Essentials of Investments PDF 12th Edition

Essentials of Investments The McGraw Hill Education Series in Finance, Insurance, and Real Estate FINANCIAL MANAGEMENT Ross, Westerfield, and Jordan Saunders and Cornett Block, Hirt, and Danielsen Essentials of Corporate Finance Financial Markets and...

Essentials of Investments The McGraw Hill Education Series in Finance, Insurance, and Real Estate FINANCIAL MANAGEMENT Ross, Westerfield, and Jordan Saunders and Cornett Block, Hirt, and Danielsen Essentials of Corporate Finance Financial Markets and Institutions Foundations of Financial Management Tenth Edition Eighth Edition Seventeenth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance INTERNATIONAL FINANCE Brealey, Myers, and Allen Principles of Corporate Finance Thirteenth Edition Eun and Resnick Thirteenth Edition International Financial Management Shefrin Eighth Edition Brealey, Myers, and Allen Behavioral Corporate Finance: Principles of Corporate Finance, Decisions That Create Value REAL ESTATE Concise Second Edition Brueggeman and Fisher Second Edition INVESTMENTS Real Estate Finance and Investments Brealey, Myers, and Marcus Sixteenth Edition Fundamentals of Corporate Finance Bodie, Kane, and Marcus Essentials of Investments Ling and Archer Tenth Edition Twelfth Edition Real Estate Principles: A Value Brooks Approach FinGame Online 5.0 Bodie, Kane, and Marcus Sixth Edition Investments Bruner, Eades, and Schill Twelfth Edition Case Studies in Finance: Managing FINANCIAL PLANNING AND for Corporate Value Creation Hirt and Block INSURANCE Eighth Edition Fundamentals of Investment Allen, Melone, Rosenbloom, and Management Mahoney Cornett, Adair, and Nofsinger Tenth Edition Finance: Applications and Theory Retirement Plans: 401(k)s, IRAs, Fifth Edition Jordan, Miller, and Dolvin and Other Deferred Compensation Fundamentals of Investments: Approaches Cornett, Adair, and Nofsinger Valuation and Management Twelfth Edition M: Finance Ninth Edition Fifth Edition Altfest Stewart, Piros, and Heisler Personal Financial Planning DeMello Running Money: Professional Second Edition Cases in Finance Portfolio Management Third Edition Harrington and Niehaus First Edition Risk Management and Insurance Grinblatt (editor) Sundaram and Das Second Edition Stephen A. Ross, Mentor: Influence Derivatives: Principles and Practice through Generations Kapoor, Dlabay, Hughes, and Hart Second Edition Focus on Personal Finance: An Grinblatt and Titman Active Approach to Help You Financial Markets and Corporate FINANCIAL INSTITUTIONS Achieve Financial Literacy Strategy AND MARKETS Seventh Edition Second Edition Rose and Hudgins Kapoor, Dlabay, Hughes, and Hart Higgins Bank Management and Personal Finance Analysis for Financial Management Financial Services Thirteenth Edition Twelfth Edition Ninth Edition Walker and Walker Ross, Westerfield, Jaffe, and Jordan Rose and Marquis Personal Finance: Building Your Corporate Finance Financial Institutions and Markets Future Thirteenth Edition Eleventh Edition Second Edition Ross, Westerfield, Jaffe, and Jordan Saunders and Cornett Corporate Finance: Core Principles Financial Institutions Management: and Applications A Risk Management Approach Sixth Edition Tenth Edition Essentials of Investments Twelfth Edition ZVI BODIE Boston University ALEX KANE University of California, San Diego ALAN J. MARCUS Boston College ESSENTIALS OF INVESTMENTS Published by McGraw Hill LLC, 1325 Avenue of the Americas, New York, NY 10121. Copyright © 2022 by McGraw Hill LLC. All rights reserved. Printed in the United States of America. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw Hill LLC, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 LWI 24 23 22 21 ISBN 978-1-265-45009-0 MHID 1-265-45009-9 Cover Image: olgers/Shutterstock All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw Hill LLC, and McGraw Hill LLC does not guarantee the accuracy of the information presented at these sites. mheducation.com/highered  About the Authors Zvi Bodie Boston University Professor of Finance and Economics Emeritus at Boston University School of Management Zvi Bodie is Professor Emeritus at Boston University. He earned his Ph.D. in economics from MIT. He has published widely on pension finance and investment strategy and is best known for applying financial theory to life-cycle saving and investing, especially asset- liability matching. He has directed major research projects for the National Bureau of Economic Research and the Pension Research Council. Bodie’s books include Foundations of Pension Finance, Pensions in the U.S. Economy, Issues in Pension Economics, and Financial Aspects of the U.S. Pension System. Bodie has been a visiting professor at the Harvard Business School and MIT’s Sloan School of Management. In 2007, the Retirement Income Industry Association gave him its Lifetime Achievement Award for applied research, and in 2019, the Plan Sponsors Council of America awarded him a lifetime achievement award. Alex Kane University of California, San Diego Professor of Finance and Economics at the Graduate School of International Relations and Pacific Studies at the University of California, San Diego Alex Kane holds a Ph.D. from the Stern School of Business of New York University and has been Visiting Professor at the Faculty of Economics, University of Tokyo; Graduate School of Business, Harvard; Kennedy School of Government, Harvard; and Research Associate, National Bureau of Economic Research. An author of many articles in finance and manage- ment journals, Professor Kane’s research is mainly in corporate finance, portfolio manage- ment, and capital markets. Alan J. Marcus Boston College Mario J. Gabelli Professor of Finance at the Carroll School of Management, Boston College Alan Marcus received his Ph.D. from MIT, has been a Visiting Professor at MIT’s Sloan School of Management and Athens Laboratory of Business Administration, and has served as a Research Fellow at the National Bureau of Economic Research, where he participated in both the Pension Economics and the Financial Markets and Monetary Economics Groups. Professor Marcus also spent two years at the Federal Home Loan Mortgage Corporation (Freddie Mac), where he helped to develop mortgage pricing and credit risk models. His con- sulting work has ranged from new-product development to provision of expert testimony in utility rate proceedings. Professor Marcus has published widely in the fields of capital mar- kets and portfolio theory. He currently serves on the Research Foundation Advisory Board of the CFA Institute. v  Brief Contents Part ONE Part FIVE ELEMENTS OF INVESTMENTS 1 DERIVATIVE MARKETS 475 1 Investments: Background and 15 Options Markets 476 Issues 2 16 Option Valuation 509 2 Asset Classes and Financial 17 Futures Markets and Risk Instruments 28 Management 547 3 Securities Markets 55 4 Mutual Funds and Other Investment Part SIX Companies 86 ACTIVE INVESTMENT MANAGEMENT 581 Part TWO PORTFOLIO THEORY 111 18 Evaluating Investment Performance 582 5 Risk, Return, and the Historical 19 International Diversification 619 Record 112 20 Hedge Funds 646 6 Efficient Diversification 147 21 Taxes, Inflation, and Investment 7 Capital Asset Pricing and Arbitrage Strategy 670 Pricing Theory 194 22 Investors and the Investment 8 The Efficient Market Hypothesis 226 Process 689 9 Behavioral Finance and Technical Analysis 258 Appendixes A References 712 Part THREE B References to CFA Questions 718 DEBT SECURITIES 283 Index 721 10 Bond Prices and Yields 284 11 Managing Bond Portfolios 328 Part FOUR SECURITY ANALYSIS 363 12 Macroeconomic and Industry Analysis 364 13 Equity Valuation 395 14 Financial Statement Analysis 436 vi  Contents Part ONE Certificates of Deposit 30 ELEMENTS OF INVESTMENTS 1 Commercial Paper 30 Bankers’ Acceptances 31 1 Investments: Background Eurodollars 31 and Issues 2 Repos and Reverses 31 1.1 Real Assets versus Financial Assets 3 Brokers’ Calls 31 1.2 Financial Assets 5 Federal Funds 32 1.3 Financial Markets and the Economy 6 The LIBOR Market 32 The Informational Role of Financial Markets 6 Money Market Funds 33 Consumption Timing 6 Yields on Money Market Instruments 34 Allocation of Risk 7 2.2 The Bond Market 34 Separation of Ownership and Management 7 Treasury Notes and Bonds 34 Corporate Governance and Corporate Ethics 9 Inflation-Protected Treasury Bonds 35 1.4 The Investment Process 10 Federal Agency Debt 35 1.5 Markets are Competitive 11 International Bonds 36 The Risk-Return Trade-off 11 Municipal Bonds 36 Efficient Markets 12 Corporate Bonds 39 1.6 The Players 12 Mortgage- and Asset-Backed Securities 39 Financial Intermediaries 13 2.3 Equity Securities 40 Investment Bankers 14 Common Stock as Ownership Shares 40 Venture Capital and Private Equity 16 Characteristics of Common Stock 41 Fintech and Financial Innovation 17 Stock Market Listings 41 1.7 The Financial Crisis of 2008–2009 17 Preferred Stock 42 Antecedents of the Crisis 17 Depositary Receipts 42 Changes in Housing Finance 19 2.4 Stock and Bond Market Indexes 43 Mortgage Derivatives 20 Stock Market Indexes 43 Credit Default Swaps 21 The Dow Jones Industrial Average 43 The Rise of Systemic Risk 21 The Standard & Poor’s 500 Index 45 The Shoe Drops 22 Other U.S. Market Value Indexes 46 The Dodd-Frank Reform Act 23 Equally Weighted Indexes 47 1.8 Outline of the Text 23 Foreign and International Stock Market Indexes 47 End-of-Chapter Material 24–27 Bond Market Indicators 48 2.5 Derivative Markets 48 2 Asset Classes and Financial Options 48 Instruments 28 Futures Contracts 49 2.1 The Money Market 29 Treasury Bills 29 End-of-Chapter Material 50–54 vii viii Contents 3 Securities Markets 55 4.8 Information on Mutual Funds 103 3.1 How Firms Issue Securities 56 End-of-Chapter Material 105–110 Privately Held Firms 56 Publicly Traded Companies 57 Shelf Registration 57 Part TWO Initial Public Offerings 58 PORTFOLIO THEORY 111 3.2 How Securities are Traded 59 Types of Markets 59 5 Risk, Return, and the Historical Types of Orders 60 Record 112 Trading Mechanisms 62 5.1 Rates of Return 113 3.3 The Rise of Electronic Trading 63 Measuring Investment Returns over Multiple 3.4 U.S. Markets 65 Periods 113 NASDAQ 66 Conventions for Annualizing Rates of Return 115 The New York Stock Exchange 66 5.2 Inflation and the Real Rate of Interest 116 ECNs 66 The Equilibrium Nominal Rate of Interest 117 3.5 New Trading Strategies 67 5.3 Risk and Risk Premiums 118 Algorithmic Trading 67 Scenario Analysis and Probability Distributions 119 High-Frequency Trading 67 The Normal Distribution 121 Dark Pools 68 Normality and the Investment Horizon 123 Bond Trading 69 Deviation from Normality and Tail Risk 123 3.6 Globalization of Stock Markets 70 Risk Premiums and Risk Aversion 124 3.7 Trading Costs 71 The Sharpe Ratio 125 3.8 Buying on Margin 71 5.4 The Historical Record 126 3.9 Short Sales 74 Using Time Series of Returns 126 3.10 Regulation of Securities Markets 77 Risk and Return: A First Look 127 Self-Regulation 78 5.5 Asset Allocation Across Risky and Risk-Free The Sarbanes–Oxley Act 79 Portfolios 132 Insider Trading 80 The Risk-Free Asset 133 End-of-Chapter Material 81–85 Portfolio Expected Return and Risk 133 The Capital Allocation Line 135 4 Mutual Funds and Other Risk Aversion and Capital Allocation 136 Investment Companies 86 5.6 Passive Strategies and the Capital Market Line 137 4.1 Investment Companies 87 Historical Evidence on the Capital Market Line 137 4.2 Types Of Investment Companies 87 Costs and Benefits of Passive Investing 138 Unit Investment Trusts 88 End-of-Chapter Material 139–146 Managed Investment Companies 88 Exchange-Traded Funds 89 6 Efficient Diversification 147 Other Investment Organizations 89 6.1 Diversification and Portfolio Risk 148 4.3 Mutual Funds 90 6.2 Asset Allocation with Two Risky Assets 149 Investment Policies 90 Covariance and Correlation 150 How Funds Are Sold 92 Using Historical Data 153 4.4 Costs of Investing in Mutual Funds 93 The Three Rules of Two-Risky-Assets Fee Structure 93 Portfolios 154 Fees and Mutual Fund Returns 95 The Risk-Return Trade-Off with 4.5 Taxation of Mutual Fund Income 97 Two-Risky-Assets Portfolios 155 4.6 Exchange-Traded Funds 98 The Mean-Variance Criterion 156 4.7 Mutual Fund Investment Performance: 6.3 The Optimal Risky Portfolio with a A First Look 100 Risk-Free Asset 159  Contents ix 6.4 Efficient Diversification with 8 The Efficient Market Hypothesis 226 many Risky Assets 163 8.1 Random Walks and Efficient Markets 227 The Efficient Frontier of Risky Assets 163 Competition as the Source of Efficiency 228 Choosing the Optimal Risky Portfolio 165 Versions of the Efficient Market Hypothesis 230 The Preferred Complete Portfolio and a 8.2 Implications of the EMH 231 Separation Property 166 Technical Analysis 231 Constructing the Optimal Risky Portfolio: Fundamental Analysis 233 an Illustration 166 Active versus Passive Portfolio Management 233 6.5 A Single-Index Stock Market 168 The Role of Portfolio Management in Statistical Interpretation of the an Efficient Market 234 Single-Index Model 171 Resource Allocation 235 Learning from the Index Model 173 8.3 Are Markets Efficient? 235 Using Security Analysis with the Index Model 176 The Issues 235 6.6 Risk Pooling, Risk Sharing, and Time Diversification 177 Weak-Form Tests: Patterns in Stock Returns 237 Time Diversification 180 Predictors of Broad Market Returns 239 Semistrong Tests: Market Anomalies 239 End-of-Chapter Material 181–193 Other Predictors of Stock Returns 242 Strong-Form Tests: Inside Information 243 7 Capital Asset Pricing and Arbitrage Interpreting the Anomalies 243 Pricing Theory 194 Bubbles and Market Efficiency 245 7.1 The Capital Asset Pricing Model 195 8.4 Mutual Fund and Analyst Performance 246 The Model: Assumptions and Implications 195 Stock Market Analysts 246 Why All Investors Would Hold the Market Mutual Fund Managers 247 Portfolio 196 So, Are Markets Efficient? 251 The Passive Strategy Is Efficient 197 The Risk Premium of the Market Portfolio 198 End-of-Chapter Material 251–257 Expected Returns on Individual Securities 199 The Security Market Line 200 9 Behavioral Finance and Technical Applications of the CAPM 201 Analysis 258 7.2 The CAPM and Index Models 202 9.1 The Behavioral Critique 259 7.3 How Well Does the CAPM Predict Risk Information Processing 260 Premiums? 203 Behavioral Biases 261 7.4 Multifactor Models and the CAPM 204 Limits to Arbitrage 264 The Fama-French Three-Factor Model 206 Limits to Arbitrage and the Law of One Price 265 Estimating a Three-Factor SML 206 Bubbles and Behavioral Economics 267 Multifactor Models and the Validity of the Evaluating the Behavioral Critique 268 CAPM 208 9.2 Technical Analysis and Behavioral Finance 268 7.5 Arbitrage Pricing Theory 208 Trends and Corrections 269 Diversification in a Single-Index Security Sentiment Indicators 273 Market 209 A Warning 274 Well-Diversified Portfolios 210 End-of-Chapter Material 276–282 The Security Market Line of the APT 210 Individual Assets and the APT 211 Well-Diversified Portfolios in Practice 212 Part THREE The APT and the CAPM 212 DEBT SECURITIES 283 Multifactor Generalization of the APT 213 Smart Betas and Multifactor Models 214 10 Bond Prices and Yields 284 End-of-Chapter Material 215–225 10.1 Bond Characteristics 285 x Contents Treasury Bonds and Notes 285 Part FOUR Corporate Bonds 287 SECURITY ANALYSIS 363 Preferred Stock 288 Other Domestic Issuers 289 12 Macroeconomic and Industry International Bonds 289 Analysis 364 Innovation in the Bond Market 289 12.1 The Global Economy 365 10.2 Bond Pricing 291 12.2 The Domestic Macroeconomy 367 Bond Pricing between Coupon Dates 294 Gross Domestic Product 367 Bond Pricing in Excel 295 Employment 368 10.3 Bond Yields 296 Inflation 368 Yield to Maturity 296 Interest Rates 368 Yield to Call 298 Budget Deficit 368 Realized Compound Return versus Sentiment 368 Yield to Maturity 300 12.3 Interest Rates 369 10.4 Bond Prices Over Time 301 12.4 Demand and Supply Shocks 370 Yield to Maturity versus Holding-Period 12.5 Federal Government Policy 371 Return 303 Fiscal Policy 371 Zero-Coupon Bonds and Treasury STRIPS 304 Monetary Policy 371 After-Tax Returns 304 Supply-Side Policies 372 10.5 Default Risk and Bond Pricing 306 12.6 Business Cycles 373 Junk Bonds 306 The Business Cycle 373 Determinants of Bond Safety 306 Economic Indicators 374 Bond Indentures 308 Other Indicators 375 Yield to Maturity and Default Risk 309 12.7 Industry Analysis 377 Credit Default Swaps 311 Defining an Industry 377 10.6 The Yield Curve 312 Sensitivity to the Business Cycle 380 The Expectations Theory 313 Sector Rotation 381 The Liquidity Preference Theory 316 Industry Life Cycles 382 A Synthesis 317 Industry Structure and Performance 385 End-of-Chapter Material 318–327 End-of-Chapter Material 386–394 Managing Bond Portfolios 328 13 Equity Valuation 395 11.1 Interest Rate Risk 329 13.1 Valuation by Comparables 396 Interest Rate Sensitivity 329 Limitations of Book Value 397 Duration 331 13.2 Intrinsic Value Versus Market Price 397 What Determines Duration? 335 13.3 Dividend Discount Models 399 11.2 Passive Bond Management 337 The Constant-Growth DDM 400 Immunization 337 Stock Prices and Investment Cash Flow Matching and Dedication 343 Opportunities 402 11.3 Convexity 344 Life Cycles and Multistage Growth Models 405 Why Do Investors Like Convexity? 346 Multistage Growth Models 409 11.4 Active Bond Management 348 13.4 Price–Earnings Ratios 410 Sources of Potential Profit 348 The Price–Earnings Ratio and Growth Horizon Analysis 349 Opportunities 410 An Example of a Fixed-Income Investment P/E Ratios and Stock Risk 414 Strategy 349 Pitfalls in P/E Analysis 414 End-of-Chapter Material 350–361 The Cyclically Adjusted P/E Ratio 416  Contents xi Combining P/E Analysis and the DDM 417 Other Listed Options 480 Other Comparative Valuation Ratios 417 15.2 Values of Options at Expiration 481 13.5 Free Cash Flow Valuation Approaches 418 Call Options 481 Comparing the Valuation Models 421 Put Options 482 The Problem with DCF Models 422 Options versus Stock Investments 483 13.6 The Aggregate Stock Market 423 15.3 Option Strategies 485 End-of-Chapter Material 424–435 15.4 Optionlike Securities 493 Callable Bonds 493 Convertible Securities 494 14 Financial Statement Analysis 436 Warrants 496 14.1 The Major Financial Statements 437 Collateralized Loans 496 The Income Statement 437 Leveraged Equity and Risky Debt 497 The Balance Sheet 438 15.5 Exotic Options 498 The Statement of Cash Flows 439 Asian Options 498 14.2 Measuring Firm Performance 441 Currency-Translated Options 498 14.3 Profitability Measures 442 Digital Options 498 Return on Assets 442 Return on Capital 442 End-of-Chapter Material 499–508 Return on Equity 442 Financial Leverage and ROE 442 16 Option Valuation 509 Economic Value Added 444 16.1 Option Valuation: Introduction 510 14.4 Ratio Analysis 445 Intrinsic and Time Values 510 Decomposition of ROE 445 Determinants of Option Values 510 Turnover and Asset Utilization 448 16.2 Binomial Option Pricing 512 Liquidity Ratios 450 Two-State Option Pricing 512 Market Price Ratios 451 Generalizing the Two-State Approach 515 Choosing a Benchmark 452 Making the Valuation Model Practical 516 14.5 An Illustration of Financial Statement 16.3 Black-Scholes Option Valuation 519 Analysis 453 The Black-Scholes Formula 520 14.6 Comparability Problems 456 The Put-Call Parity Relationship 526 Inventory Valuation 456 Put Option Valuation 529 Depreciation 457 16.4 Using the Black-Scholes Formula 529 Inflation and Interest Expense 458 Hedge Ratios and the Black-Scholes Fair Value Accounting 458 Formula 529 Quality of Earnings and Accounting Practices 459 Portfolio Insurance 531 International Accounting Conventions 461 Option Pricing and the Financial Crisis 534 14.7 Value Investing: The Graham Technique 462 16.5 Empirical Evidence 535 End-of-Chapter Material 463–474 End-of-Chapter Material 536–546 Part FIVE 17 Futures Markets and Risk DERIVATIVE MARKETS 475 Management 547 17.1 The Futures Contract 548 15 Options Markets 476 The Basics of Futures Contracts 548 15.1 The Option Contract 477 Existing Contracts 551 Options Trading 478 17.2 Trading Mechanics 551 American versus European Options 479 The Clearinghouse and Open Interest 551 The Option Clearing Corporation 479 Marking to Market and the Margin Account 554 xii Contents Cash versus Actual Delivery 556 18.6 Performance Attribution Procedures 602 Regulations 557 Asset Allocation Decisions 604 Taxation 557 Sector and Security Selection Decisions 604 17.3 Futures Market Strategies 557 Summing Up Component Contributions 605 Hedging and Speculation 557 End-of-Chapter Material 607–618 Basis Risk and Hedging 560 17.4 Futures Prices 560 19 International Diversification 619 Spot-Futures Parity 560 19.1 Global Markets for Equities 620 Spreads 565 Developed Countries 620 17.5 Financial Futures 565 Emerging Markets 621 Stock-Index Futures 565 Market Capitalization and GDP 622 Foreign Exchange Futures 567 Home-Country Bias 622 Interest Rate Futures 568 19.2 Exchange Rate Risk and International 17.6 Swaps 570 Diversification 623 Swaps and Balance Sheet Restructuring 571 Exchange Rate Risk 623 The Swap Dealer 571 Imperfect Exchange Rate Risk Hedging 627 End-of-Chapter Material 573–580 Investment Risk in International Markets 628 International Diversification 630 Part SIX Are Benefits from International Diversification Preserved in Bear Markets? 634 ACTIVE INVESTMENT 19.3 Political Risk 635 MANAGEMENT 581 19.4 International Investing and Performance Attribution 638 18 Evaluating Investment Performance 582 Constructing a Benchmark Portfolio of Foreign Assets 638 18.1 The Conventional Theory of Performance Performance Attribution 639 Evaluation 583 Average Rates of Return 583 End-of-Chapter Material 640–645 Time-Weighted Returns versus Dollar-Weighted Returns 583 20 Hedge Funds 646 Adjusting Returns for Risk 584 20.1 Hedge Funds versus Mutual Funds 647 Risk-Adjusted Performance Measures 585 20.2 Hedge Fund Strategies 648 The Sharpe Ratio for Overall Portfolios 586 Directional versus Nondirectional Strategies 648 The Treynor Ratio 588 Statistical Arbitrage 650 The Information Ratio 590 High-Frequency Strategies 650 The Role of Alpha in Performance Measures 591 20.3 Portable Alpha 651 Implementing Performance Measurement: An Example 592 An Example of a Pure Play 651 Selection Bias and Portfolio Evaluation 594 20.4 Style Analysis for Hedge Funds 653 18.2 Style Analysis 594 20.5 Performance Measurement for Hedge Funds 655 18.3 Morningstar’s Risk-Adjusted Rating 596 Liquidity and Hedge Fund Performance 655 18.4 Performance Measurement with Hedge Fund Performance and Selection Bias 657 Changing Portfolio Composition 597 Hedge Fund Performance and Changing Factor 18.5 Market Timing 598 Loadings 658 The Potential Value of Market Timing 600 Tail Events and Hedge Fund Performance 659 Valuing Market Timing as a Call Option 601 20.6 Fee Structure in Hedge Funds 662 The Value of Imperfect Forecasting 602 End-of-Chapter Material 665–669  Contents xiii 21 Taxes, Inflation, and Investment 22 Investors and the Investment Strategy 670 Process 689 21.1 Taxes and Investment Returns 671 22.1 The Investment Management Process 690 Equity, Debt, and Tax Deferral 671 22.2 Investor Objectives 692 Tax-Protected Retirement Plans 672 Individual Investors 692 Deferred Annuities 673 Professional Investors 694 Sheltered versus Unsheltered Savings 673 22.3 Investor Constraints 697 21.2 Saving for the Long Run 674 Liquidity 697 A Hypothetical Household 674 Investment Horizon 697 The Retirement Annuity 674 Regulations 697 21.3 Accounting for Inflation 675 Tax Considerations 698 A Real Savings Plan 676 Unique Needs 698 An Alternative Savings Plan 677 22.4 Investment Policies 699 21.4 Accounting for Taxes 678 Taxes and Investment Policies for Individual 21.5 Tax Shelters and the Savings Plan 679 Investors 701 A Benchmark Tax Shelter 679 Top-Down Policies for Institutional Investors 702 The Effect of the Progressive Nature Active versus Passive Policies 703 of the Tax Code 680 22.5 Monitoring and Revising Investment Portfolios 704 Roth Accounts with the Progressive End-of-Chapter Material 705–711 Tax Code 682 21.6 Social Security 683 21.7 Home Ownership: The Rent-Versus-Buy Appendixes Decision 684 21.8 Uncertain Longevity and Other A References 712 Contingencies 684 B References to CFA Questions 718 End-of-Chapter Material 686–688 Index 721  Organization of the Twelfth Edition Essentials of Investments, Twelfth Edition, is intended as a textbook on investment analysis most applicable for a student’s first course in investments. The chapters are written in a modular format to give instructors the flexibility to either omit certain chapters or rearrange their order. The highlights in the margins describe updates and important features in this edition. This part lays out the general framework for the investment process in a nontechnical manner. We Part ONE discuss the major players in the financial markets and provide an overview of security types and trad- ELEMENTS OF INVESTMENTS 1 ing mechanisms. These chapters make it possible for instructors to assign term projects analyzing securi- 1 Investments: Background ties early in the course. and Issues 2 Includes sections on securitization, the roots of the 2 Asset Classes and Financial financial crisis, and the fallout from the crisis. Instruments 28 Extensive coverage of the rise of electronic markets, 3 Securities Markets 55 algorithmic and high-speed trading, and changes in 4 Mutual Funds and Other Investment market structure. Companies 86 Includes coverage of innovations in exchange-traded funds. Part TWO This part contains the core of modern portfolio theory. PORTFOLIO THEORY 111 For courses emphasizing security analysis, this part may be skipped without loss of continuity. 5 Risk, Return, and the Historical All data are updated and available on the web through Record 112 the Connect resources. The data are used to discuss 6 Efficient Diversification 147 risk management and tail risk. 7 Capital Asset Pricing and Arbitrage Introduces simple in-chapter spreadsheets that can be Pricing Theory 194 used to compute investment opportunity sets and the index model. 8 The Efficient Market Hypothesis 226 Includes single-factor as well as multifactor models. 9 Behavioral Finance and Technical Analysis 258 Considers evidence both supporting and refuting efficient markets. Contains extensive treatment of behavioral finance and provides an introduction to technical analysis.  This is the first of three parts on security valuation. Part THREE Includes material on sovereign credit default swaps. DEBT SECURITIES 283 Contains spreadsheet material on duration and convexity. 10 Bond Prices and Yields 284 This part is presented in a “top-down” manner, starting 11 Managing Bond Portfolios 328 with the broad macroeconomic environment before moving to more specific analysis. Part FOUR Discusses how international political developments SECURITY ANALYSIS 363 such as the sovereign debt crisis can have major impacts on economic prospects. 12 Macroeconomic and Contains free cash flow equity valuation models as Industry Analysis 364 well as a discussion of the pitfalls of discounted cash 13 Equity Valuation 395 flow models. 14 Financial Statement Analysis 436 Includes a top-down rationale for how ratio analysis can be organized to guide one’s analysis of firm performance. Part FIVE DERIVATIVE MARKETS 475 This part highlights how these markets have become crucial and integral to the financial universe and are 15 Options Markets 476 major sources of innovation. 16 Option Valuation 509 Offers thorough introduction to option payoffs, strategies, and securities with embedded options. 17 Futures Markets and Risk Includes an introduction to risk-neutral valuation Management 547 methods and their implementation in the binomial option-pricing model. Part SIX This part unifies material on active management and is ACTIVE INVESTMENT ideal for a closing-semester unit on applying theory to MANAGEMENT 581 actual portfolio management. Rigorous development of performance evaluation 18 Evaluating Investment methods. Performance 582 Provides evidence on political risk as well as the 19 International benefits of international diversification. Diversification 619 Updated assessment of hedge fund performance and 20 Hedge Funds 646 the exposure of hedge funds to “black swans.” 21 Taxes, Inflation, and Investment Employs extensive spreadsheet analysis of the interaction Strategy 670 of taxes and inflation on long-term financial strategies. 22 Investors and the Investment Modeled after the CFA Institute curriculum, also Process 689 includes guidelines on “How to Become a Chartered Financial Analyst.”  Pedagogical Features Learning Objectives Learning Objectives Each chapter begins with a summary of the chapter learning objectives, providing students LO 8-1 Demonstrate why security price changes should be essentially unpredictable in an with an overview of the concepts they should efficient market. understand after reading the chapter. The end-of- LO 8-2 Cite evidence that supports and contradicts the efficient market hypothesis. chapter problems and CFA questions are tagged LO 8-3 Provide interpretations of various stock market “anomalies.” with the corresponding learning objective. LO 8-4 Formulate investment strategies that make sense in informationally efficient markets. Chapter Overview Each chapter begins with a brief narrative to explain the concepts that T O his chapter will provide you with a broad introduction to the many ven- ues and procedures available for trading securities. We will see that trading mechanisms range from direct negotiation and formal stock exchanges. With this back- ground, we then turn to specific trading are- nas such as the New York Stock Exchange, NASDAQ, and several all-electronic markets. We compare the mechanics of trade execu- will be covered in more among market participants to fully automated tion and the impact of cross-market integra- depth. Relevant web- computer crossing of trade orders. tion of trading. sites related to chapter The first time a security trades is when it is We then turn to the essentials of some spe- material can be found issued to the public. Therefore, we begin with a cific types of transactions, such as buying on in Connect. These sites look at how securities are first marketed to the margin and short-selling stocks. We close the make it easy for students public by investment bankers, the midwives of chapter with a look at some important aspects to research topics further securities. We turn next to a broad survey of of the regulations governing security trading, and retrieve financial how already-issued securities may be traded including insider trading laws, circuit breakers, data and information. among investors, focusing on the differences and the role of security markets as self-regulating between dealer markets, electronic markets, organizations. frontier diverges further from the unconstrained frontier for extreme-risk premiums. Key Terms in the Margin Key terms are indicated in color 6.5 A SINGLE-INDEX STOCK MARKET and defined in the margin the first index model Model that relates stock We started this chapter with the distinction between systematic and firm-specific risk. Sys- time the term is used. A full list of returns to returns on both a tematic risk is macroeconomic, affecting all securities, while firm-specific risk factors affect broad market index and firm- only one particular firm or, at most, a cluster of firms. Index models are statistical mod- key terms is included in the end-of- specific factors. els designed to estimate these two components of risk for a particular security or portfolio. chapter materials. One way of comparing bonds is to determine the interest rate on taxable bonds that would be necessary to provide an after-tax return equal to that of municipals. To derive this value, we set after-tax yields equal and solve for the equivalent taxable yield of the tax-exempt bond. This is the rate a taxable bond would need to offer in order to match the after-tax yield on the tax-free municipal. Numbered Equations Key equations are called out in the text and identi- r taxable(1 − t) = r muni (2.1) fied by equation numbers. These key formulas are or listed at the end of each chapter. Equations that are r muni frequently used are also featured on the text’s end r taxable = ____ (2.2) 1−t sheets for convenient reference. Thus, the equivalent taxable yield is simply the tax-free rate divided by 1 − t. Table 2.2 presents equivalent taxable yields for several municipal yields and tax rates. This table frequently appears in the marketing literature for tax-exempt mutual bond funds  On the MARKET FRONT THE LIBOR SCANDALS LIBOR was designed initially as a survey of interbank lending rates cartel essentially set up a “favor bank” to help each other move the survey average up or down depending on their trading positions. To date, more than $6 billion of fines have been paid, among On the Market Front Boxes but soon became a key determinant of short-term interest rates with far-reaching significance. More than $500 trillion of derivative them, Deutsche Bank ($2.5 billion), UBS ($1.5 billion), Royal Bank of Scotland ($1.1 billion), Rabobank ($1 billion), and SocGen Current articles from financial contracts have payoffs tied to it, and many trillion dollars of loans ($600 million). But government fines may be only the beginning. and bonds with floating interest rates linked to LIBOR are currently outstanding. LIBOR is quoted for loans in five currencies (the U.S. A federal appeals court in 2016 ruled that private lawsuits involving antitrust violations may proceed. Borrowers paying an publications such as The Wall dollar, yen, euro, U.K. pound, and Swiss franc) for maturities ranging from a day to a year, although three months is the most common. interest rate tied to LIBOR argue that they were harmed by the collusion of participating banks to coordinate rates. Street Journal are featured as boxed However, LIBOR is not a rate at which actual transactions occur; Several reforms have been suggested, and some have instead, it is just a survey of “estimated” borrowing rates, and this has made it vulnerable to manipulation. Several large banks are asked been implemented. The British Bankers Association, which until recently ran the LIBOR survey, yielded responsibility for LIBOR readings. Each box is referred to to report the rate at which they claim they can borrow in the inter- bank market. Outliers are trimmed from the sample of responses, and LIBOR is calculated as the average of the mid-range estimates. to British regulators. LIBOR quotes in less-active currencies and maturities, where collusion is easier, have been eliminated. More substantive proposals would replace the survey rates with ones within the narrative of the text, and Over time, several problems surfaced. First, it appeared that many banks understated the rates at which they claimed they based on actual, verifiable transactions—that is, real loans. Brit- ish regulators have expressed their wish to phase out LIBOR by its real-world relevance to the chapter could borrow in an effort to make themselves look financially stron- 2021. Two primary contenders to replace it are SONIA (Sterling ger. Other surveys that asked for estimates of the rates at which other banks could borrow resulted in higher values. Moreover, Overnight Interbank Average Rate), an overnight interest rate in the U.K. market, and, for U.S. dollar rates, SOFR (secured over- material is clearly defined. LIBOR did not seem to reflect current market conditions. A major- night financing rate), the rate on repurchase agreements on ity of LIBOR submissions were unchanged from day to day even Treasury securities. when other interest rates fluctuated, and LIBOR spreads showed These proposals leave some important questions unanswered. surprisingly low correlation with other measures of credit risk. When LIBOR is phased out, what will happen to LIBOR-based Even worse, once the market came under scrutiny, it emerged long-term contracts with maturities that extend beyond 2021? that participating banks were colluding to manipulate their LIBOR For example, LIBOR is the most common index for adjustable Concept Checks These self-test questions in the body of the chapter enable students Why does it make sense for shelf registration to be limited in time? CONCEPT 3.1 to determine whether the c h e c k preceding material has been understood and then reinforce understanding before students read further. Detailed Solutions to the Concept Checks are found at the end of each chapter. Numbered Examples Numbered and titled EXAMPLE 2.4 To illustrate how value-weighted indexes are computed, look again at Table 2.3. The final value examples are integrated of all outstanding stock in our two-stock universe is $690 million. The initial value was $600 million. Value-Weighted Indexes Therefore, if the initial level of a market value–weighted index of stocks ABC and XYZ were set in each chapter. Using the equal to an arbitrarily chosen starting value such as 100, the index value at year-end would be 100 × (690/600) = 115. The increase in the index would reflect the 15% return earned on a portfolio worked-out solutions to these consisting of those two stocks held in proportion to outstanding market values. Unlike the price-weighted index, the value-weighted index gives more weight to ABC. Whereas examples as models, students the price-weighted index fell because it was dominated by higher-priced XYZ, the value-weighted index rose because it gave more weight to ABC, the stock with the higher total market value. can learn how to solve Note also from Tables 2.3 and 2.4 that market value–weighted indexes are unaffected by stock splits. The total market value of the outstanding XYZ stock increases from $100 million to $110 million specific problems step-by- regardless of the stock split, thereby rendering the split irrelevant to the performance of the index. step as well as gain insight into general principles by seeing how they are applied to answer concrete questions.  Excel Integration Excel Applications Because many courses now require students to perform Chapter 3: Buying on Margin; Short Sales analyses in spreadsheet format, Excel has been integrated Chapter 6: Estimating the Index Model throughout the book. It is used in examples as well as in Chapter 11: Immunization; Convexity this chapter feature, which shows students how to create Chapter 15: Options, Stock, and Lending; and manipulate spreadsheets to solve specific problems. Straddles and Spreads This feature starts with an example presented in the chapter, briefly discusses how a spreadsheet can be valuable for Chapter 17: Spot-Futures Parity investigating the topic, shows a sample spreadsheet, and Chapter 18: Performance Measurement; asks students to apply the data to answer questions. These Performance Attribution applications also direct the student to the web to work with Chapter 19: International Diversification an interactive version of the spreadsheet. The spreadsheet files are available for download in Connect; available Spreadsheet exhibit templates are also spreadsheets are denoted by an icon. As extra guidance, available for the following: the spreadsheets include a comment feature that documents Chapter 5: Spreadsheet 5.1 both inputs and outputs. Solutions for these exercises are Chapter 6: Spreadsheets 6.1–6.6 located on the password-protected instructor site only, so Chapter 10: Spreadsheets 10.1 & 10.2 instructors can assign these exercises either for homework or just for practice. Chapter 11: Spreadsheets 11.1 & 11.2 Chapter 13: Spreadsheets 13.1 & 13.2 Excel application spreadsheets are available for the Chapter 16: Spreadsheet 16.1 following: Chapter 21: Spreadsheets 21.1–21.10 E XC E L APPLICATIONS Buying on Margin The Excel spreadsheet model below makes it easy to analyze the impacts of different margin levels and the volatility of stock prices. It also allows you to compare return on investment for a margin trade with a This spreadsheet is trade using no borrowed funds. available in Connect A B C D E F G H 1 2 Action or Formula Ending Return on Endingg Return with 3 for Column B St Price Investment St Price No Margin 4 Initial Equity Investment $10,000.00 Enter data −42.00% −19.00% 5 Amount Borrowed $10,000.00 (B4/B10)−B4 $20.00 −122.00% $20.00 −59.00% 6 Initial Stock Price $50.00 Enter data 25.00 −102.00% 25.00 −49.00% 7 Shares Purchased 400 (B4/B10)/B6 30.00 −82.00% 30.00 −39.00% 8 Ending Stock Price $40.00 Enter data 35.00 −62.00% 35.00 −29.00% 9 Cash Dividends During Hold Per. $0.50 Enter data 40.00 −42.00% 40.00 −19.00% 10 Initial Margin Percentage 50.00% Enter data 45.00 −22.00% 45.00 −9.00% 11 Maintenance Margin Percentage 30.00% Enter data 50.00 −2.00% 50.00 1.00% 12 55.00 18.00% 55.00 11.00% 13 Rate on Margin Loan 8.00% Enter data 60.00 38.00% 60.00 21.00% 14 Holding Period in Months 6 Enter data 65.00 58.00% 65.00 31.00% 15 70.00 78.00% 70.00 41.00% 16 Return on Investment 75.00 98.00% 75.00 51.00% 17 Capital Gain on Stock −$4,000.00 B7*(B8−B6) 80.00 118.00% 80.00 61.00% 18 Dividends $200.00 B7*B9 19 Interest on Margin Loan $400.00 B5*(B14/12)*B13 20 Net Income −$4,200.00 B17+B18−B19 LEGEND: 21 Initial Investment $10,000.00 B4 Enter data 22 Return on Investment −42.00% B20/B21 Value calculated Excel Questions 1. Suppose you buy 100 shares of stock initially selling for $50, borrowing 25% of the necessary funds from your broker; that is, the initial margin on your purchase is 25%. You pay an interest rate of 8% on margin loans. a. How much of your own money do you invest? How much do you borrow from your broker? b. What will be your rate of return for the following stock prices at the end of a one-year holding period? (i) $40; (ii) $50; (iii) $60. 2. Repeat Question 1 assuming your initial margin was 50%. How does margin affect the risk and return of  End-of-Chapter Features ® Select problems are available in McGraw-Hill’s PROBLEM SETS Problem Sets Connect. Please see the Supplements section of the book’s frontmatter for more information. We strongly believe that practice in solving 1. In forming a portfolio of two risky assets, what must be true of the correlation coefficient between their returns if there are to be gains from diversification? Explain. (LO 6-1) problems is a critical part of learning invest- 2. When adding a risky asset to a portfolio of many risky assets, which property of the asset hasofa this stock? greater influence on risk: its standard deviation or its covariance with the ments, so we provide a good variety. We have 18. You other are Explain. assets? have $5,000 3. A portfolio’s bullish on Telecom of your expected (LO 6-1)stock. The current market price is $50 per share, and you ownisto12%, return invest. its You borrow standard an additional deviation is 20%,$5,000 and thefrom your rate risk-free broker at arranged questions by level of difficulty. Templates and spreadsheets an interest rate of 8% is 4%. Which of the following per would year and makeinvest for$10,000 in the the greatest stock. in(LO increase the 3-4) portfolio’s are available in Connect a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next year? (Ignore the expected dividend.) b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately. 19. You are bearish on Telecom and decide to sell short 100 shares at the current market Excel Problems Select end-of-chapter questions require the use of Excel. These problems are denoted with an icon. Templates and spreadsheets are available in Connect. Market orders entail greater time-of-execution uncertainty than limit orders. 11. Where would an illiquid security in a developing economy most likely trade? (LO 3-3) Kaplan-Schweser Problems a. Broker markets. b. Electronic crossing networks. Each chapter contains select CFA-style ques- c. Electronic limit-order markets. 12. Are the following statements true or false? If false, correct them. (LO 3-4) tions derived from the Kaplan-Schweser CFA a. An investor who wishes to sell shares immediately should ask his or her broker to preparation courses. These questions are tagged enter a limit order. b. The ask price is less than the bid price. with an icon for easy reference. c. An issue of additional shares of stock to the public by Microsoft would be called an IPO. CFA Problems 1. Jones Group has been generating stable after-tax return on equity (ROE) despite CFA Problems declining operating income. Explain how it might be able to maintain its stable We provide several questions from past CFA after-tax ROE. (LO 14-3) 2. Which of the following best explains a ratio of “net sales to average net fixed assets” exams in applicable chapters. These questions that exceeds the industry average? (LO 14-3) a. The firm added to its plant and equipment in the past few years. represent the kinds of questions that profes- b. The firm makes less efficient use of its assets than other firms. c. The firm has a lot of old plant and equipment. sionals in the field believe are relevant to the d. The firm uses straight-line depreciation. practicing money manager. Appendix B, at the back of the book, lists each CFA question and the level and year of the CFA Exam it was included in, for easy reference when studying for the exam. Web Master Exercises WEB master 1. Go to the website for The Walt Disney Co. (DIS) and download its most recent annual report (its 10-K). Locate the company’s Consolidated Balance Sheets and answer these questions: These exercises are a great way to allow stu- a. How much preferred stock is Disney authorized to issue? How much has been issued? b. How much common stock is Disney authorized to issue? How many shares are cur- dents to test their skills on the Internet. Each rently outstanding? c. Search for the term “Financing Activities.” What is the total amount of borrowing exercise consists of an activity related to practi- listed for Disney? How much of this is medium-term notes? d. What other types of debt does Disney have outstanding? cal problems and real-world scenarios. 2. Not all stock market indexes are created equal. Different methods are used to calculate various indexes, and different indexes will yield different assessments of “market performance.” Using one of the following data sources, retrieve the stock price for five  Supplements MCGRAW HILL CONNECT® Instructor Library The Connect Instructor Library is your repository for Less Managing. More Teaching. Greater Learning. additional resources to improve student engagement in McGraw Hill Connect is an online assignment and and out of class. You can select and use any asset that assessment solution that connects students with the tools enhances your lecture. and resources they’ll need to achieve success. 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Find out more at www.mheducation.com/readanywhere - Jordan Cunningham, Eastern Washington University Everything you need in one place Your Connect course has everything you need—whether reading on your digital eBook or completing assignments for class, Connect makes it easy to get your work done. Calendar: owattaphotos/Getty Images Learning for everyone McGraw Hill works directly with Accessibility Services Departments and faculty to meet the learning needs of all students. Please contact your Accessibility Services Office and ask them to email [email protected], or visit www.mheducation.com/about/accessibility for more information. Top: Jenner Images/Getty Images, Left: Hero Images/Getty Images, Right: Hero Images/Getty Images  Acknowledgments We received help from many people as we prepared this Philip Fanara Howard University book. An insightful group of reviewers commented on this Joseph Farinella University of North Carolina, Wilmington and previous editions of this text. Their comments and Greg Feigel University of Texas, Arlington suggestions improved the exposition of the material con- James F. Feller Middle Tennessee State University siderably. These reviewers all deserve special thanks for James Forjan York College their contributions. Beverly Frickel University of Nebraska, Kearney Anna Agapova Florida Atlantic University, Boca Raton Ken Froewiss New York University Sandro C. Andrade University of Miami Phillip Ghazanfari California State University, Pomona Bala Arshanapalli Indiana University Northwest Eric Girard Siena College Rasha Ashraf Georgia State University Richard A. Grayson University of Georgia Anand Bhattacharya Arizona State University, Tempe Greg Gregoriou SUNY, Plattsburgh Randall S. Billingsley Virginia Polytechnic Institute and State Richard D. Gritta University of Portland University Anthony Yanxiang Gu SUNY Geneseo Howard Bohnen St. Cloud State University Deborah Gunthorpe University of Tennessee Paul Bolster Northeastern University Weiyu Guo University of Nebraska, Omaha Lyle Bowlin University of Northern Iowa Pamela Hall Western Washington University Brian Boyer Brigham Young University Thomas Hamilton St. Mary’s University Nicole Boyson Northeastern University Bing Han University of Texas, Austin Ben Branch University of Massachussets, Amherst Yvette Harman Miami University of Ohio Thor W. Bruce University of Miami Gay Hatfield University of Mississippi Timothy Burch University of Miama, Coral Gables Larry C. Holland Oklahoma State University Alyce R. Campbell University of Oregon Harris Hordon New Jersey City University Mark Castelino Rutgers University Stephen Huffman University of Wisconsin, Oshkosh Greg Chaudoin Loyola University Ron E. Hutchins Eastern Michigan University Ji Chen University of Colorado, Denver David Ikenberry University of Illinois, Urbana-Champaign Joseph Chen University of California, Davis A. Can (John) Inci Florida State University Mustafa Chowdhury Louisiana State University Victoria Javine University of Southern Alabama Ron Christner Loyola University, New Orleans Nancy Jay Mercer University Shane Corwin University of Notre Dame Richard Johnson Colorado State University Brent Dalrymple University of Central Florida Douglas Kahl University of Akron Praveen Das University of Louisiana, Lafayette Richard J. Kish Lehigh University Diane Del Guercio University of Oregon Tom Krueger University of Wisconsin, La Crosse David C. Distad University of California at Berkeley Donald Kummer University of Missouri, St. Louis Gary R. Dokes University of San Diego Merouane Lakehal-Ayat St. John Fisher College James Dow California State University, Northridge Reinhold P. Lamb University of North Florida Robert Dubil University of Utah, Salt Lake City Angeline Lavin University of South Dakota John Earl University of Richmond Hongbok Lee Western Illinois University Jeff Edwards Portland Community College Kartono Liano Mississippi State University Peter D. Ekman Kansas State University Jim Locke Northern Virginia Community College John Elder Colorado State University John Loughlin St. Louis University Richard Elliott University of Utah, Salt Lake City David Louton Bryant College James Falter Franklin University David Loy Illinois State University xxiv  Acknowledgments xxv Christian Lundblad Indiana University Bruce Swensen Adelphi University Robert A. Lutz University of Utah Glenn Tanner University of Hawaii Laurian Casson Lytle University of Wisconsin, Whitewater John L. Teall Pace University Leo Mahoney Bryant College Anne Macy Terry West Texas A&M University Herman Manakyan Salisbury State University Donald J. Thompson Georgia State University Steven V. Mann University of South Carolina Steven Thorley Brigham Young University Jeffrey A. Manzi Ohio University James Tipton Baylor University James Marchand Westminster College Steven Todd DePaul University Robert J. Martel Bentley College Michael Toyne Northeastern State University Linda J. Martin Arizona State University William Trainor Western Kentucky University Stanley A. Martin University of Colorado, Boulder Andrey Ukhov Indiana University, Bloomington Thomas Mertens New York University Cevdet Uruk University of Memphis Edward Miller University of New Orleans Joseph Vu DePaul University Michael Milligan California State University, Fullerton Jessica Wachter New York University Rosemary Minyard Pfeiffer University Joe Walker University of Alabama at Birmingham Walter Morales Louisiana State University Richard Warr North Carolina State University Mbodja Mougoue Wayne State University William Welch Florida International University Shabnam Mousavi Georgia State University Russel Wermers University of Maryland Majed Muhtaseb California State Polytechnic University Andrew L. Whitaker North Central College Deborah Murphy University of Tennessee, Knoxville Howard Whitney Franklin University Mike Murray Winona State University Michael E. Williams University of Texas at Austin C. R. Narayanaswamy Georgia Institute of Technology Alayna Williamson University of Utah, Salt Lake City Walt Nelson Missouri State University Michael Willoughby University of California, San Diego Karyn Neuhauser SUNY, Plattsburgh Tony Wingler University of North Carolina Mike Nugent SUNY Stonybrook Annie Wong Western Connecticut State University Raj Padmaraj Bowling Green University David Wright University of Wisconsin, Parkside Elisabeta Pana Illinois Wesleyan University Richard H. Yanow North Adams State College John C. Park Frostburg State University Tarek Zaher Indiana State University Percy Poon University of Nevada, Las Vegas Allan Zebedee San Diego State University Robert B. Porter University of Florida Zhong-guo Zhou California State University, Northridge Dev Prasad University of Massachusetts, Lowell Thomas J. Zwirlein University of Colorado, Colorado Springs Rose Prasad Central Michigan University For granting us permission to include many of their exam- Elias A. Raad Ithaca College ination questions in the text, we are grateful to the CFA Michael Radin Montclair State University Institute. Murli Rajan University of Scranton A special t