Investment analysis and portfolio management(reilly brown)7th edt

www.elsolucionario.net Chapter The Investment Setting ➤ ➤ ➤ ➤ ➤ Why individuals invest? What is an investment? How investors measure the rate of return on an investment? How investors measure the risk related to alternative investments? What factors contribute to the rates of return that investors require on alternative investments? ➤ What macroeconomic and microeconomic factors contribute to changes in the required rates of return for individual investments and investments in general? 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 This leads to a presentation of how to measure the expected and historical rates of returns for an individual asset or a portfolio of assets In addition, we consider how to measure risk not only for an individual investment but also for an investment that is part of a portfolio The third section of the chapter discusses the factors that determine the required rate of return for an individual investment The factors discussed are those that contribute to an asset’s total risk Because most investors have a portfolio of investments, it is necessary to consider how to measure the risk of an asset when it is a part of a large portfolio of assets The risk that prevails when an asset is part of a diversified portfolio is referred to as its systematic risk The final section deals with what causes changes in an asset’s required rate of return over time Changes occur because of both macroeconomic events that affect all investment assets and microeconomic events that affect the specific asset W HAT I S AN I NVESTMENT ? For most of your life, you will be earning and spending money Rarely, though, will your current money income exactly balance with your consumption desires Sometimes, you may have more money than you want to spend; at other times, you may want to purchase more than you can afford These imbalances will lead you either to borrow or to save to maximize the long-run benefits from your income When current income exceeds current consumption desires, people tend to save the excess They can any of several things with these savings One possibility is to put the money under a mattress or bury it in the backyard until some future time when consumption desires exceed current income When they retrieve their savings from the mattress or backyard, they have the same amount they saved Another possibility is that they can give up the immediate possession of these savings for a future larger amount of money that will be available for future consumption This tradeoff of www.elsolucionario.net After you read this chapter, you should be able to answer the following questions: www.elsolucionario.net present consumption for a higher level of future consumption is the reason for saving What you with the savings to make them increase over time is investment.1 Those who give up immediate possession of savings (that is, defer consumption) expect to receive in the future a greater amount than they gave up Conversely, those who consume more than their current income (that is, borrow) must be willing to pay back in the future more than they borrowed The rate of exchange between future consumption (future dollars) and current consumption (current dollars) is the pure rate of interest Both people’s willingness to pay this difference for borrowed funds and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money This interest rate is established in the capital market by a comparison of the supply of excess income available (savings) to be invested and the demand for excess consumption (borrowing) at a given time If you can exchange $100 of certain income today for $104 of certain income one year from today, then the pure rate of exchange on a risk-free investment (that is, the time value of money) is said to be percent (104/100 – 1) The investor who gives up $100 today expects to consume $104 of goods and services in the future This assumes that the general price level in the economy stays the same This price stability has rarely been the case during the past several decades when inflation rates have varied from 1.1 percent in 1986 to 13.3 percent in 1979, with an average of about 5.4 percent a year from 1970 to 2001 If investors expect a change in prices, they will require a higher rate of return to compensate for it For example, if an investor expects a rise in prices (that is, he or she expects inflation) at the rate of percent during the period of investment, he or she will increase the required interest rate by percent In our example, the investor would require $106 in the future to defer the $100 of consumption during an inflationary period (a percent nominal, risk-free interest rate will be required instead of percent) Further, if the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate The uncertainty of the payments from an investment is the investment risk The additional return added to the nominal, risk-free interest rate is called a risk premium In our previous example, the investor would require more than $106 one year from today to compensate for the uncertainty As an example, if the required amount were $110, $4, or percent, would be considered a risk premium Investment Defined From our discussion, we can specify a formal definition of investment Specifically, an investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for (1) the time the funds are committed, (2) the expected rate of inflation, and (3) the uncertainty of the future payments The “investor” can be an individual, a government, a pension fund, or a corporation Similarly, this definition includes all types of investments, including investments by corporations in plant and equipment and investments by individuals in stocks, bonds, commodities, or real estate This text emphasizes investments by individual investors In all cases, the investor is trading a known dollar amount today for some expected future stream of payments that will be greater than the current outlay At this point, we have answered the questions about why people invest and what they want from their investments They invest to earn a return from savings due to their deferred consumption They want a rate of return that compensates them for the time, the expected rate of inflation, and the uncertainty of the return This return, the investor’s required rate of return, is discussed throughout this book A central question of this book is how investors select investments that will give them their required rates of return In contrast, when current income is less than current consumption desires, people borrow to make up the difference Although we will discuss borrowing on several occasions, the major emphasis of this text is how to invest savings www.elsolucionario.net WHAT IS AN INVESTMENT? www.elsolucionario.net CHAPTER THE INVESTMENT SETTING The next section of this chapter describes how to measure the expected or historical rate of return on an investment and also how to quantify the uncertainty of expected returns You need to understand these techniques for measuring the rate of return and the uncertainty of these returns to evaluate the suitability of a particular investment Although our emphasis will be on financial assets, such as 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 M EASURES OF R ETURN AND R ISK The purpose of this book is to help you understand how to choose among alternative investment assets This selection process requires that you estimate and evaluate the expected risk-return trade-offs for the alternative investments available Therefore, you must understand how to measure the rate of return and the risk involved in an investment accurately To meet this need, in this section we examine ways to quantify return and risk The presentation will consider how to measure both historical and expected rates of return and risk We consider historical measures of return and risk because this book and other publications provide numerous examples of historical average rates of return and risk measures for various assets, and understanding these presentations is important In addition, these historical results are often used by investors when attempting to estimate the expected rates of return and risk for an asset class The first measure is the historical rate of return on an individual investment over the time period the investment is held (that is, its holding period) Next, we consider how to measure the average historical rate of return for an individual investment over a number of time periods The third subsection considers the average rate of return for a portfolio of investments Given the measures of historical rates of return, we will present the traditional measures of risk for a historical time series of returns (that is, the variance and standard deviation) Following the presentation of measures of historical rates of return and risk, we turn to estimating the expected rate of return for an investment Obviously, such an estimate contains a great deal of uncertainty, and we present measures of this uncertainty or risk Measures of Historical Rates of Return When you are evaluating alternative investments for inclusion in your portfolio, you will often be comparing investments with widely different prices or lives As an example, you might want to compare a $10 stock that pays no dividends to a stock selling for $150 that pays dividends of $5 a year To properly evaluate these two investments, you must accurately compare their historical rates of returns A proper measurement of the rates of return is the purpose of this section When we invest, we defer current consumption in order to add to our wealth so that we can consume more in the future Therefore, when we talk about a return on an investment, we are concerned with the change in wealth resulting from this investment This change in wealth can be either due to cash inflows, such as interest or dividends, or caused by a change in the price of the asset (positive or negative) If you commit $200 to an investment at the beginning of the year and you get back $220 at the end of the year, what is your return for the period? The period during which you own an investment is called its holding period, and the return for that period is the holding period return (HPR) In this example, the HPR is 1.10, calculated as follows: ➤1.1 HPR = = Ending Value of Investment Beginning Value of Investment $220 = 1.10 $200 www.elsolucionario.net www.elsolucionario.net MEASURES OF RETURN AND RISK This value will always be zero or greater—that is, it can never be a negative value A value greater than 1.0 reflects an increase in your wealth, which means that you received a positive rate of return during the period A value less than 1.0 means that you suffered a decline in wealth, which indicates that you had a negative return during the period An HPR of zero indicates that you lost all your money Although HPR helps us express the change in value of an investment, investors generally evaluate returns in percentage terms on an annual basis This conversion to annual percentage rates makes it easier to directly compare alternative investments that have markedly different characteristics The first step in converting an HPR to an annual percentage rate is to derive a percentage return, referred to as the holding period yield (HPY) The HPY is equal to the HPR minus HPY = HPR – ➤1.2 In our example: HPY = 1.10 – = 0.10 To derive an annual HPY, you compute an annual HPR and subtract Annual HPR is found by: Annual HPR = HPR1/n ➤1.3 where: n = number of years the investment is held Consider an investment that cost $250 and is worth $350 after being held for two years: HPR = Ending Value of Investment $350 = Beginning Value of Investment $250 = 1.40 Annual HPR = 1.40 1/ n = 1.40 1/ = 1.1832 Annual HPY = 1.1832 – = 0.1832 = 18.32% If you experience a decline in your wealth value, the computation is as follows: HPR = Ending Value $400 = = 0.80 Beginning Value $500 HPY = 0.80 – 1.00 = – 0.20 = –20% A multiple year loss over two years would be computed as follows: HPR = Ending Value $750 = = 0.75 Beginning Value $1, 000 Annual HPR = ( 0.75 ) 1/ n = 0.75 1/ = 0.866 Annual HPY = 0.866 – 1.00 = – 0.134 = –13.4% www.elsolucionario.net = 10% www.elsolucionario.net CHAPTER THE INVESTMENT SETTING In contrast, consider an investment of $100 held for only six months that earned a return of $12: $112 = 1.12 ( n = 0.5 ) $100 Annual HPR = 1.12 1/.5 HPR = = 1.12 = 1.2544 Annual HPY = 1.2544 – = 0.2544 = 25.44% Note that we made some implicit assumptions when converting the HPY to an annual basis This annualized holding period yield computation assumes a constant annual yield for each year In the two-year investment, we assumed an 18.32 percent rate of return each year, compounded In the partial year HPR that was annualized, we assumed that the return is compounded for the whole year That is, we assumed that the rate of return earned during the first part of the year is likewise earned on the value at the end of the first six months The 12 percent rate of return for the initial six months compounds to 25.44 percent for the full year.2 Because of the uncertainty of being able to earn the same return in the future six months, institutions will typically not compound partial year results Remember one final point: The ending value of the investment can be the result of a positive or negative change in price for the investment alone (for example, a stock going from $20 a share to $22 a share), income from the investment alone, or a combination of price change and income Ending value includes the value of everything related to the investment Computing Mean Historical Returns Now that we have calculated the HPY for a single investment for a single year, we want to consider mean rates of return for a single investment and for a portfolio of investments Over a number of years, a single investment will likely give high rates of return during some years and low rates of return, or possibly negative rates of return, during others Your analysis should consider each of these returns, but you also want a summary figure that indicates this investment’s typical experience, or the rate of return you should expect to receive if you owned this investment over an extended period of time You can derive such a summary figure by computing the mean annual rate of return for this investment over some period of time Alternatively, you might want to evaluate a portfolio of investments that might include similar investments (for example, all stocks or all bonds) or a combination of investments (for example, stocks, bonds, and real estate) In this instance, you would calculate the mean rate of return for this portfolio of investments for an individual year or for a number of years Single Investment Given a set of annual rates of return (HPYs) for an individual investment, there are two summary measures of return performance The first is the arithmetic mean return, the second the geometric mean return To find the arithmetic mean (AM), the sum (∑) of annual HPYs is divided by the number of years (n) as follows: ➤1.4 AM = ∑HPY/n where: ¬HPY = the sum of annual holding period yields To check that you understand the calculations, determine the annual HPY for a three-year HPR of 1.50 (Answer: 14.47 percent.) Compute the annual HPY for a three-month HPR of 1.06 (Answer: 26.25 percent.) www.elsolucionario.net www.elsolucionario.net MEASURES OF RETURN AND RISK An alternative computation, the geometric mean (GM), is the nth root of the product of the HPRs for n years GM = [π HPR]1/n – ➤1.5 where: o = the product of the annual holding period returns as follows: (HPR1) × (HPR2) (HPRn) YEAR BEGINNING VALUE ENDING VALUE HPR HPY 100.0 115.0 138.0 115.0 138.0 110.4 1.15 1.20 0.80 0.15 0.20 –0.20 AM = [(0.15) + (0.20) + (–0.20)]/3 = 0.15/3 = 0.05 = 5% GM = [(1.15) × (1.20) × (0.80)]1/3 – = (1.104)1/3 – = 1.03353 – = 0.03353 = 3.353% Investors are typically concerned with long-term performance when comparing alternative investments GM is considered a superior measure of the long-term mean rate of return because it indicates the compound annual rate of return based on the ending value of the investment versus its beginning value.3 Specifically, using the prior example, if we compounded 3.353 percent for three years, (1.03353)3, we would get an ending wealth value of 1.104 Although the arithmetic average provides a good indication of the expected rate of return for an investment during a future individual year, it is biased upward if you are attempting to measure an asset’s long-term performance This is obvious for a volatile security Consider, for example, a security that increases in price from $50 to $100 during year and drops back to $50 during year The annual HPYs would be: YEAR BEGINNING VALUE ENDING VALUE HPR HPY 50 100 100 50 2.00 0.50 1.00 –0.50 Note that the GM is the same whether you compute the geometric mean of the individual annual holding period yields or the annual HPY for a three-year period, comparing the ending value to the beginning value, as discussed earlier under annual HPY for a multiperiod case www.elsolucionario.net To illustrate these alternatives, consider an investment with the following data: www.elsolucionario.net CHAPTER THE INVESTMENT SETTING This would give an AM rate of return of: [(1.00) + (–0.50)]/2 = 50/2 = 0.25 = 25% This investment brought no change in wealth and therefore no return, yet the AM rate of return is computed to be 25 percent The GM rate of return would be: (2.00 × 0.50)1/2 – = (1.00)1/2 – = 1.00 – = 0% This answer of a percent rate of return accurately measures the fact that there was no change in wealth from this investment over the two-year period When rates of return are the same for all years, the GM will be equal to the AM If the rates of return vary over the years, the GM will always be lower than the AM The difference between the two mean values will depend on the year-to-year changes in the rates of return Larger annual changes in the rates of return—that is, more volatility—will result in a greater difference between the alternative mean values An awareness of both methods of computing mean rates of return is important because published accounts of investment performance or descriptions of financial research will use both the AM and the GM as measures of average historical returns We will also use both throughout this book Currently most studies dealing with long-run historical rates of return include both AM and GM rates of return A Portfolio of Investments The mean historical rate of return (HPY) for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments in the portfolio, or the overall change in value of the original portfolio The weights used in computing the averages are the relative beginning market values for each investment; this is referred to as dollar-weighted or value-weighted mean rate of return This technique is demonstrated by the examples in Exhibit 1.1 As shown, the HPY is the same (9.5 percent) whether you compute the weighted average return using the beginning market value weights or if you compute the overall change in the total value of the portfolio Although the analysis of historical performance is useful, selecting investments for your portfolio requires you to predict the rates of return you expect to prevail The next section discusses how you would derive such estimates of expected rates of return We recognize the great uncertainty regarding these future expectations, and we will discuss how one measures this uncertainty, which is referred to as the risk of an investment Calculating Expected Rates of Return Risk is the uncertainty that an investment will earn its expected rate of return In the examples in the prior section, we examined realized historical rates of return In contrast, an investor who is evaluating a future investment alternative expects or anticipates a certain rate of return The investor might say that he or she expects the investment will provide a rate of return of 10 percent, but this is actually the investor’s most likely estimate, also referred to as a point estimate Pressed further, the investor would probably acknowledge the uncertainty of this point estimate return and admit the possibility that, under certain conditions, the annual rate of return on this investment might go as low as –10 percent or as high as 25 percent The point is, the specification of a larger range of possible returns from an investment reflects the investor’s uncertainty regarding what the actual return will be Therefore, a larger range of expected returns makes the investment riskier www.elsolucionario.net 10 www.elsolucionario.net MEASURES EXHIBIT 1.1 INVESTMENT A B C Total RETURN AND RISK 11 COMPUTATION OF HOLDING PERIOD YIELD FOR A PORTFOLIO NUMBER SHARES BEGINNING PRICE BEGINNING MARKET VALUE ENDING PRICE ENDING MARKET VALUE 100,000 200,000 500,000 $10 20 30 $ 1,000,000 4,000,000 15,000,000 $20,000,000 $12 21 33 $ 1,200,000 4,200,000 16,500,000 $21,900,000 OF OF HPR HPY MARKET WEIGHTa WEIGHTED HPY 1.20 1.05 1.10 20% 10 0.05 0.20 0.75 0.01 0.01 0.075 0.095 21, 900 , 000 = 1.095 20 , 000 , 000 HPY = 1.095 – = 0.095 = 9.5% HPR = a An investor determines how certain the expected rate of return on an investment is by analyzing estimates of expected returns To this, the investor assigns probability values to all possible returns These probability values range from zero, which means no chance of the return, to one, which indicates complete certainty that the investment will provide the specified rate of return These probabilities are typically subjective estimates based on the historical performance of the investment or similar investments modified by the investor’s expectations for the future As an example, an investor may know that about 30 percent of the time the rate of return on this particular investment was 10 percent Using this information along with future expectations regarding the economy, one can derive an estimate of what might happen in the future The expected return from an investment is defined as: n Expected Return = ∑ ( Probability of Return) × (Possible Return) i =1 ➤1.6 E(Ri) = [(P1)(R1) + (P2)(R2) + (P3)(R3) + + (PnRn)] n E ( Ri ) = ∑ ( Pi )( Ri ) i =1 Let us begin our analysis of the effect of risk with an example of perfect certainty wherein the investor is absolutely certain of a return of percent Exhibit 1.2 illustrates this situation Perfect certainty allows only one possible return, and the probability of receiving that return is 1.0 Few investments provide certain returns In the case of perfect certainty, there is only one value for PiRi: E(Ri) = (1.0)(0.05) = 0.05 In an alternative scenario, suppose an investor believed an investment could provide several different rates of return depending on different possible economic conditions As an example, in a strong economic environment with high corporate profits and little or no inflation, the investor might expect the rate of return on common stocks during the next year to reach as high as 20 percent In contrast, if there is an economic decline with a higher-than-average rate of inflation, the investor might expect the rate of return on common stocks during the next year to be –20 percent Finally, with no major change in the economic environment, the rate of return during the next year would probably approach the long-run average of 10 percent www.elsolucionario.net Weights are based on beginning values www.elsolucionario.net CHAPTER EXHIBIT 1.2 THE INVESTMENT SETTING PROBABILITY DISTRIBUTION FOR RISK-FREE INVESTMENT Probability 1.00 0.75 0.50 0.25 –.05 0.0 0.05 0.10 0.15 Rate of Return The investor might estimate probabilities for each of these economic scenarios based on past experience and the current outlook as follows: ECONOMIC CONDITIONS Strong economy, no inflation Weak economy, above-average inflation No major change in economy PROBABILITY RATE OF RETURN 0.15 0.15 0.70 0.20 –0.20 0.10 This set of potential outcomes can be visualized as shown in Exhibit 1.3 The computation of the expected rate of return [E(Ri)] is as follows: E(Ri) = [(0.15)(0.20)] + [(0.15)(–0.20)] + [(0.70)(0.10)] = 0.07 Obviously, the investor is less certain about the expected return from this investment than about the return from the prior investment with its single possible return A third example is an investment with 10 possible outcomes ranging from –40 percent to 50 percent with the same probability for each rate of return A graph of this set of expectations would appear as shown in Exhibit 1.4 In this case, there are numerous outcomes from a wide range of possibilities The expected rate of return [E(Ri)] for this investment would be: E(Ri) = (0.10)(–0.40) + (0.10)(–0.30) + (0.10)(–0.20) + (0.10)(–0.10) + (0.10)(0.0) + (0.10)(0.10) + (0.10)(0.20) + (0.10)(0.30) + (0.10)(0.40) + (0.10)(0.50) = (–0.04) + (–0.03) + (–0.02) + (–0.01) + (0.00) + (0.01) + (0.02) + (0.03) + (0.04) + (0.05) = 0.05 www.elsolucionario.net 12 www.elsolucionario.net G-5 Cross-sectional analysis An examination of a firm’s performance in comparison to other firms in the industry with similar characteristics to the firm being studied Cross-sectional return studies Studies wherein investigators look for public information regarding individual stocks that predict the cross-sectional distribution of risk-adjusted returns—e.g., is there an inverse relationship between market-value size of a firm and future risk-adjusted rates of return for its stock? Currency swap A swap transaction in which the cash flows, which can be either fixed or variable, are denominated in different currencies Current income A return objective in which the investor seeks to generate income rather than capital gains; generally a goal of an investor who wants to supplement earnings with income to meet living expenses Current yield A bond’s yield as measured by its current income (coupon) as a percentage of its market price Cyclical change An economic trend arising from the ups and downs of the business cycle Cyclical company A firm whose earnings rise and fall with general economic activity Cyclical stock A stock with a high beta; its gains typically exceed those of a rising market and its losses typically exceed those of a falling market Debentures 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 unsecured bonds Declining trend channel The range defined by security prices as they move progressively lower Dedication A portfolio management technique in which the portfolio’s cash flows are used to retire a set of liabilities over time Dedication with reinvestment A dedication strategy in which portfolio cash flows may precede their corresponding liabilities Such cash flows can be reinvested to earn a return until the date the liability is due to be paid Defensive company Firms whose future earnings are likely to withstand an economic downturn Defensive competitive strategy Positioning the firm so that its capabilities provide the best means to deflect the effect of the competitive forces in the industry Defensive stock A stock whose return is not expected to decline as much as that of the overall market during a bear market Defined benefit pension plan A pension plan to which the company contributes a certain amount each year and that pays employees an income after they retire The benefit size is based on factors such as workers’ salary and time of employment Defined contribution pension plan A pension plan in which worker benefits are determined by the size of employees’ contributions to the plan and the returns earned on the fund’s investments Delta The change in the price of the option with respect to a one dollar change in the price of the underlying asset; this is the option’s hedge ratio, or the number of units of the underlying asset that can be hedged by a single option contract Derivative security An instrument whose market value ultimately depends upon, or derives from, the value of a more fundamental investment vehicle called the underlying asset or security Diffusion index An indicator of the number of stocks rising during a specified period of time relative to the number of stocks declining and not changing price Discount A bond selling at a price below par value due to capital market conditions Dividend discount model (DDM) A technique for estimating the value of a stock issue as the present value of all future dividends Dollar-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 Downtick A price decline in a transaction price compared to the previous transaction price DuPont system A method of examining ROE by breaking it down into three component parts: (1) profit margin, (2) total asset turnover, and (3) financial leverage www.elsolucionario.net GLOSSARY www.elsolucionario.net Duration A measure of the interest rate sensitivity of a bond’s market price taking into consideration its coupon and term to maturity Duration strategy A portfolio management strategy employed to reduce the interest rate risk of a bond portfolio by matching the modified duration of the portfolio with its investment horizon For example, if the investment horizon is 10 years, the portfolio manager would construct a portfolio that has a modified duration of 10 years This strategy is referred to as immunization of the portfolio Earnings momentum A strategy in which portfolios are constructed of stocks of firms with rising earnings Earnings multiplier Also known as the price/earnings ratio, it is a measure of the relationship between a company’s, or the aggregate stock market’s, stock prices and earnings Earnings multiplier model A technique for estimating the value of a stock issue as a multiple of its earnings per share Earnings surprise A company announcement of earnings that differ from analysts’ prevailing expectations Economic value added (EVA) Internal management performance measure that compares net operating profit to total cost of capital Indicates how profitable company projects are as a sign of management performance Effective duration Direct measure of the interest rate sensitivity of a bond (or any financial instrument) based upon price changes derived from a pricing model Efficient capital market A market in which security prices rapidly reflect all information about securities Efficient frontier The set of portfolios that has the maximum rate of return for every given level of risk, or the minimum risk for every potential rate of return Empirical duration Measures directly the interest rate sensitivity of an asset by examining the percentage price change for an asset in response to a change in yield during a specified period of time Ending-wealth value The total amount of money derived from investment in a bond until maturity, including principal, coupon payments, and income from reinvestment of coupon payments Equipment trust certificates Mortgage bonds that are secured by specific pieces of transportation equipment like boxcars and planes Equity collar An option-based hedging strategy that protects a stock position from price declines by purchasing a put option that is paid for by the sale of a call option Equity swap A swap transaction in which one cash flow is tied to the return to an equity portfolio position, often an index such as the Standard and Poor’s 500, while the other is based on a floating-rate index Estimated rate of return The rate of return an investor anticipates earning from a specific investment over a particular future holding period Eurobonds Bonds denominated in a currency not native to the country in which they are issued European option An option contract that can only be exercised on its expiration date Event study Research that examines the reaction of a security’s price to a specific company, world event, or news announcement Exchange clearinghouse The functional unit attached to a futures exchange that guarantees contract performance, oversees delivery, serves as a bookkeeper, and calculates settlement transactions Exchange rate risk Uncertainty due to the denomination of an investment in a currency other than that of the investor’s own country Exercise price The transaction price specified in an option contract; also known as the strike price Exotic option Designed to have payoffs that differ from those of standard contract options Three such nonstandard contracts are Asian, lookback, and digital options Expected rate of return The return that analysts’ calculations suggest a security should provide, based on the market’s rate of return during the period and the security’s relationship to the market Expiry The expiration date of a derivative security www.elsolucionario.net G-6 GLOSSARY www.elsolucionario.net G-7 External efficiency When prices reflect all available information about an asset, which implies that prices adjust quickly to new information regarding supply or demand Also referred to as informational efficiency Fiduciary A person who supervises or oversees the investment portfolio of a third party, such as in a trust account, and makes investment decisions in accordance with the owner’s wishes Filter rule A trading rule that recommends security transactions when price changes exceed a previously determined percentage Financial risk The variability of future income arising from the firm’s fixed financing costs, for example, interest payments The effect of fixed financial costs is to magnify the effect of changes in operating profit on net income or earnings per share Fixed-income investments Loans with contractually mandated payment schedules from investors to firms or governments Flat trend channel The range defined by security prices as they maintain a relatively steady level Flexible portfolio fund Mutual fund that allows managers to shift assets between stocks, bonds, and cash acccording to changing market conditions; also known as asset allocation fund Floating-rate note (FRN) Short- to intermediate-term bonds with regularly scheduled coupon payments linked to a variable interest rate, most often LIBOR Floor agreement A contract that on each settlement date pays the holder the greater of the difference between the floor rate and the reference rate or zero; it is equivalent to a series of put options on the reference rate Floor brokers Independent members of an exchange who act as brokers for other members Forward contract An agreement between two counterparties that requires the exchange of a commodity or security at a fixed time in the future at a predetermined price Forward discount A situation where, from the perspective of the domestic country, the spot exchange rate is smaller than the forward exchange rate with a foreign country Forward premium A situation where, from the perspective of the domestic country, the spot exchange rate is larger than the forward exchange rate with a foreign country Forward rate A short-term yield for a future holding period implied by the spot rates of two securities with different maturities Forward rate agreement (FRA) A transaction in which two counterparties agree to a single exchange of cash flows based on a fixed and floating rate, respectively Fourth market Direct trading of securities between owners, usually institutions, without any broker intermediation Franchise factor A firm’s unique competitive advantage that makes it possible for a firm to earn excess returns (rates of return above a firm’s cost of capital) on its capital projects In turn, these excess returns and the franchise factor cause the firm’s stock price to have a P/E ratio above its base P/E ratio that is equal to 1/k Free cash flow This cash flow measure equals cash flow from operations minus capital expenditures and debt payments Full replication A technique for constructing a passive index portfolio in which all securities in an index are purchased in proportion to their weights in the index Fully taxable equivalent yield (FTEY) A yield on a tax-exempt bond that adjusts for its tax benefits to allow comparisons with taxable bonds Futures contract An agreement that provides for the future exchange of a particular asset at a specified delivery date in exchange for a specified payment at the time of delivery General obligation bond (GO) A municipal issue serviced from and guaranteed by the issuer’s full taxing authority Generally accepted accounting principles (GAAP) Accounting principles formulated by the Financial Accounting Standards Board and used to construct financial statements Geometric mean (GM) The nth root of the product of the annual holding period returns for n years minus www.elsolucionario.net GLOSSARY www.elsolucionario.net Gifting phase Phase in the investment life cycle during which individuals use excess assets to financially assist relatives or friends, establish charitable trusts, or construct trusts to minimize estate taxes Growth company A company that consistently has the opportunities and ability to invest in projects that provide rates of return that exceed the firm’s cost of capital Because of these investment opportunities, it retains a high proportion of earnings, and its earnings grow faster than those of average firms Growth stock A stock issue that generates a higher rate of return than other stocks in the market with similar risk characteristics; usually identified by high P/E or high price-to-book ratios Hedge A trading strategy in which derivative securities are used to reduce or completely offset a counterparty’s risk exposure to an underlying asset Hedge ratio The number of derivative contracts that must be transacted to offset the price volatility of an underlying commodity or security position High-yield bond A bond rated below investment grade Also referred to as speculative-grade bonds or junk bonds Holding period return (HPR) The total return from an investment, including all sources of income, for a given period of time A value of 1.0 indicates no gain or loss Holding period yield (HPY) The total return from an investment for a given period of time stated as a percentage Immunization A bond portfolio management technique of matching modified duration to the investment horizon of the portfolio to eliminate interest rate risk Implied volatility The standard deviation of changes in the price of the underlying asset that can be inferred from an option’s market price in relation to a specific valuation model In the money An option that has positive intrinsic value Income bonds Debentures that stipulate interest payments only if the issuer earns the income to make the payments by specified dates Income effect The known component of the total return for a bond during a period of time if the shape and position of the yield curve did not change 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) A new issue by a firm that has no existing public market 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 effect The return on a bond portfolio caused by changes in the term structure of interest rates during a period that affect both bond prices and reinvestment rates 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 www.elsolucionario.net G-8 GLOSSARY www.elsolucionario.net G-9 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 Bond income from reinvestment of coupon payments Internal liquidity (solvency) ratios Financial ratios that measure the ability of the firm to meet future short-term financial obligations Internal rate of return (IRR) The discount rate at which cash outflows of an investment equal cash inflows International domestic bonds Bonds issued by a foreign firm, denominated in the firm’s native currency, and sold within its own country 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 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 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 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 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 Liquid Term used to describe an asset that can be quickly converted to cash at a price close to fair market value Liquidity The ability to buy or sell an asset quickly and at a reasonable price 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 www.elsolucionario.net GLOSSARY www.elsolucionario.net 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 about to percent 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 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 Market-value-weighted series An indicator series calculated as the total market value of the securities in the sample 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 mutual 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 sta- www.elsolucionario.net G-10 GLOSSARY www.elsolucionario.net G-11 ble securities available They include Treasury bills, certificates of deposit of large banks, and commercial paper (short-term IOUs of large corporations) 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) 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 National Association of Securities Dealers Automated Quotation (Nasdaq) system An electronic system for providing bid-ask quotes on OTC securities 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 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 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 www.elsolucionario.net GLOSSARY www.elsolucionario.net 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 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 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 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 and displaying them in a simple boxplot format Performance presentation standards (PPS) A comprehensive set of reporting guidelines created by the Association for Investment Management and Research (AIMR), in an effort to fulfill the call for uniform, accurate, and consistent performance reporting 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 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 payments Premium A bond selling at a price above par value due to capital market conditions Price change effect The unknown component of the total return for a bond portfolio during a period of time due to the interest rate effect, sector/quality effect, and residual effect Price continuity A feature of a liquid market in which prices change little from one transaction to the next due to the depth of the market www.elsolucionario.net G-12 GLOSSARY www.elsolucionario.net G-13 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 possible 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 series An indicator series calculated as an arithmetic average of the current prices of the sampled securities 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 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 Public bond A long-term, fixed-obligation debt security in a convenient, affordable denomination for sale to individuals and financial institutions Pure cash-matched dedicated portfolio A conservative dedicated portfolio management technique aimed at developing a bond portfolio that will provide payments exactly matching the specified liability schedules Put options Options to sell a firm’s common stock 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 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 Range forward A trading strategy based on a variation of the put-call 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 www.elsolucionario.net GLOSSARY www.elsolucionario.net 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 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 Residual effect The return on a bond portfolio after taking account of the three prior factors—yield to maturity, interest rate effect, and sector/quality effect 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—e.g., 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 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 Risk averse The assumption about investors that they will choose the least risky alternative, all else being equal Risk premium (RP) The increase over the nominal risk-free rate that investors demand as compensation for an investment’s uncertainty 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 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 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 Sector/quality effect The return on a bond portfolio caused by changing yield spreads between bonds in different sectors and with different quality ratings Secured (senior) bond A bond backed by a legal claim on specified assets of the issuer 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) www.elsolucionario.net G-14 GLOSSARY www.elsolucionario.net G-15 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 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 its standard deviation 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 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 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 risk-adjusted 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 firms 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 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 Speculative company A firm with a great degree of business and/or financial risk, with commensurate high earnings potential Speculative stock A stock that appears to be highly overpriced compared to its reasonable 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 that consider a spread 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 www.elsolucionario.net GLOSSARY www.elsolucionario.net 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 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 Sustainable growth rate 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 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 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 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 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 Over-the-counter trading of securities listed on an exchange 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 Tracking error The standard deviation of the difference in returns between an active investment portfolio and its benchmark porfolio; 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 www.elsolucionario.net G-16 GLOSSARY www.elsolucionario.net G-17 Treasury note A U.S government security with maturities of to 10 years that pays interest periodically Treynor 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 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 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 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; taxes on unrealized capital gains can be deferred indefinitely 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 Uptick An incremental movement upward in a transaction price over the previous transaction price Uptick-downtick ratio A ratio of the number of uptick block transactions (indicating buyers) to the number of downtick block transactions (indicating sellers of blocks) An indicator of institutional investor sentiment 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 Variable-rate note A debt security for which the interest rate changes to follow some specified shortterm rate, for example, the T-bill rate; see floating rate note 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 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 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 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 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.elsolucionario.net GLOSSARY www.elsolucionario.net www.elsolucionario.net Finance www.elsolucionario.net Finance QuickGuide: Select Chapters/Sections Below to Insert into Custom Book Return to Titles - The Investment Setting (32pgs.) Add Section View Section - The Asset Allocation Decision (32pgs.) Add Section View Section - Selecting Investments in a Global Market (38pgs.) Add Section View Section - Organization and Functioning of Securities Markets (44pgs.) Add Section View Section - Security Market Indicator Series (24pgs.) Add Section View Section - Efficient Capital Markets (34pgs.) Add Section View Section - An Introduction to Portfolio Management (28pgs.) Add Section View Section - An Introduction to Asset Pricing Models (42pgs.) Add Section View Section - Multifactor Models of Risk and Return (32pgs.) Add Section View Section 10 - Analysis of Financial Statements (56pgs.) Add Section View Section 11 - An Introduction to Security Valuation (40pgs.) Add Section View Section 12 - Macroeconomic and Market Analysis: The Global Asset Allocation Decision (28pgs.) Add Section View Section 13 - Stock Market Analysis (50pgs.) Add Section View Section 14 - Industry Analysis (54pgs.) Add Section View Section 15 - Company Analysis and Stock Valuation (86pgs.) Add Section View Section 16 - Technical Analysis (28pgs.) Add Section View Section 17 - Equity Portfolio Management Strategies (42pgs.) Add Section View Section 18 - Bond Fundamentals (34pgs.) Add Section View Section 19 - The Analysis and Valuation of Bonds (78pgs.) Add Section View Section 20 - Bond Portfolio Management Strategies (52pgs.) Add Section View Section 21 - An Introduction to Derivative Markets and Securities (42pgs.) Add Section View Section 22 - Forward and Futures Contracts (50pgs.) Add Section View Section 23 - Option Contracts (60pgs.) Add Section View Section 24 - Swap Contracts, Convertible Securities, and Other Embedded Derivatives (52pgs.) Add Section View Section 25 - Professional Asset Management (40pgs.) Add Section View Section 26 - Evaluation of Portfolio Performance (58pgs.) Add Section View Section Appendix A - How to Become a CFA Charterholder (2pgs.) Add Section View Section Appendix B - AIMR Code of Ethics and Standards of Professional Conduct (4pgs.) Add Section View Section Appendix C - Interest Tables (6pgs.) Add Section View Section Appendix D - Standard Normal Probabilities (2pgs.) Add Section View Section Glossary (18pgs.) Add Section View Section www.elsolucionario.net Investment Analysis and Portfolio Management Reilly/Brown (0-324-17173-0) ... of return for a single investment and for a portfolio of investments Over a number of years, a single investment will likely give high rates of return during some years and low rates of return,... AM and GM rates of return A Portfolio of Investments The mean historical rate of return (HPY) for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments... alternative investments with widely different rates of return and standard deviations of returns As an illustration, consider the following two investments: Expected return Standard deviation INVESTMENT