Essentials of Investments

The McGraw-Hill/Irwin Series in Finance, Insurance, and Real EstateStephen A. RossFranco Modigliani Professor of Finance and Economics Sloan School o f M anagem ent Massachusetts In stitu te o f Technology Consulting Editor

FINANCIAL MANAGEMENT

Block, Hirt, and DanielsenF o undations o f F inancial M anagem en tFourteenth Edition

Brealey, Myers, and AllenPrincip les o f C o rp o ra te F inanceTenth Edition

Brealey, Myers, and AllenPrincip les o f C o rp o ra te F inance , C onciseSecond Edition

Brealey, Myers, and MarcusFundam en ta ls o f C o rp o ra te F inanceSeventh Edition

BrooksF in G am e O n lin e 5.0

BrunerC ase S tudies in F inance : M an ag in g for C orpo ra te Value C rea tionSixth Edition

Cornett, Adair, and Nofsinger Finance : A pplications a nd T h e o rySecond Edition

Cornett, Adair, and NofsingerM : F inanceFirst Edition

DeMcUoC ases in F inanceSecond Edition

Grinblatt (editor)Stephen A . R oss, M en to r: In fluence th rough G en era tio n sEighth Edition

Grinblatt and Titman F inancial M arke ts and C orpo ra te S trategySecond Edition

HigginsAnalysis fo r F inanc ia l M anagem en tTenth Edition

KcllisonT h eo ry o f In te re stThird Edition

Ross, Westerfield, and Jaffe C orpora te F inanceTenth Edition

Ross, Westerfield, Jaffe, and Jordan C o rp o ra te F inance : C ore Princip les and A pplicationsThird Edition

Ross, Westerfield, and Jordan Kssentials o f C orpo ra te F inanceSeventh Edition

Ross, Westerfield, and Jordan F undam en tals o f C o rp o ra te F inanceTenth Edition

ShefrinBehavioral C orpo ra te F inance:D ecisions T h a t C rea te ValueFirst Edition

WhiteF inancial A nalysis w ith an E lectron ic C alcu la to rSixth Edition

INVESTMENTS

Bodie, Kane, and Marcus Essentia ls o f Investm en tsN in th Edition

Bodie, Kane, and Marcus Investm en tsN in th Edition

Hirt and Block Fundam en ta ls o f Investm en t M anagem en tTenth Edition

Jordan ana Miller Fundam en ta ls o f Investm ents:V aluation a nd M anagem en tSixth Edition

Stewart, Piros, and Heisler R u n n in g M oney : P rofessional Portfo lio M anagem en tFirst Edition

Sundaram and DasD erivatives: P rinc ip les and PracticeFirst Edition

FINANCIAL INSTITUTIONS AND MARKETS

Rose and HudginsB ank M anagem en t an d F inancial ServicesN in th Edition

Rose and MarquisFinanc ia l I n s titu tio n s a nd M arketsEleventh Edition

Saunders and CornettFinanc ia l I n s titu tio n s M anagem en t:A R isk M an agem en t A pproachSeventh Edition

Saunders and CornettFinanc ia l M arke ts and In s titu tio n sF ifth Edition

INTERNATIONAL FINANCE

Eun and ResnickIn te rn a tio n a l F inancial M an agem en tSixth Edition

REAL ESTATE

Brueggeman and FisherReal E sta te F in an ce and Investm en tsFourteenth Edition

Ling and ArcherReal E sta te P rincip les: A ValueA pproachFourth E dition

FINANCIAL PLANNING AND INSURANCE

A llen , M e ln n e , R oK enblnom , and MahoneyR etirem en t P lans: 401(k)s, IR A s, and O th e r D eferred C o m p en sa tio n A pproachesTenth Edition

AltfestPersonal F inanc ia l P lan n in gFirst Edition

Harrington and NiehausR isk M an ag em en t and In su ranceSecond Edition

Kapoor, Dlabay, and Hughes Focus o n Personal F inance : A n A ctive A pproach to H e lp You D evelop Successful F inanc ia l S killsFourth Edition

Kapoor, Dlabay, and Hughes Personal F inanceTenth Edition

Walker and WalkerPersonal F inance : B u ild ing Your F u tu reFirst Edition

Essentials of Investments

Ninth Edition

ZVI BODIEBoston University

ALEX KANEUniversity o f California, San Diego

ALAN J. MARCUSB u n lu l l C u lle y e

MeGrawHill

Essentials o f Investments, N inth Edition Zvi Bodie, Alex Kane and Alan J. Marcus ISBN-13 9780077148249 ISBN-10 007714824X

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Zvi BodieBoston University

Zvi Bodie is Professor o f Finance and Economics at Boston University School o f Management. He holds 11 P hD from the Massachusetts Institute o f Technology and has served on the finance faculty at Harvard Business School and M IT ’s Sloan School o f Management. Professor Bodie has published widely on pension finance and investment strategy in leading professional journals. His books include Foundations o f Pension Finance, Pensions in the U.S. Economy, Issues in Pension Economics, and Financial Aspects o f the U.S. Pension System. Professor Bodie is a member ot the Pension Research Council of the W harton School, University of Pennsylvania. His latest book is Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals.

Alex KaneUniversity of California. San Diego

Alex Kane is Professor o f Finance and Economics at the Graduate School o f International Relations and Pacific Studies at the University o f California, San Diego. He holds a PhD from the Stern School o f Business o f New York University and has been Visiting Professor at the Faculty o f Economics, University o f Tokyo; Graduate School o f Business, Harvard; Kennedy School o f Government, Harvard; and Research Associate, National Bureau o f Economic Research. An author o f many articles in finance and management journals, Professor Kane’s research is mainly in corporate finance, portfolio management, and capital markets.

Alan J. MarcusBoston College

Alan Marcus is the M ario J. Gabelli Professor o f Finance in the Carroll School o f Management at Boston College. H e received his PhD from M IT, has been a Visiting Professor at M IT ’s Sloan School o f M anagement and Athens Laboratory o f Business Administration, and has served as a Research Fellow at the National Bureau o f Economic Research, where he participated in both the Pension Economics and the Financial M arkets and Monetary Economics Groups. Professor Marcus also spent two years at the Federal Hom e Loan Mortgage Corporation (Freddie Mac), where he helped to develop mortgage pricing and credit risk models. Professor Marcus has published widely in the fields o f capital markets and portfolio theory. H e currently serves on the Research Foundation Advisory Board o f the CFA Institute.

f t

V

Brief Contents

P a rt ONEELEMENTS OF INVESTMENTS 1

1 Investments: Background and Issues 2

2 Asset Classes and Financial Instruments 26

3 Securities Markets 544 Mutual Funds and o ther Investment

Companies 84

P a rt TW OPORTFOLIO THEORY 109___________

5 Risk and Return: Past and Prologue 110

6 Efficient Diversification 1487 Capital Asset Pricing and Arbitrage

Pricing Theory 193

8 The Efficient Market Hypothesis 2349 Behavioral Finance and Technical

Analysis 265

P a rt T H R E EDEBT SECURITIES 291______________

10 Bond Prices and Yields 29211 Managing Bond Portfolios 337

P a rt FOU RSECURITY ANALYSIS 371

12 Macroeconomic and Industry Analysis 372

13 Equity Valuation 40514 Financial Statement Analysis 446

P a rt F IV EDERIVATIVE MARKETS 485

15 Options Markets 48616 Option Valuation 52217 Futures Markets and Risk

Management 561

P a rt S IXACTIVE INVESTMENT MANAGEMENT 595

18 Portfolio PerformanceEvaluation 596

19 Globalization and InternationalInvesting 630

20 Hedge Funds 66621 Taxes, Inflation, and Investment

Strategy 68922 Investors and the Investment

Process 714

AppendixesA References 736

B References to CFA Questions 742

Index I

vl

P a rt O NEELEMENTS OF INVESTMENTS 1

1 Investments: Background and Issues 2

1.1 Real Assets versus Financial Assets 31 .2 Financial Assets 51 .3 Financial M arkets and the Economy 6

The Informational Role o f Financial Markets 6Consumption Timing 7 Allocation o f Risk 7Separation o f Ownership and Management 7 Corporate Governance and Corporate Ethics 8

1 .4 The Investment Process 91 .5 Markets Are Competitive 10

The Risk-Return Trade-O ff 10 Efficient Markets 11

1.0 The Players 11 Financial Intermediaries 12 Investment Bankers 14Venture Capital and Private Equity 15

1 .7 The Financial Crisis o f 2008 15 Antecedents o f the Crisis 15 Changes in Housing Finance 1 7 Mortgage Derivatives 19 Credit Default Swaps 20The Rise o f Systemic Risk 20The Shoe Drops 20The Dodd-Frank Reform Act 21

1 .8 Outline o f the Text 22

End of Chapter M aterial 22-25

2 Asset Classes and Financial Instruments 26

2 .1 The M oney M arket 27

Treasury Bills 27Certificates o f Deposit 28Commercial Paper 28Bankers' Acceptances 29Eurodollars 29Repos and Reverses 29Brokers'Calls 29Federal Funds 30The LIB O R Market 30Yields on Money M arket Instruments 30

2 .2 The Bond M arket 31 Treasury Notes and Bonds 31 Inflation-Protected Treasury Bonds 32 Federal Agency Debt 32 International Bonds 33 Municipal Bonds 33Corporate Bonds 36Mortgages and Mortgage-Backed Securities 36

2 .3 Equity Securities 37Common Stock as Ownership Shares 37 Characteristics o f Common Stock 38 Stock M arket Listings 38 Preferred Stock 39 Depository Receipts 40

2 .4 Stock and Bond M arket Indexes 40 Stock M arket Indexes 40Dow Jones Averages 40 Standard ĨỔ Poor's Indexes 42 Other Ư. S. M arket Value Indexes 44 Equally Weighted Indexes 44 Foreign and International Stock Market Indexes 45Bond M arket Indicators 45

2 .5 Derivative M arkets 46 Options 46Futures Contracts 47

End of Chapter M aterial 48-53

vii

viii Contents

3 Securities Markets 543 .1 H ow Firms Issue Securities 55

Privately Held Firms 55 Publicly Traded Companies 56 Shelf Registration 56Initial Public Offerings 57

3 .2 How Securities Are Traded 57 Types o f Markets 58Types o f Orders 59 Trading Mechanisms 61

3 .3 T he Rise o f Electronic Trading 623 .4 U.S. Markets 64

N ASD AQ 64The N ew York Stock Exchange 65 ECNs 65

3 .5 New Trading Strategies 65 Algorithmic Trading 66 High-Frequency Trading 66 Dark Pools 67Bond Trading 67

3 .6 Globalization o f Stock M arkets 683 .7 Trading Costs 683 .8 Buying on M argin 693 .9 Short Sales 723 .1 0 Regulation o f Securities M arkets 74

Self-Regulation 76The Sarbanes-Oxley Act 76 Insider Trading 78

End of Chapter Material 78-83

4 Mutual Funds and other Investment Companies 84

4 .1 Investment Companies 854 .2 Types o f Investment Companies 86

Unit Investment Trusts 86 Managed Investment Companies 86 Other Investment Organizations 87

4 .3 M utual Funds 88 Investment Policies 88 How Funds Are Sold 91

4 .4 Costs o f Investing in M utual Funds 91Fee Structure 91Fees and M utual Fund Returns 93

4 .5 Taxation o f M utual Fund Income 94

4.6 Exchange-Traded Funds 954.7 M utual Fund Investment Performance: A First

Look 984.8 Information on M utual Funds 101

End of Chapter M aterial 104-108

P a rt TW OPORTFOLIO THEORY 109

5 Risk and Return: Past and Prologue 110

5 .1 Rates o f Return 111Measuring Investment Returns over Multiple Periods 111Conventions fo r Annualizing Rates o f Return 113

5 .2 Risk and Risk Premiums 115Scenario Analysis and Probability Distributions 115The Normal Distribution 116Normality over Time 119Deviation from Normality and Value at Risk 119Using Time Series o f Return 121Risk Premiums and Risk Aversion 122The Sharpe (Reward-to-Volatility) Ratio 123

5 .3 T he Historical Record 126World and U.S. Risky Stock and Bond Portfolios 126

5 .4 Inflation and Real Rates o f Return 130The Equilibrium Nominal Rate o f Interest 131 U.S. History o f Interest Rates, Inflation, and Real Interest Rates 132

5 .5 Asset Allocation across Risky and Risk-Free Portfolios 133The Risk-Free Asset 134 Portfolio Expected Return and Risk 134 The Capital Allocation Line 136 Risk Aversion and Capital Allocation 137

5 .6 Passive Strategies and the Capital M arket Line 138Historical Evidence on the Capital Market Line 138Costs and Benefits o f Passive Investing 139

End of Chapter M aterial 140-147

6 Efficient Diversification 1486 .1 Diversification and Portfolio Risk 149