock prices, 369 industry analysis, 444 inflation and interest rates, 374–376 monetary variables, 372–373 overview, 368 world security markets, 376–377 Maintenance margin, 115 Management effect, portfolio performance, 995 Mandatory securities valuation reserve (MSVR), 60 Margin, futures contracts, 78 Margin accounts, 785 Marginal tax rates, 46 Margin calls, 115 Margin debt, 533 Margin requirement, 113–114 Margin transactions, 113–115 Marked-to-market process, 785 Marked-to-market swap value, 874 Marketability, defined, 96 Market multiplier, industry analysis versus, 445 Market orders, 112, 117 Market portfolio capital asset pricing model, 217–219, 226, 250 capital market line, 210–214 defined, 207, 210 proxies for, 221–222, 250 ... Issues in Investments, Ethics and the Investment Industry, and High Yield Bonds: Analysis and Risk Assessment Professor Reilly was named on the list of Outstanding Educators in America and has... bonds and stocks, we will refer to other assets, such as art and antiques Chapter discusses the range of financial assets and also considers some nonfinancial assets 1.2 MEASURES OF RETURN AND RISK... investments? This initial chapter discusses several topics basic to the subsequent chapters We begin by defining the term investment and discussing the returns and risks related to investments