Investment Analysis & Portfolio Management PDF

Investment Analysis & Portfolio Management TENTH EDITION FRANK K. REILLY University of Notre Dame KEITH C. BROWN University of Texas at Austin Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States  This is an electronic version of the print...

Investment Analysis & Portfolio Management TENTH EDITION FRANK K. REILLY University of Notre Dame KEITH C. BROWN University of Texas at Austin Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States  This is an electronic version of the print textbook. Due to electronic rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest.  Investment Analysis & Portfolio © 2012, 2009 South-Western, Cengage Learning Management, Tenth Edition ALL RIGHTS RESERVED. 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II, Michelle, Sophie, and Cara Therese B. and Denise Z. Edgar B., Lisa, Kayleigh, Madison J. T., Francesca, and Alessandra —F. K. R. To Sheryl, Alexander, and Andrew, who make it all worthwhile —K. C. B. Brief Contents Preface xiii Acknowledgments xvii About the Authors xxi PART 1 The Investment Background 1 CHAPTER 1 The Investment Setting 3 CHAPTER 2 The Asset Allocation Decision 33 CHAPTER 3 Selecting Investments in a Global Market 63 CHAPTER 4 Organization and Functioning of Securities Markets 95 CHAPTER 5 Security-Market Indexes 123 PART 2 Developments in Investment Theory 147 CHAPTER 6 Efficient Capital Markets 149 CHAPTER 7 An Introduction to Portfolio Management 181 CHAPTER 8 An Introduction to Asset Pricing Models 207 CHAPTER 9 Multifactor Models of Risk and Return 241 PART 3 Valuation Principles and Practices 269 CHAPTER 10 Analysis of Financial Statements 271 CHAPTER 11 An Introduction to Security Valuation 327 PART 4 Analysis and Management of Common Stocks 365 CHAPTER 12 Macroanalysis and Microvaluation of the Stock Market 367 CHAPTER 13 Industry Analysis 413 CHAPTER 14 Company Analysis and Stock Valuation 459 CHAPTER 15 Technical Analysis 525 CHAPTER 16 Equity Portfolio Management Strategies 549 PART 5 Analysis and Management of Bonds 589 CHAPTER 17 Bond Fundamentals 591 CHAPTER 18 The Analysis and Valuation of Bonds 623 CHAPTER 19 Bond Portfolio Management Strategies 691 iv  Brief Contents v PART 6 Derivative Security Analysis 739 CHAPTER 20 An Introduction to Derivative Markets and Securities 741 CHAPTER 21 Forward and Futures Contracts 781 CHAPTER 22 Option Contracts 821 CHAPTER 23 Swap Contracts, Convertible Securities, and Other Embedded Derivatives 867 PART 7 Specification and Evaluation of Asset Management 909 CHAPTER 24 Professional Money Management, Alternative Assets, and Industry Ethics 911 CHAPTER 25 Evaluation of Portfolio Performance 959 Appendixes A-D 1009 Comprehensive References List 1017 Glossary 1032 Index 1045 Contents Preface....................................... xiii The Importance of Asset Allocation 49 Acknowledgments............................. xvii Investment Returns after Taxes and Inflation 51, Returns About the Authors............................. xxi and Risks of Different Asset Classes 52, Asset Allocation Summary 53 Chapter 2 Appendix: Objectives and Constraints of PART 1 The Investment Background 1 Institutional Investors 58 CHAPTER 1 CHAPTER 3 The Investment Setting......................... 3 Selecting Investments in a Global Market....... 63 What Is an Investment? 3 The Case for Global Investments 64 Investment Defined 4 Relative Size of U.S. Financial Markets 65, Rates of Return Measures of Return and Risk 5 on U.S. and Foreign Securities 66, Risk of Combined Measures of Historical Rates of Return 5, Computing Country Investments 66 Mean Historical Returns 7, Calculating Expected Rates of Global Investment Choices 71 Return 9, Measuring the Risk of Expected Rates of Return Fixed-Income Investments 72, International Bond 12, Risk Measures for Historical Returns 14 Investing 75, Equity Instruments 76, Special Equity Determinants of Required Rates of Return 14 Instruments: Options 78, Futures Contracts 78, The Real Risk-Free Rate 15, Factors Influencing the Investment Companies 79, Real Estate 81, Nominal Risk-Free Rate (NRFR) 15, Risk Premium 17, Low-Liquidity Investments 82 Risk Premium and Portfolio Theory 20, Fundamental Historical Risk-Returns on Alternative Risk versus Systematic Risk 20, Summary of Required Investments 83 Rate of Return 20 World Portfolio Performance 83, Art and Antiques 87, Relationship between Risk and Return 21 Real Estate 87 Movements along the SML 22, Changes in the Slope of the SML 22, Changes in Capital Market Conditions or Chapter 3 Appendix: Covariance 93 Expected Inflation 24, Summary of Changes in the Required Rate of Return 24 CHAPTER 4 Organization and Functioning of Securities Chapter 1 Appendix: Computation of Variance and Standard Deviation 30 Markets.................................... 95 What Is a Market? 96 CHAPTER 2 Characteristics of a Good Market 96, Decimal Pricing 97, The Asset Allocation Decision................. 33 Organization of the Securities Market 98 Individual Investor Life Cycle 34 Primary Capital Markets 98 The Preliminaries 34, Investment Strategies over an Government Bond Issues 98, Municipal Bond Issues 98, Investor’s Lifetime 35, Life Cycle Investment Goals 37 Corporate Bond Issues 99, Corporate Stock Issues 99, Private Placements and Rule 144A 101 The Portfolio Management Process 37 Secondary Financial Markets 101 The Need for a Policy Statement 38 Why Secondary Markets Are Important 101, Secondary Understand and Articulate Realistic Investor Goals 38, Bond Markets 102, Financial Futures 102, Secondary Standards for Evaluating Portfolio Performance 39, Other Equity Markets 102 Benefits 40 Classification of U.S. Secondary Equity Markets 105 Input to the Policy Statement 41 Primary Listing Markets 105, Regional Stock Exchanges Investment Objectives 41, Investment Constraints 45 109, The Third Market 109, The Significant Transition of Constructing the Policy Statement 49 the U.S. Equity Markets 109 General Guidelines 49, Some Common Mistakes 49 vi  Contents vii Alternative Types of Orders Available 112 CHAPTER 7 Market Orders 112, Limit Orders 112, Special Orders 113, An Introduction to Portfolio Management..... 181 Margin Transactions 113, Short Sales 115, Exchange Some Background Assumptions 181 Market-Makers 117, New Trading Systems 117, Exchange Risk Aversion 182, Definition of Risk 182 Merger Mania 118 Markowitz Portfolio Theory 182 Alternative Measures of Risk 183, Expected Rates of CHAPTER 5 Return 183, Variance (Standard Deviation) of Returns for Security Market Indexes...................... 123 an Individual Investment 184, Variance (Standard Uses of Security-Market Indexes 124 Deviation) of Returns for a Portfolio 185, Standard Differentiating Factors in Constructing Market Deviation of a Portfolio 190, A Three-Asset Portfolio 197, Indexes 125 Estimation Issues 198, The Efficient Frontier 198, The The Sample 125, Weighting Sample Members 125, Efficient Frontier and Investor Utility 200 Computational Procedure 125 Chapter 7 Appendix: Stock-Market Indexes 125 A. Proof That Minimum Portfolio Variance Occurs with Price-Weighted Index 126, Value-Weighted Index 127, Equal Weights When Securities Have Equal Unweighted Index 129, Fundamental Weighted Index Variance 205 130, Style Indexes 130, Global Equity Indexes 131 B. Derivation of Weights That Will Give Zero Variance When Bond-Market Indexes 133 Correlation Equals −1.00 205 U.S. Investment-Grade Bond Indexes 135, High-Yield Bond Indexes 135, Global Government Bond CHAPTER 8 Indexes 135 An Introduction to Asset Pricing Models...... 207 Composite Stock-Bond Indexes 137 Capital Market Theory: An Overview 207 Comparison of Indexes over Time 138 Background for Capital Market Theory 208, Developing Correlations between Monthly Equity Price Changes 138, the Capital Market Line 208, Risk, Diversification, and the Correlations between Monthly Bond Index Returns 139, Market Portfolio 212, Investing with the CML: An Mean Annual Security Returns and Risk 139 Example 215 Chapter 5 Appendix: Stock-Market Indexes 144 The Capital Asset Pricing Model 216 A Conceptual Development of the CAPM 217, The Security Market Line 218 PART 2 Developments in Investment Relaxing the Assumptions 225 Differential Borrowing and Lending Rates 225, Theory 147 Zero-Beta Model 226, Transaction Costs 227, Heterogeneous Expectations and Planning CHAPTER 6 Periods 228, Taxes 228 Efficient Capital Markets..................... 149 Additional Empirical Tests of the CAPM 229 Why Should Capital Markets Be Efficient? 150 Stability of Beta 229, Relationship between Systematic Alternative Efficient Market Hypotheses 151 Risk and Return 229, Summary of CAPM Risk-Return Weak-Form Efficient Market Hypothesis 151, Empirical Results 231 Semistrong-Form Efficient Market Hypothesis 152, The Market Portfolio: Theory versus Practice 232 Strong-Form Efficient Market Hypothesis 152 Tests and Results of Efficient Market Hypotheses 152 CHAPTER 9 Weak-Form Hypothesis: Tests and Results 152, Multifactor Models of Risk and Return........ 241 Semistrong-Form Hypothesis: Tests and Results 155, Arbitrage Pricing Theory 242 Strong-Form Hypothesis: Tests and Results 165 Using the APT 244, Security Valuation with the Behavioral Finance 169 APT: An Example 245, Empirical Tests of the Explaining Biases 170, Fusion Investing 171 APT 247 Implications of Efficient Capital Markets 171 Multifactor Models and Risk Estimation 250 Efficient Markets and Technical Analysis 171, Efficient Multifactor Models in Practice 250, Estimating Risk in a Markets and Fundamental Analysis 172, Efficient Markets Multifactor Setting: Examples 256 and Portfolio Management 174 viii Contents Stock 336, Why and When to Use the Discounted Cash PART 3 Valuation Principles and Flow Valuation Approach 337, Why and Practices 269 When to Use the Relative Valuation Techniques 338, Discounted Cash Flow Valuation Techniques 339, Infinite CHAPTER 10 Period DDM and Growth Companies 343, Valuation with Analysis of Financial Statements.............. 271 Temporary Supernormal Growth 344, Present Value of Operating Free Cash Flows 346, Present Value of Free Major Financial Statements 272 Cash Flows to Equity 347 Generally Accepted Accounting Principles 272, Balance Sheet 273, Income Statement 273, Statement of Cash Relative Valuation Techniques 347 Flows 273, Measures of Cash Flow 275, Purpose of Earnings Multiplier Model 347, The Price/Cash Flow Financial Statement Analysis 277 Ratio 350, The Price/Book Value Ratio 350, The Price/ Sales Ratio 351, Implementing the Relative Valuation Analysis of Financial Ratios 277 Technique 351 Importance of Relative Financial Ratios 278 Estimating the Inputs: The Required Rate of Return Computation of Financial Ratios 279 and the Expected Growth Rate of Valuation Common Size Statements 279 Variables 352 Evaluating Internal Liquidity 279 Required Rate of Return (k) 352, Estimating the Internal Liquidity Ratios 280, Inventory Turnover 283 Required Return for Foreign Securities 354, Expected Evaluating Operating Performance 284 Growth Rates 356, Estimating Dividend Growth for Operating Efficiency Ratios 285, Operating Profitability Foreign Stocks 359 Ratios 287 Chapter 11 Appendix: Derivation of Constant Growth Dividend Risk Analysis 293 Discount Model (DDM) 364 Business Risk 294, Financial Risk 295, External Market Liquidity Risk 303 Analysis of Growth Potential 304 PART 4 Analysis and Management of Importance of Growth Analysis 304, Determinants of Growth 305 Common Stocks 365 Comparative Analysis of Ratios 307 CHAPTER 12 Internal Liquidity 307, Operating Performance 307, Risk Analysis 309, Growth Analysis 309 Macroanalysis and Microvaluation of the Stock Market................................... 367 Analysis of Non-U.S. Financial Statements 309 The Components of Market Analysis 367 The Quality of Financial Statements 309 Balance Sheet 309, Income Statement 310, Footnotes 310 Macromarket Analysis 368 Economic Activity and Security Markets 368, The Value of Financial Statement Analysis 310 Economic Series and Stock Prices 369, The Cyclical Specific Uses of Financial Ratios 311 Indicator Approach 369, Monetary Variables, the Stock Valuation Models 311, Estimating the Ratings on Economy, and Stock Prices 372, Money Supply and the Bonds 312, Predicting Insolvency (Bankruptcy) 313, Economy 372, Money Supply and Stock Prices 373, Limitations of Financial Ratios 313 Monetary Policy and Stock Returns 373, Inflation, Interest Rates, and Security Prices 374, Analysis of World Security CHAPTER 11 Markets 376 An Introduction to Security Valuation........ 327 Microvaluation Analysis 377 An Overview of the Valuation Process 329 Applying the DDM Valuation Model to the Market 377, Why a Three-Step Valuation Process? 329 Market Valuation Using the Free Cash Flow to Equity General Economic Influences 329, Industry (FCFE) Model 384 Influences 331, Company Analysis 332, Does the Valuation Using the Earnings Multiplier Approach 387 Three-Step Process Work? 332 Two-Part Valuation Procedure 387, Importance of Both Theory of Valuation 333 Components of Value 387 Stream of Expected Returns (Cash Flows) 333, Required Estimating Expected Earnings per Share 390 Rate of Return 333, Investment Decision Process: A Estimating Gross Domestic Product 390, Estimating Comparison of Estimated Values and Market Prices 334 Sales per Share for a Market Series 391, Valuation of Alternative Investments 334 Alternative Estimates of Corporate Net Profits 392, Valuation of Bonds 334, Valuation of Preferred Stock 335, Estimating Aggregate Operating Profit Margin 393, Approaches to the Valuation of Common Estimating Interest Expense 396,  Contents ix Estimating the Tax Rate 398, Calculating Earnings per Stocks 461, Speculative Companies and Stocks 462, Value Share: An Example 398 versus Growth Investing 462 Estimating the Stock Market Earnings Multiplier 399 Economic, Industry, and Structural Links to Company Determinants of the Earnings Multiplier 400, Estimating Analysis 462 the Required Rate of Return (k) 400, Estimating the Economic and Industry Influences 462, Structural Growth Rate of Dividends (g) 400, Estimating the Influences 463 Dividend-Payout Ratio (D1/E1) 401, Estimating an Company Analysis 463 Earnings Multiplier: An Example 402, Calculating an Firm Competitive Strategies 464, Focusing a Strategy 465, Estimate of the Value for the Market Series 405, Using SWOT Analysis 466, Some Lessons from Lynch 466, Other Relative Valuation Ratios 406 Tenets of Warren Buffett 467 Microvaluation of World Markets 408 Estimating Intrinsic Value 467 Present Value of Dividends 468, Present Value of CHAPTER 13 Dividends Model (DDM) 471, Present Value of Free Industry Analysis............................ 413 Cash Flow to Equity 472, Present Value of Operating Why Do Industry Analysis? 414 Free Cash Flow 474, Relative Valuation Ratio Cross-Sectional Industry Performance 415, Industry Techniques 477 Performance over Time 416, Performance of the Estimating Company Earnings per Share 480 Companies within an Industry 416, Differences in Company Sales Forecast 480, Estimating the Company Industry Risk 416, Summary of Research on Industry Profit Margin 483 Analysis 417, Industry Analysis Process 417 Walgreen Co.’s Competitive Strategies 483 The Business Cycle and Industry Sectors 417 The Internal Performance 483, Importance of Quarterly Inflation 419, Interest Rates 419, International Economics Estimates 485 419, Consumer Sentiment 419 Estimating Company Earnings Multipliers 487 Structural Economic Changes and Alternative Macroanalysis of the Earnings Multiple 487, Industries 420 Microanalysis of the Earnings Multiplier 488, Making the Demographics 420, Lifestyles 420, Technology 420, Investment Decision 492 Politics and Regulations 421 Additional Measures of Relative Value 494 Evaluating the Industry Life Cycle 422 Price/Book Value (P/BV) Ratio 494, Price/Cash Flow Analysis of Industry Competition 423 (P/CF) Ratio 496, Prices/Sales (P/S) Ratio 497, Summary Competition and Expected Industry Returns 423 of Relative Valuation Ratios 499 Estimating Industry Rates of Return 425 Analysis of Growth Companies 499 Valuation Using the Reduced Form DDM 426, Industry Growth Company Defined 500, Actual Returns Valuation Using the Free Cash Flow to Equity (FCFE) above Required Returns 500, Growth Companies Model 433 and Growth Stocks 500, Alternative Growth Models 501, No-Growth Firm 501, Long-Run Growth Industry Analysis Using the Relative Valuation Models 501, The Real World 504 Approach 435 The Earnings Multiple Technique 435 Measures of Value Added 504 Economic Value Added (EVA) 505, Market Value Other Relative Valuation Ratios 446 Added (MVA) 507, Relationships between EVA and The Price/Book Value Ratio 446, The Price/Cash Flow MVA 507, The Franchise Factor 507, Growth Duration Ratio 449, The Price/Sales Ratio 449, Summary of Model 508 Industry/Market Ratios 451 Site Visits and the Art of the Interview 512 Global Industry Analysis 451 When to Sell 512 Chapter 13 Appendix: Influences on Analysts 513 A. Preparing an Industry Analysis: What Is an Industry? 455 Efficient Markets 513, Paralysis of Analysis 514, Analyst B. Insights on Analyzing Industry ROAs 456 Conflicts of Interest 514 Global Company and Stock Analysis 514 CHAPTER 14 Availability of Data 514, Differential Accounting Company Analysis and Stock Valuation....... 459 Conventions 515, Currency Differences (Exchange Company Analysis versus Stock Valuation 460 Rate Risk) 515, Political (Country) Risk 515, Transaction Growth Companies and Growth Stocks 460, Defensive Costs and Liquidity 515, Valuation Differences 515, Companies and Stocks 461, Cyclical Companies and Summary 515 x Contents CHAPTER 15 Alternative Bond Issues 598 Technical Analysis........................... 525 Domestic Government Bonds 599, Government Agency Underlying Assumptions of Technical Analysis 526 Issues 602, Municipal Bonds 604, Corporate Bonds 606, International Bonds 613 Advantages of Technical Analysis 527 Obtaining Information on Bond Prices 614 Challenges to Technical Analysis 528 Interpreting Bond Quotes 615 Challenges to the Assumptions of Technical Analysis 528, Challenges to Technical Trading Rules 529 CHAPTER 18 Technical Trading Rules and Indicators 529 The Analysis and Valuation of Bonds......... 623 Contrary-Opinion Rules 530, Follow the Smart Money 532, Momentum Indicators 533, Stock Price and Volume The Fundamentals of Bond Valuation 624 Techniques 534 The Present Value Model 624, The Yield Model 626 Technical Analysis of Foreign Markets 541 Computing Bond Yields 627 Foreign Stock Market Indexes 541, Technical Analysis of Nominal Yield 627, Current Yield 628, Promised Yield to Foreign Exchange Rates 542 Maturity 628, Promised Yield to Call 630, Realized (Horizon) Yield 631 Technical Analysis of Bond Markets 542 Calculating Future Bond Prices 632 CHAPTER 16 Realized (Horizon) Yield with Differential Reinvestment Equity Portfolio Management Strategies....... 549 Rates 633, Price and Yield Determination on Noninterest Dates 635, Yield Adjustments for Tax-Exempt Bonds 635, Passive versus Active Management 550 Bond Yield Books 636 An Overview of Passive Equity Portfolio Management Bond Valuation Using Spot Rates 636 Strategies 551 Index Portfolio Construction Techniques 552, Tracking What Determines Interest Rates? 638 Error and Index Portfolio Construction 553, Methods of Forecasting Interest Rates 639, Fundamental Index Portfolio Investing 555 Determinants of Interest Rates 640, The Term Structure of Interest Rates 643 An Overview of Active Equity Portfolio Management Strategies 558 Calculating Forward Rates from the Spot Rate Fundamental Strategies 559, Technical Strategies 562, Curve 647 Anomalies and Attributes 563, Forming Momentum- Term Structure Theories 650 Based Stock Portfolios: Two Examples 565, Tax Efficiency Expectations Hypothesis 650, Liquidity Preference (Term and Active Equity Management 568 Premium) Hypothesis 652, Segmented Market Hypothesis Value versus Growth Investing: A Closer Look 569 652, Trading Implications of the Term Structure 653, Yield Spreads 653 An Overview of Style Analysis 573 What Determines the Price Volatility for Bonds? 654 Asset Allocation Strategies 577 Trading Strategies 657, Duration Measures 657, Modified Integrated Asset Allocation 578, Strategic Asset Allocation Duration and Bond Price Volatility 661, Bond Convexity 580, Tactical Asset Allocation 581, Insured Asset 662, Duration and Convexity for Callable Bonds 667, Allocation 582, Selecting an Active Allocation Limitations of Macaulay and Modified Duration 670 Method 583 Yield Spreads with Embedded Options 678 Static Yield Spreads 678, Option-Adjusted Spread 679 PART 5 Analysis and Management of Bonds 589 CHAPTER 19 Bond Portfolio Management Strategies........ 691 CHAPTER 17 Bond Portfolio Performance, Style, and Strategy 691 Bond Fundamentals.......................... 591 Passive Management Strategies 694 Basic Features of a Bond 591 Buy-and-Hold Strategy 694, Indexing Strategy 695, Bond Bond Characteristics 592, Rates of Return on Bonds 594 Indexing in Practice: An Example 696 The Global Bond Market Structure 594 Active Management Strategies 697 Participating Issuers 595, Participating Investors 597, Interest Rate Anticipation 698, Valuation Analysis 700, Bond Ratings 597 Credit Analysis 700, Yield Spread Analysis 705,  Contents xi Implementing an Active Bond Transaction 705, Active Forward and Futures Contracts: Basic Valuation Global Bond Investing: An Example 709 Concepts 788 Core-Plus Management Strategies 711 Valuing Forwards and Futures 789, The Relationship between Spot and Forward Prices 790 Matched-Funding Management Strategies 713 Dedicated Portfolios 713, Immunization Strategies 715, Financial Forwards and Futures: Applications and Horizon Matching 723 Strategies 791 Interest Rate Forwards and Futures 792, Long-Term Contingent and Structured Management Strategies 724 Interest Rate Futures 792, Short-Term Interest Rate Contingent Immunization 724 Futures 796, Stock Index Futures 800, Currency Forwards Chapter 19 Appendix: Bond Immunization and Portfolio and Futures 806 Rebalancing 737 Chapter 21 Appendix: A. A Closed-Form Equation for Calculating Duration 819 B. Calculating Money Market Implied Forward Rates 820 PART 6 Derivative Security Analysis 739 CHAPTER 22 Option Contracts............................ 821 CHAPTER 20 An Overview of Option Markets and An Introduction to Derivative Markets and Contracts 822 Securities................................. 741 Option Market Conventions 822, Price Quotations for Overview of Derivative Markets 742 Exchange-Traded Options 823 The Language and Structure of Forward and The Fundamentals of Option Valuation 830 FuturesMarkets 743, Interpreting Futures Price The Basic Approach 831, Improving Forecast Quotations: An Example 744, The Language and Accuracy 832, The Binomial Option Pricing Model 837, Structure of Option Markets 747, Interpreting Option The Black-Scholes Valuation Model 839, Price Quotations: An Example 748 Estimating Volatility 842, Problems with Black-Scholes Investing with Derivative Securities 750 Valuation 844 The Basic Nature of Derivative Investing 750, Basic Payoff Option Valuation: Extensions and Advanced and Profit Diagrams for Forward Contracts 754, Basic Topics 845 Payoff and Profit Diagrams for Call and Put Options 755, Valuing European-Style Put Options 845, Valuing Option Profit Diagrams: An Example 758 Options on Dividend-Bearing Securities 845, Valuing The Relationship between Forward and American-Style Options 847, Other Extensions of the OptionContracts 760 Black-Scholes Model 848 Put-Call-Spot Parity 760, Put-Call Parity: An Example Option Trading Strategies 850 762, Creating Synthetic Securities Using Put-Call Parity Protective Put Options 850, Covered Call Options 852, 763, Adjusting Put-Call-Spot Parity for Dividends 764, Straddles, Strips, and Straps 853, Strangles 855, Chooser Put-Call-Forward Parity 765 Options 856, Spreads 857, Range Forwards 859 An Introduction to the Use of Derivatives inPortfolio Management 767 Restructuring Asset Portfolios with Forward Contracts CHAPTER 23 767, Protecting Portfolio Value with Put Options 768, An Swap Contracts, Convertible Securities, and Alternative Way to Pay for a Protective Put 771 Other Embedded Derivatives............... 867 OTC Interest Rate Agreements 868 CHAPTER 21 Forward-Based Interest Rate Contracts 868, Option-Based Forward and Futures Contracts............... 781 Interest Rate Contracts 875 An Overview of Forward and Futures Trading 782 Swap Contracting Extensions 878 Futures Contract Mechanics 783, Comparing Forward Equity Index-Linked Swaps 878, Credit-Related and Futures Contracts 785 Swaps 879 Hedging with Forwards and Futures 786 Warrants and Convertible Securities 883 Hedging and the Basis 786, Understanding Basis Risk 787, Warrants 883, Convertible Securities 885, Convertible Calculating the Optimal Hedge Ratio 787 Preferred Stock 885, Convertible Bonds 886 xii Contents Other Embedded Derivatives 890 CHAPTER 25 Dual Currency Bonds 891, Equity-Index Linked Notes Evaluation of Portfolio Performance.......... 959 892, Commodity-Linked Bull and Bear Bonds 894, Swap- What Is Required of a Portfolio Manager? 960 Linked Notes 896 Early Performance Measurement Techniques 961 Valuing Flexibility: An Introduction to Real Portfolio Evaluation before 1960 961, Peer Group Options 898 Comparisons 961 Company Valuation with Real Options 899 Composite Portfolio Performance Measures 961 Treynor Portfolio Performance Measure 963, Sharpe Portfolio Performance Measure 965, Jensen Portfolio PART 7 Specification and Evaluation of Performance Measure 967, The Information Ratio Asset Management 909 Performance Measure 968, Comparing the Composite Performance Measures 970 CHAPTER 24 Application of Portfolio Performance Measures 972 Professional Money Management, Alternative Portfolio Performance Evaluation: Some Extensions 978 Assets, and Industry Ethics................ 911 Components of Investment Performance 978, The Asset Management Industry: Structure and Performance Measurement with Downside Risk 980, Evolution 912 Holdings-Based Performance Measurement 982, Performance Attribution Analysis 986, Measuring Market Private Management and Advisory Firms 916 Timing Skills 989 Investment Strategy at a Private Money Management Firm 918 Factors That Affect Use of Performance Measures 990 Demonstration of the Global Benchmark Problem 990, Organization and Management of Investment Implications of the Benchmark Problems 992, Required Companies 919 Characteristics of Benchmarks 992 Valuing Investment Company Shares 919, Closed-End versus Open-End Investment Companies 920, Evaluation of Bond Portfolio Performance 993 Fund Management Fees 923, Investment Company Returns-Based Bond Performance Measurement 993, Portfolio Objectives 923, Breakdown by Fund Bond Performance Attribution 994 Characteristics 924, Global Investment Companies 927, Reporting Investment Performance 997 Mutual Fund Organization and Strategy: Time-Weighted and Money-Weighted Returns 997, An Example 927 Performance Presentation Standards 998 Investing in Alternative Asset Classes 929 Hedge Funds 931, Characteristics of a Hedge Fund 932, Appendix A How to Become a CFA® Hedge Fund Strategies 933, Risk Arbitrage Investing: A Charterholder............................ 1009 Closer Look 935, Hedge Fund Performance 936, Private Appendix B Code of Ethics and Standards of Equity 938 Professional Conduct...................... 1010 Ethics and Regulation in the Professional Asset Appendix C Interest Tables.................. 1012 Management Industry 946 Appendix D Standard Normal Probabilities.... 1016 Regulation in the Asset Management Industry 946, Comprehensive References List............... 1017 Standards for Ethical Behavior 948, Examples of Ethical Glossary.................................... 1032 Conflicts 949 Index...................................... 1045 What Do You Want from a Professional Asset Manager? 950  Preface The pleasure of authoring a textbook comes from writing about a subject that we enjoy and find exciting. As authors, we hope that we can pass on to the reader not only knowledge but also the excitement that we feel for the subject. In addition, writing about investments brings an added stimulant because the subject can affect the reader during his or her entire business career and beyond. We hope that what readers derive from this course will help them enjoy better lives through managing their financial resources properly. The purpose of this book is to help you learn how to manage your money so you will de- rive the maximum benefit from what you earn. To accomplish this purpose, you need to learn about the many investment alternatives that are available today and, what is more important, to develop a way of analyzing and thinking about investments that will remain with you in the years ahead when new and different investment opportunities become available. Because of its dual purpose, the book mixes description and theory. The descriptive mate- rial discusses available investment instruments and considers the purpose and operation of capital markets in the United States and around the world. The theoretical portion details how you should evaluate current investments and future opportunities to develop a portfolio of investments that will satisfy your risk-return objectives. Preparing this tenth edition has been challenging for two reasons. First, we continue to experi- ence rapid changes in the securities markets in terms of theory, new financial instruments, innova- tive trading practices, and the fallout from the significant credit and liquidity disruption and the numerous regulatory changes that followed. Second, as mentioned in prior editions, capital markets continue to become very global in nature. Consequently, early in the book we present the compel- ling case for global investing. Subsequently, to ensure that you are prepared to function in a global environment, almost every chapter discusses how investment practice or theory is influenced by the globalization of investments and capital markets. This completely integrated treatment is to ensure that you develop a broad mindset on investments that will serve you well in the 21st century. Intended Market This text is addressed to both graduate and advanced undergraduate students who are looking for an in-depth discussion of investments and portfolio management. The presentation of the material is intended to be rigorous and empirical, without being overly quantitative. A proper discussion of the modern developments in investments and portfolio theory must be rigorous. The discussion of numerous empirical studies reflects the belief that it is essential for alterna- tive investment theories to be exposed to the real world and be judged on the basis of how well they help us understand and explain reality. Key Features of the Tenth Edition When planning the tenth edition of Investment Analysis and Portfolio Management, we wanted to retain its traditional strengths and capitalize on new developments in the investments area to make it the most comprehensive investments textbook available. First, the current edition maintains its unparalleled international coverage. Investing knows no borders, and although the total integration of domestic and global investment opportunities may seem to contradict the need for separate discussions of international issues, it, in fact, makes the need for specific information on non-U.S. markets, instruments, conventions, and techniques even more compelling. xiii xiv Preface Second, both technology and regulations have caused more significant changes during the last decade in the functioning and organization of global security markets than during the prior 40 years. Chapter 4 contains a detailed discussion of this evolution and the results for global markets. Third, today’s investing environment includes derivative securities not as exotic anomalies but as standard investment instruments. We felt that Investment Analysis and Portfolio Management must reflect that reality. Consequently, our four chapters on derivatives are written to provide the reader with an intuitive, clear discussion of the different instruments, their markets, valuation, trading strategies, and general use as risk management and return enhancement tools. Fourth, we have added many new questions and problems to the end-of-chapter material to provide more student practice on executing computations concerned with more sophisticated investment problems. Fifth, we have updated and enhanced the collection of Thomson ONE: Business School Edi- tion (BSE) exercises in several end-of-chapter problem sets. Thomson ONE: BSE is a profes- sional analytical package used by professionals worldwide. Our text allows one-year access for students to Thomson ONE: BSE, which contains information on firms, including financial statement comparisons with competitors, stock price information, and indexes for comparing firm performance against the market or sector. Thomson ONE: BSE is a great package for hands-on learning, which rivals or exceeds that offered by other textbook publishers. Major Content Changes in the Tenth Edition The text has been thoroughly updated for currency. In addition to these time-related revisions, we have also made the following specific changes to individual chapters: Chapter 3 The updated evidence of returns (through 2010) continues to support global diver- sification, and an updated study on global assets supports the use of a global measure of sys- tematic risk to explain asset returns. Also, we consider new investment instruments available for global investors, including global index funds and the continued growth of exchange- traded funds (ETFs) for numerous countries and sectors. Chapter 4 Because of the continuing growth in trading volume handled by electronic commu- nications networks (ECNs), this chapter was heavily rewritten to discuss in detail the signifi- cant changes in the market as well as the results of this new environment including the “flash crash” in 2008. This includes a discussion on the continuing changes on the NYSE during 2008–2011. We also consider the rationale for the continuing consolidation of global ex- changes across asset classes of stocks, bonds, and derivatives. In addition, we document recent mergers and discuss several proposed and failed mergers. Finally, we note that the corporate bond market continues to experience major changes in how and when trades are reported and the number of bond issues involved. Chapter 5 This chapter contains a discussion of fundamental weighted stock and bond indexes that use sales and earnings to weight components rather than market value. Also included is an updated analysis of the relationship among indexes. Chapter 6 New studies that both support the efficient market hypothesis but also provide new ev- idence of anomalies are examined in this chapter. There is also discussion of behavioral finance and how it explains many of the anomalies. Further, we discuss the implications of the recent changes in the cost of trading (considered in Chapter 4) on some of the empirical results of prior studies. Chapter 8 This chapter has been revised to enhance the presentation of the important transition be- tween modern portfolio theory and the Capital Asset Pricing Model (CAPM) in a more intuitive way, including a new section on industry-specific characteristic lines. The discussion contains several exam- ples of how the CAPM is measured and used in practice, in both the United States and global markets. Chapter 9 The discussion of the theory and practice of using multifactor models of risk and expected return has been updated and expanded. The connection between the Arbitrage  Preface xv Pricing Theory (APT) and empirical implementations of the APT continues to be stressed, both conceptually and with several revised examples using Morningstar style classification data. Chapter 10 This chapter contains a detailed comparison of alternative cash flow specifications and how they are used in valuation models and credit analysis. When we apply the extensive ratio analysis to Walgreens, it uncovers several changes in the performance by Walgreens, which highlights the usefulness of the analysis. Chapter 11 Here we emphasize the two alternative approaches to valuation (present value of cash flows and relative valuation). An updated presentation of the yield spread during the 2008–2010 period enforces the importance of the changing risk premium. Chapter 12 This chapter both considers the macroeconomic variables that affect capital mar- kets and demonstrates the microvaluation of these markets. The demonstration was very chal- lenging and insightful due to the economic and market environment in 2008–2011. Chapter 13 We continue to emphasize the importance of the macroanalysis of an industry and the large impact this has on the subsequent valuation of the industry. Chapter 14 We advocate a two-part analysis that first involves a deep analysis of a company to understand both its business and financial risk and its growth outlook. The second part of the analysis is a stock valuation component that depends upon the company analysis for in- puts. The result is two decisions—one on the company and the second on the stock. It is em- phasized that these decisions do not have to be the same (e.g., the stock of a good company may be a poor stock—it may be overvalued). Chapter 16 This chapter contains an enhanced discussion of the relative merits of passive versus active management techniques for equity portfolio management focusing on the important role of tracking error. Expanded material on measuring the tax efficiency of an equity portfolio has been introduced, along with additional analysis of equity portfolio investment strategies, including fun- damental and technical approaches, as well as a detailed description of equity style analysis. Chapter 17 Because of the major credit-liquidity problems encountered in the U.S. bond mar- ket during 2007–2009, which continue to impact security markets around the world, several topics in the chapter have been added or adjusted. This includes discussions on government- sponsored entities (GSEs), bond-rating firms, municipal bond insurance, collateralized debt obligations (CDOs), auction-rate securities, and covered bonds. Chapter 18 We discuss four specifications of duration including the strengths and problems for each of them. Similarly, we consider three yield spreads—traditional spreads, static yield spreads, and option adjusted spreads (OAS)—and the relationships among them. Chapter 19 This chapter on bond portfolio management strategies has been enhanced and revised to include an extended discussion comparing active and passive fixed-income strategies, as well as new and updated examples of how the bond immunization process functions. Both new and up- dated material on how the investment style of a fixed-income portfolio is defined and measured in practice has also been included, along with new examples of active bond management strategies. Chapter 20 Expanded discussions of the fundamentals associated with using derivative securities (e.g., interpreting price quotations, basic payoff diagrams, basic strategies) are included in this chap- ter. We also provide updated examples of both basic and intermediate risk management applications using derivative positions, as well as new material on how these contracts trade in the marketplace. Chapter 21 New and updated examples and applications are provided throughout the chapter, emphasizing the role that forward and futures contracts play in managing exposures to equity, fixed-income, and foreign exchange risk. Also included is an enhanced discussion of how fu- tures and forward markets are structured and operate. Chapter 22 Here we expand the discussion linking valuation and applications of call and put options in the context of investment management. The chapter contains both new and xvi Preface updated examples designed to illustrate how investors use options in practice, as well as a dis- cussion of the recent changes to options markets. Chapter 23 This chapter includes a revised discussion of several advanced derivative applica- tions (e.g., swap contracting, convertible securities, structured notes, real options), as well as updated examples and applications of each of these applications. An extensive discussion of how credit default derivatives are used in practice has also been updated. Chapter 24 Contained in this chapter is a revised and updated discussion of the organization and participants in the professional asset management industry. Of particular note is an exten- sive update of the structure and strategies employed by hedge funds as well as enhanced anal- ysis of how private equity funds function. The discussion of ethics and regulation in the asset management industry that concludes the chapter has also been updated and expanded. Chapter 25 An updated and considerably expanded application of the performance measure- ment techniques introduced throughout the chapter is provided, including new material re- garding the calculation of information ratios. The discussion emphasizes how the concept of “downside” risk can be incorporated into the performance measurement process and the ex- amination of techniques that focus on the security holdings of a manager’s portfolio, rather than the returns that the portfolio generates. Supplement Package Preparation of the tenth edition provided the opportunity to enhance the supplement products offered to instructors and students who use Investment Analysis and Portfolio Management. The result of this examination is a greatly improved package that provides more than just ba- sic answers and solutions. We are indebted to the supplement writers who devoted their time, energy, and creativity to making this supplement package the best it has ever been. ® STOCK-TRAK Thousands of students every year use STOCK-TRAK to practice invest- ® ment strategies, test theories, practice day trading, and learn about the various markets. A cou- pon for a price reduction for this optional stock simulation is included with the text. Instructor’s Manual The Instructor’s Manual is available on the IRCD. Written by Narendar Rao at Northeastern Illinois University, it contains a brief outline of each chapter’s key concepts and equations, which can be easily copied and distributed to students as a reference tool. Test Bank The Test Bank, written by Brian Boscaljon at Penn State University–Erie, includes an extensive set of new questions and problems and complete solutions to the testing material. The Test Bank is available on the IRCD. For instructors who would like to prepare their exams electronically, the ExamView version contains all the test questions found in the printed ver- sion. It is available on the IRCD. Solutions Manual This contains all the answers to the end-of-chapter questions and solutions to end-of-chapter problems. Edgar A. Norton at Illinois State University was ever-diligent in the prepa- ration of these materials, ensuring the most error-free solutions possible. It is available on the IRCD. Lecture Presentation Software A comprehensive set of PowerPoint slides created by Yulong Ma at California State University, Long Beach, is available on the IRCD. Each chapter has a self- contained presentation that covers all the key concepts, equations, and examples within the chap- ter. The files can be used as is for an innovative, interactive class presentation. Instructors who have access to Microsoft PowerPoint can modify the slides in any way they wish, adding or delet- ing materials to match their needs. Website The text’s Website can be accessed through http://login.cengage.com/ and includes up-to-date teaching and learning aids for instructors and students. The Instructor’s Manual, Test Bank, and PowerPoint slides are available to instructors for download. If they choose to, instructors may post, on a password-protected site only, the PowerPoint presentation for their students.  Acknowledgments So many people have helped us in so many ways that we hesitate to list them, fearing that we may miss someone. Accepting this risk, we will begin with the University of Notre Dame and the University of Texas at Austin be- cause of their direct support. Reviewers for this edition were: BOLONG CAO DRAGON TANG YEXIAO XU University of California, San Diego University of Hong Kong The University of Texas at Dallas DONALD L. DAVIS ELEANOR XU Golden Gate University Seton Hall University We were fortunate to have the following excellent reviewers for earlier editions: JOHN ALEXANDER ATREYA CHAKRABORTY EURICO FERREIRA Clemson University Brandeis University Clemson University ROBERT ANGELL HSIU-LANG CHEN MICHAEL FERRI East Carolina University University of Illinois John Carroll University at Chicago GEORGE ARAGON GREG FILBECK Boston College DOSOUNG CHOI University of Toledo University of Tennessee BRIAN BELT JOSEPH E. FINNERTY University of Missouri-Kansas City ROBERT CLARK University of Illinois University of Vermont OMAR M. BENKATO HARRY FRIEDMAN Ball State University JOHN CLINEBELL New York University University of Northern Colorado ARAND BHATTACHARYA R. H. GILMER University of Cincinnati JAMES D’MELLO University of Mississippi Western Michigan University CAROL BILLINGHAM STEVEN GOLDSTEIN Central Michigan University EUGENE F. DRZYCIMSKI University of South Carolina University of Wisconsin–Oshkosh SUSAN BLOCK STEVEN GOLDSTEIN University of California, Santa WILLIAM DUKES Robinson-Humphrey/American Barbara Texas Tech University Express GERALD A. BLUM JOHN DUNKELBERG KESHAV GUPTA Babson College Wake Forest University Oklahoma State University PAUL BOLSTER ERIC EMORY SALLY A. HAMILTON Northeastern University Sacred Heart University Santa Clara University ROBERT E. BROOKS THOMAS EYSSELL ERIC HIGGINS University of Alabama University of Missouri–St. Louis Drexel University ROBERT J. BROWN HEBER FARNSWORTH RONALD HOFFMEISTER Harrisburg, Pennsylvania Washington University, St. Louis Arizona State University CHARLES Q. CAO JAMES FELLER SHELLY HOWTON Pennsylvania State University Middle Tennessee State University Villanova University xvii xviii Acknowledgments RON HUTCHINS JACOB MICHAELSEN JIMMY SENTEZA Eastern Michigan University University of California, Santa Cruz Drake University A. JAMES IFFLANDER NICHOLAS MICHAS KATRINA F. SHERRERD Arizona State University Northern Illinois University CFA Institute STAN JACOBS THOMAS W. MILLER JR. SHEKAR SHETTY Central Washington University University of Missouri–Columbia University of South Dakota KWANG JUN LALATENDU MISRA FREDERIC SHIPLEY Michigan State University University of Texas at San Antonio DePaul University JAROSLAW KOMARYNSKY MICHAEL MURRAY DOUGLAS SOUTHARD Northern Illinois University LaCrosse, Wisconsin Virginia Polytechnic Institute MALEK LASHGARI JONATHAN OHN HAROLD STEVENSON University of Hartford Wagner College Arizona State University DANNY LITT HENRY OPPENHEIMER LAWRENCE S. TAI Century Software Systems/UCLA University of Rhode Island Loyola Marymount College MILES LIVINGSTON JOHN PEAVY KISHORE TANDON University of Florida Southern Methodist University The City University of New York, Baruch College CHRISTOPHER MA GEORGE PHILIPPATOS Texas Tech University University of Tennessee DONALD THOMPSON Georgia State University ANANTH MADHAVEN GEORGE PINCHES University of Southern California University of Kansas DAVID E. UPTON Virginia Commonwealth University DAVINDER MALHOTRA ROSE PRASAD Philadelphia College of Textiles and Central Michigan University E. THEODORE VEIT Science Rollins College LAURIE PRATHER STEPHEN MANN University of Tennessee at PREMAL VORA University of South Carolina Chattanooga King’s College IQBAL MANSUR GEORGE A. RACETTE BRUCE WARDREP Widener University University of Oregon East Carolina University LINDA MARTIN MURLI RAJAN RICHARD S. WARR Arizona State University University of Scranton North Carolina State University GEORGE MASON NARENDAR V. RAO ROBERT WEIGAND University of Hartford Northeastern Illinois University University of South Florida JOHN MATTHYS STEVE RICH RUSSELL R. WERMERS DePaul University Baylor University University of Maryland MICHAEL MCBAIN BRUCE ROBIN ROLF WUBBELS Marquette University Old Dominion University New York University DENNIS MCCONNELL JAMES ROSENFELD SHENG-PING YANG University of Maine Emory University Wayland Baptist University JEANETTE MEDEWITZ STANLEY D. RYALS University of Nebraska–Omaha Investment Counsel, Inc.  Acknowledgments xix Valuable comments and data support have come from my frequent coauthor, David Wright, University of Wisconsin–Parkside. Once more, we were blessed with bright, dedicated research assistants when we needed them the most. These include David Young, who carried the heavy load with strong support from Aaron Lin. Both of them were extremely careful, dependable, and creative. Current colleagues have been very helpful: Yu-Chi Chang, Rob Batallio, Mike Hemler, Jerry Langley, and Paul Schultz, University of Notre Dame. As always, some of the best insights and most stimulating comments continue to come during too-infrequent walks with a very good friend, Jim Gentry of the University of Illinois. We are convinced that professors who want to write a book that is academically respectable and relevant, as well as realistic, require help from the “real world.” We have been fortunate to develop relationships with a num- ber of individuals (including a growing number of former students) whom we consider our contacts with reality. The following individuals have graciously provided important insights and material: DAVID G. BOOTH MARTIN S. FRIDSON SANDY LEEDS Dimensional Fund Advisors, Inc. Fridson Vision, LLC University of Texas GARY BRINSON M. CHRISTOPHER GARMAN MARTIN LEIBOWITZ GP Investments Bank of America/Merrill Lynch Morgan Stanley KEVIN CASEY KHALID GHAYUR DOUGLAS R. LEMPEREUR Casey Capital Morgan Stanley Templeton Investment Counsel, Inc. DAVID CHAPMAN WILLIAM J. HANK ROBERT LEVINE Boston College Moore Financial Corporation Nomura Securities DWIGHT D. CHURCHILL RICK HANS AMY LIPTON Fidelity Investments Walgreens Corporation Bankers Trust ABBY JOSEPH COHEN LEA B. HANSEN GEORGE W. LONG Goldman, Sachs Greenwich Associates Long Investment Management Ltd. ROBERT CONWAY W. VAN HARLOW SCOTT LUMMER Goldman, Sachs Putnam Investments Lummer Investment Consulting ROBERT J. DAVIS BRITT HARRIS JOHN MAGINN Crimson Capital Company Teacher Retirement System of Texas Maginn Associates PHILIP DELANEY JR. CRAIG HESTER SCOTT MALPASS Northern Trust Bank Hester Capital Management University of Notre Dame MICHAEL DOW JOANNE HILL JACK MALVEY UBS Global Asset Management Goldman, Sachs Barclays Capital SAM EISENSTADT JOHN W. JORDAN II ANDRAS MAROSI Value Line The Jordan Company University of Alberta FRANK J. FABOZZI ANDREW KALOTAY DOMINIC MARSHALL Journal of Portfolio Management Kalotay Associates Pacific Ridge Capital Partners KENNETH FISHER LUKE KNECHT TODD MARTIN Forbes Dresdner RCM Capital Management Timucuan Asset Management JOHN J. FLANAGAN JR. WARREN N. KOONTZ JR. JOSEPH MCALINDEN Lawrence, O’Donnell, Marcus and Loomis, Sayles Morgan Stanley Company MARK KRITZMAN RICHARD MCCABE H. GIFFORD FONG Windham Capital Management Bank of America/Merrill Lynch Gifford Fong Associates xx Acknowledgments MICHAEL MCCOWIN JACK PYCIK LAWRENCE S. TAI State of Wisconsin Investment Board Consultant Loyola Marymount College TERRENCE J. MCGLINN JOHN C. RUDOLF KEVIN TERHAAR McGlinn Capital Markets Summit Capital Management UBS Global Asset Management OLEG MELENTYEV GUY RUTHERFORD JOSE RAMON VALENTE Bank of America/Merrill Lynch Morgan Stanley Econsult KENNETH MEYER RON RYAN WILLIAM M. WADDEN Lincoln Capital Management Asset Liability Management LongShip Capital Management JANET T. MILLER MARK RYPZINSKI WILLIAM WAY Rowland and Company Henry & Co. University of Texas BRIAN MOORE ROBERT F. SEMMENS JR. KEN WILES U.S. Gypsum Corp. Semmens Private Investments Fulcrum Financial Group SALVATOR MUOIO BRIAN SINGER ROBERT WILMOUTH SM Investors, LP William Blair & Co. National Futures Association DAVID NELMS CLAY SINGLETON RICHARD S. WILSON Discover Financial Services Rollins College Consultant GEORGE NOYES DONALD J. SMITH ARNOLD WOOD Standish Mellon Asset Management Boston University Martingale Asset Management WIL O’HARA FRED H. SPEECE JR. HONG YAN University of Texas Speece, Thorson Capital Group University of South Carolina IAN ROSSA O’REILLY LAURA STARKS BRUCE ZIMMERMAN Wood Gundy, Inc. University of Texas University of Texas Investment Management Company ROBERT PARRINO WILLIAM M. STEPHENS University of Texas Husic Capital Management PHILIP J. PURCELL III JAMES STORK PJP Investments Uitermarkt & Associates We continue to benefit from the help and consideration of the dedicated people who are or have been associ- ated with the CFA Institute: Tom Bowman, Whit Broome, Jeff Diermeier, Bob Johnson, Bob Luck, Sue Martin, Katie Sherrerd, and Donald Tuttle. Professor Reilly would like to thank his assistant, Rachel Karnafel, who had the unenviable task of keeping his office and his life in some sort of order during this project. As always, our greatest gratitude is to our families—past, present, and future. Our parents gave us life and helped us understand love and how to give it. Most important are our wives who provide love, understanding, and support throughout the day and night. We thank God for our children and grandchildren who ensure that our lives are full of love, laughs, and excitement. Frank K. Reilly Notre Dame, Indiana Keith C. Brown Austin, Texas September 2011  About the Authors Frank K. Reilly is the Bernard J. Hank Professor of Finance and former dean of the Mendoza College of Business at the University of Notre Dame. Holding degrees from the University of Notre Dame (BBA), Northwestern University (MBA), and the University of Chicago (PhD), Pro- fessor Reilly has taught at the University of Illinois, the University of Kansas, and the University of Wyoming in addition to the University of Notre Dame. He has several years of experience as a senior securities analyst, as well as experience in stock and bond trading. A chartered financial analyst (CFA), he has been a member of the Council of Examiners, the Council on Education and Research, the grading committee, and was chairman of the board of trustees of the Institute of Charted Financial Analysts and chairman of the board of the Association of Investment Man- agement and Research (AIMR; now the CFA Institute). Professor Reilly has been president of the Financial Management Association, the Midwest Business Administration Association, the Eastern Finance Association, the Academy of Financial Services, and the Midwest Finance Association. He is or has been on the board of directors of the First Interstate Bank of Wiscon- sin, Norwest Bank of Indiana, the Investment Analysts Society of Chicago, UBS Global Funds (chairman), Fort Dearborn Income Securities (chairman), Discover Bank, NIBCO, Inc., the In- ternational Board of Certified Financial Planners, Battery Park High Yield Bond Fund, Inc., Morgan Stanley Trust FSB, the CFA Institute Research Foundation (chairman), the Financial Analysts Seminar, the Board of Certified Safety Professionals, and the University Club at the University of Notre Dame. As the author of more than 100 articles, monographs, and papers, his work has appeared in numerous publications including Journal of Finance, Journal of Financial and Quantitative Anal- ysis, Journal of Accounting Research, Financial Management, Financial Analysts Journal, Journal of Fixed Income, and Journal of Portfolio Management. In addition to Investment Analysis and Portfolio Management, 10th ed., Professor Reilly is the coauthor of another textbook, Invest- ments, 7th ed. (South-Western, 2006) with Edgar A. Norton. He is editor of Readings and Issues in Investments, Ethics and the Investment Industry, and High Yield Bonds: Analysis and Risk Assessment. Professor Reilly was named on the list of Outstanding Educators in America and has received the University of Illinois Alumni Association Graduate Teaching Award, the Outstanding Educa- tor Award from the MBA class at the University of Illinois, and the Outstanding Teacher Award from the MBA class and the senior class at Notre Dame. He also received from the CFA Insti- tute both the C. Stewart Sheppard Award for his contribution to the educational mission of the Association and the Daniel J. Forrestal III Leadership Award for Professional Ethics and Stan- dards of Investment Practice. He also received the Hortense Friedman Award for Excellence from the CFA Society of Chicago and a Lifetime Achievement Award from the Midwest Finance Association. He was part of the inaugural group selected as a fellow of the Financial Manage- ment Association International. He is or has been a member of the editorial boards of Financial Management, The Financial Review, International Review of Economics and Finance, Journal of Financial Education, Quarterly Review of Economics and Finance, and the European Journal of Finance. He is included in Who’s Who in Finance and Industry, Who’s Who in America, Who’s Who in American Education, and Who’s Who in the World. xxi xxii About the Authors Keith C. Brown holds the position of University Distinguished Teaching Professor of Finance and Fayez Sarofim Fellow at the McCombs School of Business, University of Texas. He received his BA in economics from San Diego State University, where he was a member of the Phi Beta Kappa, Phi Kappa Phi, and Omicron Delta Epsilon honor societies. He received his MS and PhD in financial economics from the Krannert Graduate School of Management at Purdue Uni- versity. Since leaving school in 1981, he has specialized in teaching investment management, portfolio management and security analysis, capital markets, and derivatives courses at the un- dergraduate, MBA, and PhD levels, and has received numerous awards for teaching innovation and excellence, including election to the university’s prestigious Academy of Distinguished Tea- chers. In addition to his academic responsibilities, he also serves as President and Chief Execu- tive Officer of The MBA Investment Fund, L.L.C., a privately funded investment company managed by graduate students at the University of Texas. Professor Brown has published more than 40 articles, monographs, chapters, and papers on topics ranging from asset pricing and investment strategy to financial risk management. His publications have appeared in such journals as Journal of Finance, Journal of Financial Econom- ics, Review of Financial Studies, Journal of Financial and Quantitative Analysis, Review of Eco- nomics and Statistics, Journal of Financial Markets, Financial Analysts Journal, Financial Management, Journal of Investment Management, Advances in Futures and Options Research, Journal of Fixed Income, Journal of Applied Corporate Finance, and Journal of Portfolio Manage- ment. In addition to his contributions to Investment Analysis and Portfolio Management, Tenth Edition, he is a coauthor of Interest Rate and Currency Swaps: A Tutorial, a textbook published through the Association for Investment Management and Research (AIMR; now the CFA Insti- tute). He received a Graham and Dodd Award from the Financial Analysts Federation as an au- thor of one of the best articles published by Financial Analysts Journal in 1990, and a Smith- Breeden Prize from the Journal of Finance in 1996. In August 1988, Professor Brown received his Chartered Financial Analyst designation from the CFA Institute and he has served as a member of that organization’s CFA Candidate Curric- ulum Committee and Education Committee, and on the CFA Examination Grading staff. For five years, he was the research director of the Research Foundation of the CFA Institute, from which position he guided the development of the research portion of the organization’s world- wide educational mission. For several years, he was also associate editor for Financial Analysts Journal and currently holds that position for Journal of Investment Management and Journal of Behavioral Finance. In other professional service, Professor Brown has been a regional director for the Financial Management Association and has served as the applied research track chairman for that organization’s annual conference. Professor Brown is the cofounder and senior partner of Fulcrum Financial Group, a portfolio management and investment advisory firm located in Austin, Texas, and Las Vegas, Nevada, that currently oversees portfolios holding a total of $60 million in fixed-income securities. From May 1987 to August 1988 he was based in New York as a senior consultant to the Corporate Professional Development Department at Manufacturers Hanover Trust Company. He has lec- tured extensively throughout the world on investment and risk management topics in the execu- tive development programs for such companies as Fidelity Investments, JP Morgan Chase, Commonfund, BMO Nesbitt Burns, Merrill Lynch, Chase Manhattan Bank, Chemical Bank, Lehman Brothers, Union Bank of Switzerland, Shearson, Chase Bank of Texas, The Beacon Group, Motorola, and Halliburton. He is an advisor to the boards of the Teachers Retirement System of Texas and the University of Texas Investment Management Company and serves on the Investment Committee of LBJ Asset Management Partners. PART 1 The Investment Background Chapter 1 The Investment Setting Chapter 2 The Asset Allocation Decision Chapter 3 Selecting Investments in a Global Market Chapter 4 Organization and Functioning of Securities Markets Chapter 5 Security-Market Indexes 1 2 The chapters in this section will provide a background for your study of investments by answering the following questions: Why do people invest? How do you measure the returns and risks for alternative investments? What factors should you consider when you make asset allocation decisions? What investments are available? How do securities markets function? How and why are securities markets in the United States and around the world changing? What are the major uses of security-market indexes? How can you evaluate the market behavior of common stocks and bonds? What factors cause differences among stock- and bond-market indexes? In the first chapter, we consider why an individual would invest, how to measure the rates of return and risk for alternative investments, and what factors determine an investor’s required rate of return on an investment. The latter point will be important in subsequent analyses when we work to understand investor behavior, the markets for alternative securities, and the valuation of various investments. Because the ultimate decision facing an investor is the makeup of his or her portfolio, Chapter 2 deals with the all-important asset allocation decision. This includes specific steps in the portfolio management process and factors that influence the makeup of an investor’s portfolio over his or her life cycle. To minimize risk, investment theory asserts the need to diversify. Chapter 3 begins our ex- ploration of investments available to investors by making an overpowering case for investing globally rather than limiting choices to only U.S. securities. Building on this premise, we dis- cuss several investment instruments found in global markets. We conclude the chapter with a review of the historical rates of return and measures of risk for a number of alternative asset groups. In Chapter 4, we examine how markets work in general, and then specifically focus on the purpose and function of primary and secondary bond and stock markets. During the last 15 years, significant changes have occurred in the operation of the securities market, including a trend toward a global capital market, electronic trading markets, and substantial worldwide consolidation. After discussing these changes and the rapid development of new capital mar- kets around the world, we speculate about how global markets will continue to consolidate and will increase available investment alternatives. Investors, market analysts, and financial theorists generally gauge the behavior of securities markets by evaluating the return and risk implied by various market indexes and evaluate portfolio performance by comparing a portfolio’s results to an appropriate benchmark. Be- cause these indexes are used to make asset allocation decisions and then to evaluate portfolio performance, it is important to have a deep understanding of how they are constructed and the numerous alternatives available. Therefore, in Chapter 5, we examine and compare a num- ber of stock-market and bond-market indexes available for the domestic and global markets. This initial section provides the framework for you to understand various securities, how to allocate among alternative asset classes, the markets where these securities are bought and sold, the indexes that reflect their performance, and how you might manage a collection of invest- ments in a portfolio. Specific portfolio management techniques are described in later chapters.  CHAPTER 1 The Investment Setting After you read this chapter, you should be able to answer the following questions: Why do individuals invest? What is an investment? How do investors measure the rate of return on an investment? How do 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 investments? This initial chapter discusses several topics basic to the subsequent chapters. We begin by defin- ing 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 indi- vidual 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 con- tribute 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. Notably, changes occur because of both macroeconomic events that affect all investment assets and microeconomic events that affect the specific asset. 1.1 WHAT IS AN INVESTMENT? 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 af- ford based on your current income. These imbalances will lead you either to borrow