Essentials of Investment

ESSENTIALS of INVESTMENTS

bod05175_fm_i-xxvi.indd i 9/3/07 4:09:38 PM

The McGraw-Hill/Irwin Series in Finance, Insurance

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ESSENTIALS of INVESTMENTS

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Seventh Edition

ZVI BODIE

Boston University

ALEX KANE

University of California, San Diego

ALAN J. MARCUS

Boston College

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ESSENTIALS OF INVESTMENTS

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Bodie, Zvi.

Essentials of investments / Zvi Bodie, Alex Kane, Alan J. Marcus. —7th ed.

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Includes index.

ISBN-13: 978-0-07-340517-9 (alk. paper)

ISBN-10: 0-07-340517-5 (alk. paper)

1. Investments. I. Kane, Alex. II. Marcus, Alan J. III. Title.

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To our wives and eight wonderful daughters.

bod05175_fm_i-xxvi.indd v 9/3/07 4:09:45 PM

vi

ABOUT THE AUTHORS

Zvi Bodie

Boston University

Zvi Bodie is Professor of Finance and Economics at Boston University School of Management.

He holds a PhD from the Massachusetts Institute of Technology and has served on the finance

faculty at Harvard Business School and MIT’s Sloan School of Management. Professor Bodie

has published widely on pension finance and investment strategy in leading professional

journals. His books include Foundations of Pension Finance, Pensions in the U.S. Economy,

Issues in Pension Economics, and Financial Aspects of the U.S. Pension System. His textbook

Investments, co-authored with Alex Kane and Alan Marcus, is the market leader and is used

in certification programs of the Financial Planning Association and the Society of Actuaries.

His textbook Finance is co-authored by Nobel Prize–winning economist Robert C. Merton.

Professor Bodie is a member of the Pension Research Council of the Wharton School,

University of Pennsylvania. His latest book is Worry-Free Investing: A Safe Approach to

Achieving Your Lifetime Financial Goals.

Alex Kane

University of California, San Diego

Alex Kane is Professor of Finance and Economics at the Graduate School of International

Relations and Pacific Studies at the University of California, San Diego. He has been Visiting

Professor at the Faculty of Economics, University of Tokyo; Graduate School of Business,

Harvard; Kennedy School of Government, Harvard; and Research Associate, National Bureau

of Economic Research. An author of many articles in finance and management journals,

Professor Kane’s research is mainly in corporate finance, portfolio management, and capital

markets.

Alan J. Marcus

Boston College

Alan Marcus is Professor of Finance in the Wallace E. Carroll School of Management at

Boston College. He received his PhD from MIT, has been a Visiting Professor at MIT’s Sloan

School of Management and Athens Laboratory of Business Administration, and has served

as a Research Fellow at the National Bureau of Economic Research, where he participated

in both the Pension Economics and the Financial Markets and Monetary Economics Groups.

Professor Marcus also spent two years at the Federal Home Loan Mortgage Corporation

(Freddie Mac), where he helped to develop mortgage pricing and credit risk models. Professor

Marcus has published widely in the fields of capital markets and portfolio theory. He currently

serves on the Research Foundation Advisory Board of the CFA Institute.

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ESSENTIALS of INVESTMENTS

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vii

BRIEF CONTENTS

Part ONE

ELEMENTS OF INVESTMENTS 1

1 Investments: Background

and Issues 2

2 Asset Classes and Financial

Instruments 24

3 Securities Markets 55

4 Mutual Funds and Other Investment

Companies 89

Part TWO

PORTFOLIO THEORY 115

5 Risk and Return: Past

and Prologue 116

6 Efficient Diversification 149

7 Capital Asset Pricing and Arbitrage

Pricing Theory 192

8 The Efficient Market Hypothesis 231

9 Behavioral Finance and Technical

Analysis 262

Part THREE

DEBT SECURITIES 289

10 Bond Prices and Yields 290

11 Managing Bond Portfolios 333

Part FOUR

SECURITY ANALYSIS 369

12 Macroeconomic and Industry

Analysis 370

13 Equity Valuation 401

14 Financial Statement Analysis 442

Part FIVE

DERIVATIVE MARKETS 479

15 Options Markets 480

16 Option Valuation 517

17 Futures Markets and Risk

Management 552

Part SIX

ACTIVE INVESTMENT

MANAGEMENT 587

18 Performance Evaluation and Active

Portfolio Management 588

19 Globalization and International

Investing 621

20 Taxes, Inflation, and Investment

Strategy 657

21 Investors and the Investment

Process 681

Appendixes

A References 701

B References to CFA Questions 707

Index I-1

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viii

Part ONE

ELEMENTS OF INVESTMENTS 1

1 Investments: Background and

Issues 2

1.1 Real Assets versus Financial Assets 3

1.2 A Taxonomy of 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 9

1.5 Markets Are Competitive 10

The Risk-Return Trade-Off 10

Efficient Markets 11

1.6 The Players 12

Financial Intermediaries 12

Investment Bankers 14

1.7 Recent Trends 15

Globalization 15

Securitization 16

Financial Engineering 17

Computer Networks 18

1.8 Outline of the Text 19

Summary 20

2 Asset Classes and Financial

Instruments 24

2.1 The Money Market 25

Treasury Bills 25

Certificates of Deposit 27

Commercial Paper 28

Bankers’ Acceptances 28

Eurodollars 28

Repos and Reverses 28

Brokers’ Calls 29

Federal Funds 29

The LIBOR Market 29

Yields on Money Market Instruments 29

2.2 The Bond Market 30

Treasury Notes and Bonds 30

Inflation-Protected Treasury Bonds 31

Federal Agency Debt 32

International Bonds 32

Municipal Bonds 32

Corporate Bonds 35

Mortgages and Mortgage-Backed Securities 35

2.3 Equity Securities 37

Common Stock as Ownership Shares 37

Characteristics of Common Stock 38

2.9 Stock Market Listings 38

Preferred Stock 39

Depository Receipts 39

2.4 Stock and Bond Market Indexes 40

Stock Market Indexes 40

Dow Jones Averages 40

Standard & Poor’s Indexes 44

Other U.S. Market Value Indexes 45

Equally Weighted Indexes 46

Foreign and International Stock Market

Indexes 46

Bond Market Indicators 46

2.5 Derivative Markets 46

Options 46

Futures Contracts 50

Summary 51

3 Securities Markets 55

3.1 How Firms Issue Securities 56

Investment Banking 56

Shelf Registration 57

Private Placements 58

Initial Public Offerings 58

CONTENTS

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Contents ix

3.2 How Securities Are Traded 60

Types of Markets 61

Types of Orders 62

Trading Mechanisms 64

3.3 U.S. Securities Markets 66

Nasdaq 66

The New York Stock Exchange 67

Electronic Communication Networks 70

The National Market System 70

Bond Trading 71

3.4 Market Structure in Other Countries 71

London 71

Euronext 72

Tokyo 72

Globalization and Consolidation

of Stock Markets 72

3.5 Trading Costs 73

3.6 Buying on Margin 74

3.7 Short Sales 77

3.8 Regulation of Securities Markets 79

Self-Regulation 80

Regulatory Responses to Recent

Scandals 80

Circuit Breakers 82

Insider Trading 82

Summary 83

4 Mutual Funds and Other

Investment Companies 89

4.1 Investment Companies 90

4.2 Types of Investment Companies 91

Unit Investment Trusts 91

Managed Investment Companies 91

Other Investment Organizations 93

4.3 Mutual Funds 94

Investment Policies 94

How Funds Are Sold 96

4.4 Costs of Investing in Mutual Funds 97

Fee Structure 97

Fees and Mutual Fund Returns 99

Late Trading and Market Timing 101

Other Potential Reforms 102

4.5 Taxation of Mutual Fund Income 102

4.6 Exchange-Traded Funds 103

4.7 Mutual Fund Investment Performance:

A First Look 104

4.8 Information on Mutual Funds 107

Summary 111

Part TWO

PORTFOLIO THEORY 115

5 Risk and Return: Past

and Prologue 116

5.1 Rates of Return 117

Measuring Investment Returns over Multiple

Periods 117

Conventions for Quoting Rates of Return 119

5.2 Risk and Risk Premiums 120

Scenario Analysis and Probability

Distributions 121

Risk Premiums and Risk Aversion 123

The Sharpe (Reward-to-Volatility)

Measure 124

5.3 The Historical Record 125

Bills, Bonds, and Stocks, 1926–2006 125

5.4 Inflation and Real Rates of Return 131

The Equilibrium Nominal Rate of

Interest 132

5.5 Asset Allocation across Risky and Risk-Free

Portfolios 133

The Risky Asset 134

The Risk-Free Asset 135

Portfolio Expected Return and Risk 136

The Capital Allocation Line 137

Risk Tolerance and Asset Allocation 138

5.6 Passive Strategies and the Capital Market

Line 139

Historical Evidence on the Capital Market

Line 140

Costs and Benefits of Passive Investing 141

Summary 142

6 Efficient Diversification 149

6.1 Diversification and Portfolio Risk 150

6.2 Asset Allocation with Two Risky Assets 152

Covariance and Correlation 152

Using Historical Data 155

The Three Rules of Two-Risky-Assets

Portfolios 157

The Risk-Return Trade-Off with Two-Risky￾Assets Portfolios 157

The Mean-Variance Criterion 159

6.3 The Optimal Risky Portfolio with a Risk-Free

Asset 164

6.4 Efficient Diversification with Many

Risky Assets 168

The Efficient Frontier of Risky Assets 168

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x Contents

Choosing the Optimal Risky Portfolio 170

The Preferred Complete Portfolio and the

Separation Property 171

6.5 A Single-Factor Asset Market 171

Specification of a Single-Index Model of

Security Returns 172

Statistical and Graphical Representation of the

Single-Index Model 173

Diversification in a Single-Factor Security

Market 177

6.6 Risk of Long-Term Investments 178

Are Stock Returns Less Risky in the Long

Run? 178

The Fly in the “Time Diversification” Ointment

(or More Accurately, the Snake Oil) 179

Summary 181

7 Capital Asset Pricing and Arbitrage

Pricing Theory 192

7.1 The Capital Asset Pricing Model 193

Why All Investors Would Hold the Market

Portfolio 194

The Passive Strategy Is Efficient 195

The Risk Premium of the Market

Portfolio 196

Expected Returns on Individual

Securities 196

The Security Market Line 198

Applications of the CAPM 199

7.2 The CAPM and Index Models 200

The Index Model, Realized Returns, and the

Expected Return–Beta Relationship 201

Estimating the Index Model 202

Predicting Betas 207

7.3 The CAPM and the Real World 209

7.4 Multifactor Models and the CAPM 211

The Fama-French Three-Factor Model 212

Factor Models with Macroeconomic

Variables 215

Multifactor Models and the Validity of the

CAPM 215

7.5 Factor Models and the Arbitrage Pricing

Theory 216

Well-Diversified Portfolios and Arbitrage

Pricing Theory 216

The APT and the CAPM 218

Multifactor Generalization of the APT

and CAPM 219

Summary 221

8 The Efficient Market

Hypothesis 231

8.1 Random Walks and the Efficient Market

Hypothesis 232

Competition as the Source of Efficiency 233

Versions of the Efficient Market

Hypothesis 235

8.2 Implications of the EMH 235

Technical Analysis 235

Fundamental Analysis 237

Active versus Passive Portfolio

Management 238

The Role of Portfolio Management in an

Efficient Market 239

Resource Allocation 239

8.3 Are Markets Efficient? 240

The Issues 240

Weak-Form Tests: Patterns in Stock

Returns 242

Predictors of Broad Market Returns 243

Semistrong Tests: Market Anomalies 243

Strong-Form Tests: Inside Information 247

Interpreting the Evidence 248

The “Noisy Market Hypothesis”

and Fundamental Indexing 249

8.4 Mutual Fund and Analyst Performance 250

Stock Market Analysts 250

Mutual Fund Managers 251

Survivorship Bias in Mutual Fund Studies 254

So, Are Markets Efficient? 255

Summary 256

9 Behavioral Finance and Technical

Analysis 262

9.1 The Behavioral Critique 263

Information Processing 264

Behavioral Biases 265

Limits to Arbitrage 267

Limits to Arbitrage and the Law

of One Price 269

Bubbles and Behavioral Economics 271

Evaluating the Behavioral Critique 272

9.2 Technical Analysis and Behavioral

Finance 273

Trends and Corrections 273

Sentiment Indicators 280

A Warning 281

Summary 282

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Contents xi

Part THREE

DEBT SECURITIES 289

10 Bond Prices and Yields 290

10.1 Bond Characteristics 291

Treasury Bonds and Notes 291

Corporate Bonds 293

Preferred Stock 295

Other Domestic Issuers 295

International Bonds 295

Innovation in the Bond Market 296

10.2 Bond Pricing 298

Bond Pricing between Coupon Dates 301

Bond Pricing in Excel 301

10.3 Bond Yields 302

Yield to Maturity 303

Yield to Call 305

Realized Compound Return versus

Yield to Maturity 307

10.4 Bond Prices over Time 308

Yield to Maturity versus Holding-Period

Return 310

Zero-Coupon Bonds and Treasury

STRIPS 311

After-Tax Returns 312

10.5 Default Risk and Bond Pricing 312

Junk Bonds 313

Determinants of Bond Safety 313

Bond Indentures 315

Yield to Maturity and Default Risk 316

10.6 The Yield Curve 318

The Expectations Theory 319

The Liquidity Preference Theory 322

A Synthesis 323

Summary 324

11 Managing Bond Portfolios 333

11.1 Interest Rate Risk 334

Interest Rate Sensitivity 334

Duration 336

What Determines Duration? 341

11.2 Passive Bond Management 343

Immunization 343

Cash Flow Matching and Dedication 349

11.3 Convexity 350

Why Do Investors Like Convexity? 352

11.4 Active Bond Management 353

Sources of Potential Profit 353

Horizon Analysis 355

Contingent Immunization 355

An Example of a Fixed-Income Investment

Strategy 357

Summary 358

Part FOUR

SECURITY ANALYSIS 369

12 Macroeconomic and Industry

Analysis 370

12.1 The Global Economy 371

12.2 The Domestic Macroeconomy 373

Gross Domestic Product 373

Employment 374

Inflation 374

Interest Rates 374

Budget Deficit 374

Sentiment 374

12.3 Interest Rates 375

12.4 Demand and Supply Shocks 376

12.5 Federal Government Policy 377

Fiscal Policy 377

Monetary Policy 377

Supply-Side Policies 378

12.6 Business Cycles 379

The Business Cycle 379

Economic Indicators 381

Other Indicators 384

12.7 Industry Analysis 385

Defining an Industry 386

Sensitivity to the Business Cycle 387

Sector Rotation 388

Industry Life Cycles 389

Industry Structure and Performance 393

Summary 393

13 Equity Valuation 401

13.1 Valuation by Comparables 402

Limitations of Book Value 403

13.2 Intrinsic Value versus Market Price 404

13.3 Dividend Discount Models 405

The Constant Growth DDM 406

Stock Prices and Investment Opportunities 409

Life Cycles and Multistage Growth Models 412

Multistage Growth Models 416

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xii Contents

13.4 Price–Earnings Ratios 417

The Price–Earnings Ratio and Growth

Opportunities 417

P/E Ratios and Stock Risk 421

Pitfalls in P/E Analysis 422

Combining P/E Analysis and the DDM 425

Other Comparative Valuation Ratios 426

13.5 Free Cash Flow Valuation Approaches 427

Comparing the Valuation Models 429

13.6 The Aggregate Stock Market 430

Summary 432

14 Financial Statement Analysis 442

14.1 The Major Financial Statements 443

The Income Statement 443

The Balance Sheet 444

The Statement of Cash Flows 445

14.2 Accounting versus Economic Earnings 446

14.3 Profitability Measures 447

Past versus Future ROE 447

Financial Leverage and ROE 447

14.4 Ratio Analysis 449

Decomposition of ROE 449

Turnover and Other Asset Utilization Ratios 451

Liquidity Ratios 453

Market Price Ratios 454

Choosing a Benchmark 456

14.5 Economic Value Added 457

14.6 An Illustration of Financial Statement

Analysis 458

14.7 Comparability Problems 460

Inventory Valuation 461

Depreciation 461

Inflation and Interest Expense 462

Fair Value Accounting 463

Quality of Earnings and Accounting

Practices 464

International Accounting Conventions 465

14.8 Value Investing: The Graham Technique 466

Summary 467

Part FIVE

DERIVATIVE MARKETS 479

15 Options Markets 480

15.1 The Option Contract 481

Options Trading 482

American and European Options 484

The Option Clearing Corporation 484

Other Listed Options 485

15.2 Values of Options at Expiration 486

Call Options 486

Put Options 488

Options versus Stock Investments 489

Option Strategies 492

Collars 498

15.3 Optionlike Securities 499

Callable Bonds 500

Convertible Securities 500

Warrants 503

Collateralized Loans 503

Leveraged Equity and Risky Debt 504

15.4 Exotic Options 505

Asian Options 505

Barrier Options 505

Lookback Options 505

Currency-Translated Options 505

Digital Options 507

Summary 507

16 Option Valuation 517

16.1 Option Valuation: Introduction 518

Intrinsic and Time Values 518

Determinants of Option Values 519

16.2 Binomial Option Pricing 520

Two-State Option Pricing 520

Generalizing the Two-State Approach 523

16.3 Black-Scholes Option Valuation 526

The Black-Scholes Formula 527

The Put-Call Parity Relationship 533

Put Option Valuation 536

16.4 Using the Black-Scholes Formula 537

Hedge Ratios and the Black-Scholes

Formula 537

Portfolio Insurance 538

16.5 Empirical Evidence 542

Summary 543

17 Futures Markets and Risk

Management 552

17.1 The Futures Contract 553

The Basics of Futures Contracts 553

Existing Contracts 556

17.2 Mechanics of Trading in Futures Markets 558

The Clearinghouse and Open Interest 558

Marking to Market and the Margin Account 560

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Contents xiii

Cash versus Actual Delivery 562

Regulations 562

Taxation 562

17.3 Futures Market Strategies 563

Hedging and Speculation 563

Basis Risk and Hedging 565

17.4 The Determination of Futures Prices 566

Spot-Futures Parity 566

Spreads 570

17.5 Financial Futures 571

Stock Index Futures 571

Creating Synthetic Stock Positions 572

Index Arbitrage 573

Foreign Exchange Futures 573

Interest Rate Futures 574

17.6 Swaps 577

Swaps and Balance Sheet Restructuring 578

The Swap Dealer 578

Summary 579

Part SIX

ACTIVE INVESTMENT

MANAGEMENT 587

18 Performance Evaluation and Active

Portfolio Management 588

18.1 Risk-Adjusted Returns 589

Comparison Groups 589

Risk Adjustments 589

The M 2

Measure of Performance 591

Choosing the Right Measure of Risk 592

Risk Adjustments with Changing Portfolio

Composition 594

18.2 Style Analysis 598

18.3 Morningstar’s Risk-Adjusted Rating 599

18.4 Performance Attribution Procedures 601

Asset Allocation Decisions 602

Sector and Security Selection Decisions 603

Summing Up Component Contributions 604

18.5 The Lure of Active Management 605

Objectives of Active Portfolios 607

18.6 Market Timing 608

Valuing Market Timing as an Option 609

The Value of Imperfect Forecasting 610

Measurement of Market Timing Performance 610

18.7 Security Selection: The Treynor-Black

Model 611

Overview of the Treynor-Black Model 611

Portfolio Construction 612

Summary 614

19 Globalization and International

Investing 621

19.1 Global Markets for Equities 622

Developed Countries 622

Emerging Markets 622

Market Capitalization and GDP 625

Home-Country Bias 626

19.2 Risk Factors in International Investing 626

Exchange Rate Risk 626

Imperfect Exchange Rate Risk Hedging 631

Country-Specific Risk 631

19.3 International Investing: Risk, Return, and

Benefits from Diversification 635

Risk and Return: Summary Statistics 635

Are Investments in Emerging Markets

Riskier? 635

Are Average Returns Higher in Emerging

Markets? 638

Is Exchange Rate Risk Important in

International Portfolios? 640

Benefits from International Diversification 641

Misleading Representation of Diversification

Benefits 644

Realistic Benefits from International

Diversification 644

Are Benefits from International Diversification

Preserved in Bear Markets? 645

19.4 How to Go About International Diversification

and the Benefit We Can Expect 647

Choosing among Efficient Portfolios 647

Choosing Lowest Beta or Covariance

Indexes 648

Choosing Largest Capitalization Indexes 648

What We Can Expect from International

Diversification 648

19.5 International Investing and Performance

Attribution 649

Constructing a Benchmark Portfolio

of Foreign Assets 649

Performance Attribution 650

Summary 653

20 Taxes, Inflation, and Investment

Strategy 657

20.1 Saving for the Long Run 658

A Hypothetical Household 658

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