Institutional investment management

7 THE FRANK J . FABOZZI SERIES

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INSTITUTIONAL

INVESTMENT

MANAGEMENT

Equity and Bond Portfolio

Strategies and Applications

I

n order to achieve an institutional investor’s

objectives— whether it is an investment

company, insurance organization, pension fund,

or endowment— you need a firm understanding of

various investment vehicles and how to value them,

as well as detailed knowledge of the specific strategies

used to properly manage these types of portfolios.

The investment process can be difficult to follow

at times, but with the right guidance, and some

discipline, you can become proficient at putting

the pieces of this puzzle together. Nobody is more

familiar with this situation than author Frank

Fabozzi— an expert in the areas of investment

management and structured finance. And now, with

Institutional Investment Management, he draws upon

his extensive experience in this field to help you excel

at this difficult endeavor.

While the basic principles of investment manage￾ment are applicable to all investors, there are nuances

that are unique to the management of institutional

funds. That's why it’s important for those involved in

this specific arena to become better acquainted with

the management of institutional investors' portfolios.

Divided into four comprehensive parts— Port￾folio Theory and Asset Pricing; Common Stock

Analysis and Portfolio Management; Bond Analysis

and Portfolio Management; and Investment

Companies, Exchange-Traded Funds, and Alternative

Investments— this reliable resource opens with an

informative overview of the investment management

process, then quickly moves on to cover an array of

issues that both new and seasoned practitioners, as

well as students of finance, can benefit from reading.

Số hóa bởi Trung tâm Học liệu – ĐH TN http://www.lrc-tnu.edu.vn

Institutional

Investment

Management

Số hóa bởi Trung tâm Học liệu – ĐH TN http://www.lrc-tnu.edu.vn

The Fra n k J . Fabozzi S e rie s

Fixed Income Securities, Second Edition by Frank J. Fabozzi

Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate

Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi

Real Options and Option-Em bedded Securities by William T. Moore

Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi

The Exchange-Traded Funds M anual by Gary L. Gastineau

Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu

H andbook o f Alternative Assets by Mark J. P. Anson

The G lobal Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry

The Handbook o f Financial Instruments edited by Frank J. Fabozzi

Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi

Investment Performance Measurement by Bruce J. Feibel

The Handbook o f Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi

The Theory and Practice o f Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz

Foundations o f Economic Value Added, Second Edition by James L. Grant

Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson

Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi,

Steven V. Mann, and Moorad Choudhry

The Handbook o f European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry

The Handbook o f European Structured Financial Products edited by Frank J. Fabozzi and Moorad Choudhry

The Mathematics o f Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. Fabozzi

Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi

The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer

Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy

Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. Mann

Fat-Tailed and Skewed Asset Return Distributions by Svedozar T. Rachev, Christian Menn, and Frank J. Fabozzi

Financial Modeling o f the Equity Market: From CA PM to Cointegration by Frank J. Fabozzi, Sergio M.

Focardi, and Petter N. Kolm

Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J. Fabozzi,

Lionel Martellini, and Philippe Priaulet

Analysis o f Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi

Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S.

Goodman, and Frank J. Fabozzi

H andbook o f Alternative Assets, Second Edition by Mark J. P. Anson

Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry

Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and Teo Jasic

Developments in Collateralized Debt Obligations: N ew Products and Insights by Douglas J. Lucas,

Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning

Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm,

Dessislava A. Pachamanova, and Sergio M. Focardi

Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev,

Stogan V. Stoyanov, and Frank J. Fabozzi

How to Select Investment Managers and Evaluate Performance by G. Timothy Haight, Stephen O. Morrell,

and Glenn E. Ross

Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank J. Fabozzi

The Handbook o f Municipal Bonds edited by Sylvan G. Feldstein and Frank J. Fabozzi

Subprime Mortgage Credit Derivatives by Laurie S. Goodman, Shumin Li, Douglas J. Lucas,

Thomas A Zimmerman, and Frank J. Fabozzi

Introduction to Securitization by Frank J. Fabozzi and Vinod Kothari

Structured Products and Related Credit Derivatives edited by Brian P. Lancaster, Glenn M. Schultz, and

Frank J. Fabozzi

Handbook o f Finance: Volume I: Financial Markets and Instruments edited by Frank J. Fabozzi

Handbook of Finance: Volume II: Financial Management and Asset Management edited by Frank J. Fabozzi

Handbook o f Finance: Volume III: Valuation, Financial Modeling, and Quantitative Tools edited by

Frank J. Fabozzi

Finance: Capital Markets, Financial Management, and Investment Management by Pamela Peterson Drake

and Frank J. Fabozzi

Leveraged Finance: Concepts, Methods, and Trading o f High Yield Bonds, Loans, and Derivatives bv

Stephen J. Antczak, Douglas J. Lucas, and Frank J. Fabozzi

Modern Financial Systems: Theory and Applications by Edwin H. Neave

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Institutional »

Investment

Management

Equity and Bond Portfolio

Strategies and Applications

FRANK J. FABOZZI

W ILEY

John Wiley Sons, Inc.

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Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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ISBN: 978-0-470-40094-4

Printed in the United States of America.

Copyright © 2009 by John Wiley 8c Sons, Inc. All rights reserved.

10 9 8 - 6 5 4 \ 2 I

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FJF

To my wife Donna, and my children

Francesco, Patricia, and Karly

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Contents

Preface xv

Acknowledgments xix

About tfie Author xxiii

CHAPTER 1

Overview of Investment Management 1

Setting Investment Objectives 2

Establishing an Investment Policy 4

Selecting a Portfolio Strategy 9

Constructing and Monitoring the Portfolio 10

Measuring and Evaluating Performance 11

References 1 1

PART ONE

P o rtfo lio T h e o r y and A s s e t P ric in g 1 3

CHAPTER 2

Theory of Portfolio Selection 15

Some Basic Concepts 16

Measuring a Portfolio’s Expected Return 19

Measuring Portfolio Risk 21

Portfolio Diversification 26

Choosing a Portfolio of Risky Assets 30

Index Model's Approximations to the Covariance Structure 36

Summary 39

References 40

vii

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viii C O N T E N T S

CHAPTER 3

Applying Mean-Variance Analysis 41

Using Historical Data to Estimate Inputs 42

Application of Portfolio Theory to Asset Allocation 46

Implementing the Optimal Portfolio 53

Summary 56

References 57

CHAPTER 4

issues in the Theory ol Portfolio Selection 59

Quick Review of Probability Theory 60

Limitations of the Variance as a Risk Measure 64

Desirable Features of Investment Risk Measures 68

Alternative Risk Measures for Portfolio Selection 74

Extensions of the Theory of Portfolio Selection

Behavioral Finance Attack on the Theory of Portfolio 80

Summary 82

References 84

CHAPTER 5

Asset Pricing Theories 89

Characteristics of an Asset Pricing Model 90

Capital Asset Pricing Model 91

Arbitrage Pricing Theory Model 102

Some Principles to Take Away 107

Summary 108

Appendix 109

References 117

PART TWO

Common Stock Analysis and Po rtfo lio M anagem ent 1 1 9

CHAPTER 6

The U.S. Equity M arkets 121

Exchange Market Structures 121

The U.S. Stock Markets: Exchanges and OTC Markets 125

Off-Exchange Markets and Alternative Electronic Markets 1 34

Evolving Stock Market Practices 1 3S

Basic Functioning of Stock Markets 140

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Contents ix

Summary 145

References 145

CHAPTER 7

Common Stock Strategies and Perform ance Evaluation 1 4 7

Marker Efficiency 147

Stock Market Indicators 149

Top-Down vs. Bottom-Up Approaches 152

Fundamental vs. Technical Analysis 153

Strategies Based on Technical Analysis 154

Strategies Based on Fundamental Analysis 161

Equity Style Investing 166

Passive Strategies 169

Measuring and Evaluating Performance 176

Summary 187

References 189

CHAPTER 8

Financial Analysis 193

Financial Ratio Analysis 194

Cash Flow Analysis 223

Usefulness of Cash Flows in Financial Analysis 235

Summary 241

References 242

CHAPTER 9

Applied Equity Valuation 245

Discounted Cash Flow Models 245

Relative Valuation Methods 266

DCF vs. RY Methods 272

Summary 275

References 276

CHAPTER 10

Forecasting Stock Returns 2 7 7

The Concept of Predictability 2~c>

A Closer Look at Pricing Models 286

Predictive Return Models 2X_

Is Forecasting Markets Worth the Effort? 293

Summary 295

References 29"

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X C O N T E N T S

CHAPTER 11

Managing a Common Stock Portfolio with Fundamental Factor Models 299

Tracking Error 300

Fundamental Factor Model Description and Estimation 309

Risk Decomposition 312

Applications in Portfolio Construction and Risk Control 316

Summary 329

References 330

CHAPTER 12

Transaction Costs and Trade Execution in

Common Stock Portfolio Management 331

Trading Mechanics 332

Trading Arrangements for Institutional Investors 335

A Taxonomy of Transaction Costs 340

Liquidity and Transaction Costs 347

Market Impact Measurements and Empirical Findings 349

Forecasting and Modeling Market Impact 352

Incorporating Transaction Costs in Asset-Allocation Models 355

Optimal Trading 356

Integrated Portfolio Management:

Beyond Expected Return and Portfolio Risk 359

Summary 360

References 362

CHAPTER 13

Using Stock Index Futures and Equity Swaps in

Equity Portfolio Management 365

Derivatives Process 366

Basic Features of Futures Contracts 36“

Basic Features of Stock Index Futures 3~3

Applications for Stock Index Futures 38 l

Equity Swaps 393

Summary 394

References 395

CHAPTER 14

Using Equity Options in Investment Management 397

Basic Features of Options 39“

Basic Features of Listed Equity Options 400

Risk and Return Characteristics of Listed Options 402

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Contents xi

The Option Price 410

Use of Listed Equity Options in Portfolio Management 415

OTC Equity Options: The Basics 421

Use of Exotic Equity Options 425

Summary 426

References 427

CHAPTER 15

Equity Option Pricing Models 429

Put-Call Parity Relationship 429

Option Pricing Models 431

Sensitivity of the Option Price to a Change in Factors 447

Estimating Expected Stock Return Volatility 452

Summary 453

References 454

PART THREE

Bond A n a ly s is and P o rtfo lio M a n a g e m e n t 4 5 5

CHAPTER 16

Bond Fundamentals and Risks 4 5 7

Features of Bonds 457

Risks Associated with Investing in Bonds 467

Summary 482

Appendix: Calculating Accrued Interest 484

References 486

CHAPTER 1 7

Treasury and Agency Securities, Corporate Bonds, and Municipal Bonds 4 8 7

Treasury Securities 487

Federal Agency Securities 490

Corporate Bonds 491

Municipal Bonds 495

Non-U.S. Bonds 501

Summary 504

References 505

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xli C O N T E N T S

C H AP TB 118

Structured Products: RMBS, CMBS, and ABS 507

Agency Residential Mortgage-Backed Securities 509

Private-Label Residential MBS 528

Mortgage-Related, Asset-Backed Securities: Subprime MBS 533

Commercial Mortgage-Backed Securities 537

Nonmortgage Asset-Backed Securities 540

Summary 546

References 547

CHAPTER 19

The Structure of Interest Rates 549

The Base Interest Rate 549

The Risk Premium Between Non-Treasury and

Treasury Securities with the Same Maturity 550

Factors Affecting the Risk Premium 551

Term Structure of Interest Rates 555

Summary 564

References 565

CHAPTER 20

Bond Pricing and Yield Measures 567

Pricing of Option-Free Bonds 567

Conventional Yield Measures 576

Portfolio Yield Measures 583

Total Return 585

Summary 592

CHAPTER 21

Bond Price Volatility and the Measurement of Interest Rate Risk 593

Price Volatility Properties of Option-Free Bonds 593

Factors that Affect a Bond’s Price Volatility 596

Measuring Interest Rate Risk Using the Price Value of a

Basis Point 596

Measuring Interest Rate Risk Using Duration and Convexity 598

Measuring Exposure to Yield Curve Changes

Key Rate Duration 610

Summary 611

References 612

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Contents xiil

CHAPTER 22

Valuing Bonds with Embedded Options 6 13

The Interest Rate Lattice 614

Calibrating the Lattice 618

Using the Lattice for Valuation 622

Using the Lattice Model to Value Bonds with

Embedded Options 625

Extensions 630

Summary 634

References 634

CHAPTER 23

Bond Portfolio Strategies 635

Bond Market Indexes 635

The Spectrum of Strategies 640

Value-Added Strategies 647

Using Factor Models to Manage a Portfolio 658

Liability-Driven Strategies 672

Summary 680

References 682

CHAPTER 24

Using Derivatives in Bond Portlolio Management 683

Using Treasury Bond and Note Futures Contracts in

Bond Portfolio Management 683

Use of Interest Rate Options in Bond Portfolio Management 692

Using Interest Rate Swaps in Bond Portfolio Management 704

Using Stock Index Futures and Treasury Bond Futures to

Implement an Asset Allocation Decision 715

Using Credit Default Swaps to Manage Credit Risk 716

Summary 720

References 722

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X iv C O N T E N T S

PART FOUR

Investm ent Com panies, Exchange-Traded Funds,

and A lte rna tive Investm ents 7 2 3

CHAPTER 25

Investment Companies, Exchange-Traded Funds,

and Investment-Oriented Lite Insurance 725

Investment Companies 725

Exchange-Traded Funds 739

Investment-Oriented Life Insurance 744

Summary 764

References 765

CHAPTER 26

Alternative Assets 76 7

Hedge Funds 767

Private Equity 786

Commodity Investments 798

Summary 806

References 807

APPENDIX

Measuring and Forecasting Yield Volatility 809

Calculating the Standard Deviation from Historical Data 809

Modeling and Forecasting Yield Volatility 814

Summary 825

References 825

Index 827

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