Part ONE
ELEMENTS OF INVESTMENTS 1
1 Investments: Background and Issues 2
2 Asset Classes and Financial Instruments 28
3 Securities Markets 55
4 Mutual Funds and Other Investment Companies 86
Part TWO
PORTFOLIO THEORY 111
5 Risk， Return， and the Historical Record 112
6 Efficient Diversification 147
7 Capital Asset Pricing and Arbitrage Pricing Theory 194
8 The Efficient Market Hypothesis 226
9 Behavioral Finance and Technical Analysis 258
Part THREE
DEBT SECURITIES 283
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
Part FIVE
DERIVATIVE MARKETS 475
15 Options Markets 476
16 Option Valuation 509
17 Futures Markets and Risk Management 547
Part SIX
ACTIVE INVESTMENT MANAGEMENT 581
18 Evaluating Investment Performance 582
Appendixes
A References 619
B References to CFA Questions 625
vi
Part ONE
ELEMENTS OF INVESTMENTS 1
1 Investments: Background
and Issues 2
1.1 Real Assets versus Financial Assets 3
1.2 Financial Assets 5
1.3 Financial Markets and the Economy 6
The Informational Role of Financial Markets 6 Consumption Timing 6
Allocation of Risk 7
Separation of Ownership and Management 7 Corporate Governance and Corporate Ethics 9
1.4 The Investment Process 10
1.5 Markets are Competitive 11 The Risk-Return Trade-off 11 Efficient Markets 12
1.6 The Players 12
Financial Intermediaries 13
Investment Bankers 14
Venture Capital and Private Equity 16 Fintech and Financial Innovation 17
1.7 The Financial Crisis of 2008–2009 17
Antecedents of the Crisis 17 Changes in Housing Finance 19 Mortgage Derivatives 20
Credit Default Swaps 21 The Rise of Systemic Risk 21 The Shoe Drops 22
The Dodd-Frank Reform Act 23
1.8 Outline of the Text 23
End-of-Chapter Material 24–27
2 Asset Classes and Financial Instruments 28
2.1 The Money Market 29
Treasury Bills 29
Certificates of Deposit 30 Commercial Paper 30
Bankers’ Acceptances 31
Eurodollars 31
Repos and Reverses 31 Brokers’ Calls 31
Federal Funds 32
The LIBOR Market 32 Money Market Funds 33
Yields on Money Market Instruments 34
2.2 The Bond Market 34
Treasury Notes and Bonds 34 Inflation-Protected Treasury Bonds 35 Federal Agency Debt 35
International Bonds 36
Municipal Bonds 36
Corporate Bonds 39
Mortgage- and Asset-Backed Securities 39
2.3 Equity Securities 40
Common Stock as Ownership Shares 40 Characteristics of Common Stock 41 Stock Market Listings 41
Preferred Stock 42
Depositary Receipts 42
2.4 Stock and Bond Market Indexes 43
Stock Market Indexes 43
The Dow Jones Industrial Average 43 The Standard & Poor’s 500 Index 45 Other U.S. Market Value Indexes 46 Equally Weighted Indexes 47
Foreign and International Stock Market Indexes 47
Bond Market Indicators 48
2.5 Derivative Markets 48
Options 48
Futures Contracts 49
End-of-Chapter Material 50–54
3 Securities Markets 55
3.1 How Firms Issue Securities 56 Privately Held Firms 56 Publicly Traded Companies 57 Shelf Registration 57
Initial Public Offerings 58
3.2 How Securities are Traded 59
Types of Markets 59 Types of Orders 60 Trading Mechanisms 62
3.3 The Rise of Electronic Trading 63
3.4 U.S. Markets 65
NASDAQ 66
The New York Stock Exchange 66 ECNs 66
3.5 New Trading Strategies 67 Algorithmic Trading 67 High-Frequency Trading 67 Dark Pools 68
Bond Trading 69
3.6 Globalization of Stock Markets 70
3.7 Trading Costs 71
3.8 Buying on Margin 71
3.9 Short Sales 74
3.10 Regulation of Securities Markets 77
Self-Regulation 78
The Sarbanes–Oxley Act 79 Insider Trading 80
End-of-Chapter Material 81–85
4 Mutual Funds and Other Investment Companies 86
4.1 Investment Companies 87
4.2 Types Of Investment Companies 87
Unit Investment Trusts 88
Managed Investment Companies 88 Exchange-Traded Funds 89
Other Investment Organizations 89
4.3 Mutual Funds 90 Investment Policies 90 How Funds Are Sold 92
4.4 Costs of Investing in Mutual Funds 93
Fee Structure 93
Fees and Mutual Fund Returns 95
4.5 Taxation of Mutual Fund Income 97
4.6 Exchange-Traded Funds 98
4.7 Mutual Fund Investment Performance: A First Look 100
4.8 Information on Mutual Funds 103
End-of-Chapter Material 105–110
Part TWO
PORTFOLIO THEORY 111
5 Risk， Return， and the Historical Record 112
5.1 Rates of Return 113
Measuring Investment Returns over Multiple Periods 113
Conventions for Annualizing Rates of Return 115
5.2 Inflation and the Real Rate of Interest 116
The Equilibrium Nominal Rate of Interest 117
5.3 Risk and Risk Premiums 118 Scenario Analysis and Probability Distributions 119
The Normal Distribution 121
Normality and the Investment Horizon 123 Deviation from Normality and Tail Risk 123 Risk Premiums and Risk Aversion 124
The Sharpe Ratio 125
5.4 The Historical Record 126
Using Time Series of Returns 126 Risk and Return: A First Look 127
5.5 Asset Allocation Across Risky and Risk-Free Portfolios 132
The Risk-Free Asset 133
Portfolio Expected Return and Risk 133 The Capital Allocation Line 135
Risk Aversion and Capital Allocation 136
5.6 Passive Strategies and the Capital Market Line 137 Historical Evidence on the Capital Market Line 137 Costs and Benefits of Passive Investing 138
End-of-Chapter Material 139–146
6 Efficient Diversification 147
6.1 Diversification and Portfolio Risk 148
6.2 Asset Allocation with Two Risky Assets 149
Covariance and Correlation 150 Using Historical Data 153
The Three Rules of Two-Risky-Assets
Portfolios 154
The Risk-Return Trade-Off with Two-Risky-Assets Portfolios 155 The Mean-Variance Criterion 156
6.3 The Optimal Risky Portfolio with a Risk-Free Asset 159
6.4 Efficient Diversification with many Risky Assets 163
The Efficient Frontier of Risky Assets 163 Choosing the Optimal Risky Portfolio 165
The Preferred Complete Portfolio and a Separation Property 166
Constructing the Optimal Risky Portfolio: an Illustration 166
6.5 A Single-Index Stock Market 168 Statistical Interpretation of the Single-Index Model 171
Learning from the Index Model 173
Using Security Analysis with the Index Model 176
6.6 Risk Pooling， Risk Sharing， and Time Diversification 177
Time Diversification 180
End-of-Chapter Material 181–193
7 Capital Asset Pricing and Arbitrage Pricing Theory 194
7.1 The Capital Asset Pricing Model 195
The Model: Assumptions and Implications 195 Why All Investors Would Hold the Market Portfolio 196
The Passive Strategy Is Efficient 197
The Risk Premium of the Market Portfolio 198 Expected Returns on Individual Securities 199 The Security Market Line 200
Applications of the CAPM 201
7.2 The CAPM and Index Models 202
7.3 How Well Does the CAPM Predict Risk Premiums? 203
7.4 Multifactor Models and the CAPM 204 The Fama-French Three-Factor Model 206 Estimating a Three-Factor SML 206
Multifactor Models and the Validity of the CAPM 208
7.5 Arbitrage Pricing Theory 208 Diversification in a Single-Index Security Market 209
Well-Diversified Portfolios 210
The Security Market Line of the APT 210 Individual Assets and the APT 211
Well-Diversified Portfolios in Practice 212 The APT and the CAPM 212
Multifactor Generalization of the APT 213 Smart Betas and Multifactor Models 214
End-of-Chapter Material 215–225
8 The Efficient Market Hypothesis 226
8.1 Random Walks and Efficient Markets 227 Competition as the Source of Efficiency 228 Versions of the Efficient Market Hypothesis 230
8.2 Implications of the EMH 231 Technical Analysis 231 Fundamental Analysis 233
Active versus Passive Portfolio Management 233 The Role of Portfolio Management in
an Efficient Market 234
Resource Allocation 235
8.3 Are Markets Efficient? 235
The Issues 235
Weak-Form Tests: Patterns in Stock Returns 237 Predictors of Broad Market Returns 239 Semistrong Tests: Market Anomalies 239
Other Predictors of Stock Returns 242 Strong-Form Tests: Inside Information 243 Interpreting the Anomalies 243
Bubbles and Market Efficiency 245
8.4 Mutual Fund and Analyst Performance 246
Stock Market Analysts 246 Mutual Fund Managers 247 So， Are Markets Efficient? 251
End-of-Chapter Material 251–257
9 Behavioral Finance and Technical Analysis 258
9.1 The Behavioral Critique 259 Information Processing 260 Behavioral Biases 261 Limits to Arbitrage 264
Limits to Arbitrage and the Law of One Price 265 Bubbles and Behavioral Economics 267 Evaluating the Behavioral Critique 268
9.2 Technical Analysis and Behavioral Finance 268
Trends and Corrections 269 Sentiment Indicators 273
A Warning 274
End-of-Chapter Material 276–282
Part THREE
DEBT SECURITIES 283
10 Bond Prices and Yields 284
10.1 Bond Characteristics 285
Treasury Bonds and Notes 285 Corporate Bonds 287
Preferred Stock 288
Other Domestic Issuers 289 International Bonds 289 Innovation in the Bond Market 289
10.2 Bond Pricing 291
Bond Pricing between Coupon Dates 294 Bond Pricing in Excel 295
10.3 Bond Yields 296 Yield to Maturity 296 Yield to Call 298
Realized Compound Return versus Yield to Maturity 300
10.4 Bond Prices Over Time 301
Yield to Maturity versus Holding-Period Return 303
Zero-Coupon Bonds and Treasury STRIPS 304 After-Tax Returns 304
10.5 Default Risk and Bond Pricing 306
Junk Bonds 306
Determinants of Bond Safety 306 Bond Indentures 308
Yield to Maturity and Default Risk 309 Credit Default Swaps 311
10.6 The Yield Curve 312
The Expectations Theory 313
The Liquidity Preference Theory 316 A Synthesis 317
End-of-Chapter Material 318–327
Managing Bond Portfolios 328
11.1 Interest Rate Risk 329 Interest Rate Sensitivity 329 Duration 331
What Determines Duration? 335
11.2 Passive Bond Management 337
Immunization 337
Cash Flow Matching and Dedication 343
11.3 Convexity 344
Why Do Investors Like Convexity? 346
11.4 Active Bond Management 348 Sources of Potential Profit 348 Horizon Analysis 349
An Example of a Fixed-Income Investment Strategy 349
End-of-Chapter Material 350–361
Part FOUR
SECURITY ANALYSIS 363
12 Macroeconomic and Industry Analysis 364
12.1 The Global Economy 365
12.2 The Domestic Macroeconomy 367 Gross Domestic Product 367 Employment 368
Inflation 368
Interest Rates 368
Budget Deficit 368
Sentiment 368
12.3 Interest Rates 369
12.4 Demand and Supply Shocks 370
12.5 Federal Government Policy 371
Fiscal Policy 371
Monetary Policy 371
Supply-Side Policies 372
12.6 Business Cycles 373
The Business Cycle 373 Economic Indicators 374
Other Indicators 375
12.7 Industry Analysis 377
Defining an Industry 377
Sensitivity to the Business Cycle 380 Sector Rotation 381
Industry Life Cycles 382
Industry Structure and Performance 385
End-of-Chapter Material 386–394
13 Equity Valuation 395
13.1 Valuation by Comparables 396
Limitations of Book Value 397
13.2 Intrinsic Value Versus Market Price 397
13.3 Dividend Discount Models 399
The Constant-Growth DDM 400 Stock Prices and Investment Opportunities 402
Life Cycles and Multistage Growth Models 405 Multistage Growth Models 409
13.4 Price–Earnings Ratios 410
The Price–Earnings Ratio and Growth Opportunities 410
P/E Ratios and Stock Risk 414 Pitfalls in P/E Analysis 414
The Cyclically Adjusted P/E Ratio 416
Combining P/E Analysis and the DDM 417 Other Comparative Valuation Ratios 417
13.5 Free Cash Flow Valuation Approaches 418
Comparing the Valuation Models 421 The Problem with DCF Models 422
13.6 The Aggregate Stock Market 423
End-of-Chapter Material 424–435
14 Financial Statement Analysis 436
14.1 The Major Financial Statements 437
The Income Statement 437 The Balance Sheet 438
The Statement of Cash Flows 439
14.2 Measuring Firm Performance 441
14.3 Profitability Measures 442 Return on Assets 442 Return on Capital 442 Return on Equity 442
Financial Leverage and ROE 442 Economic Value Added 444
14.4 Ratio Analysis 445
Decomposition of ROE 445 Turnover and Asset Utilization 448 Liquidity Ratios 450
Market Price Ratios 451 Choosing a Benchmark 452
14.5 An Illustration of Financial Statement Analysis 453
14.6 Comparability Problems 456 Inventory Valuation 456 Depreciation 457
Inflation and Interest Expense 458 Fair Value Accounting 458
Quality of Earnings and Accounting Practices 459 International Accounting Conventions 461
14.7 Value Investing: The Graham Technique 462
End-of-Chapter Material 463–474
Part FIVE
DERIVATIVE MARKETS 475
15 Options Markets 476
15.1 The Option Contract 477
Options Trading 478
American versus European Options 479 The Option Clearing Corporation 479
Other Listed Options 480
15.2 Values of Options at Expiration 481
Call Options 481
Put Options 482
Options versus Stock Investments 483
15.3 Option Strategies 485
15.4 Optionlike Securities 493 Callable Bonds 493 Convertible Securities 494 Warrants 496 Collateralized Loans 496
Leveraged Equity and Risky Debt 497
15.5 Exotic Options 498
Asian Options 498
Currency-Translated Options 498
Digital Options 498
End-of-Chapter Material 499–508
16 Option Valuation 509
16.1 Option Valuation: Introduction 510 Intrinsic and Time Values 510 Determinants of Option Values 510
16.2 Binomial Option Pricing 512
Two-State Option Pricing 512 Generalizing the Two-State Approach 515 Making the Valuation Model Practical 516
16.3 Black-Scholes Option Valuation 519
The Black-Scholes Formula 520
The Put-Call Parity Relationship 526 Put Option Valuation 529
16.4 Using the Black-Scholes Formula 529 Hedge Ratios and the Black-Scholes Formula 529
Portfolio Insurance 531
Option Pricing and the Financial Crisis 534
16.5 Empirical Evidence 535
End-of-Chapter Material 536–546
17 Futures Markets and Risk Management 547
17.1 The Futures Contract 548
The Basics of Futures Contracts 548 Existing Contracts 551
17.2 Trading Mechanics 551
The Clearinghouse and Open Interest 551 Marking to Market and the Margin Account 554
xii Contents
Cash versus Actual Delivery 556 Regulations 557
Taxation 557
17.3 Futures Market Strategies 557 Hedging and Speculation 557 Basis Risk and Hedging 560
17.4 Futures Prices 560
Spot-Futures Parity 560
Spreads 565
17.5 Financial Futures 565
Stock-Index Futures 565 Foreign Exchange Futures 567 Interest Rate Futures 568
17.6 Swaps 570
Swaps and Balance Sheet Restructuring 571 The Swap Dealer 571
End-of-Chapter Material 573–580
Part SIX
ACTIVE INVESTMENT
MANAGEMENT 581
18 Evaluating Investment
Performance 582
18.1 The Conventional Theory of Performance Evaluation 583
Average Rates of Return 583 Time-Weighted Returns versus
Dollar-Weighted Returns 583 Adjusting Returns for Risk 584
Risk-Adjusted Performance Measures 585 The Sharpe Ratio for Overall Portfolios 586 The Treynor Ratio 588
The Information Ratio 590
The Role of Alpha in Performance Measures 591 Implementing Performance Measurement: An Example 592
Selection Bias and Portfolio Evaluation 594
18.2 Style Analysis 594
18.3 Morningstar’s Risk-Adjusted Rating 596
18.4 Performance Measurement with Changing Portfolio Composition 597
18.5 Market Timing 598
The Potential Value of Market Timing 600 Valuing Market Timing as a Call Option 601 The Value of Imperfect Forecasting 602
18.6 Performance Attribution Procedures 602
Asset Allocation Decisions 604
Sector and Security Selection Decisions 604 Summing Up Component Contributions 605
End-of-Chapter Material 607–618
Appendixes
A References 619
B References to CFA Questions 625
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