Investment

To some people, security markets are like

casinos and investing is about predicting

security prices and speculating that those

predictions will come true. Investments is

here to tell you otherwise.

You could try to predict security prices by

flipping a coin or reading a horoscope, but

if you really want to become a better investor

then you need a thorough understanding of

securities, securities markets and investment

strategies. That is exactly what this book

provides.

This topical introduction to investment in

security markets discusses in detail the various

ways in which you can minimise risk and

maximise yields. One of the basic insights that

you will obtain from reading this book is that

good investments generally do not require

forecasting skills. Rather, in many cases, good

investments require the matching of the

investments with the objectives and

constraints of the investor.

Key Features

➤ Up-to-date coverage of investment practice

and academic research

➤ Many real-life case studies taken from

recent newspaper articles, in particular the

Financial Times

➤ Extensive Review Questions and Answers,

with additional questions and answers

available online

Investments is suitable for use by intermediate

to advanced undergraduate students taking

courses in investments as part of accounting,

finance, economics and business studies

degrees. It is also suitable for postgraduate

students on MBA courses and other

programmes covering investments.

The chapters are very well written, and present even relatively difficult material in

a concise and very clear way.

Thore Johnson, Norwegian School of Economics and Business

The book is well presented and substantial,

the terms are clearly explained, there are

plenty of examples, and concepts are

introduced gradually and thoroughly.

James Clunie, The University of Edinburgh

www.pearson-books.com An imprint of

INVESTMENTS Thierry Post Haim Levy

Professor Haim Levy, MA, PhD, is Myles

Robinson Professor of Business

Administration at The Hebrew University of

Jerusalem in The Jerusalem School of

Business Administration.

Professor Thierry Post is a Professor of

Finance at Rotterdam School of Economics

of Erasmus University, the Netherlands.

Cover © M.S. Kolmeijer – www.martinekolmeijer.exto.nl

Additional student support at

www.booksites.net/levy

Additional student support at

www.booksites.net/levy

Screenshot reprinted by permission from Microsoft Corporation

Levy_ppr 9/19/07 3:00 PM Page 1

..

INVESTMENTS

Would you like to get a better grade in your course? Visit the

Investments Companion Website at www.booksites.net/levy

to access a rich resource of valuable learning materials for

students, including:

n Multiple Choice Questions for every chapter, with instant feedback

n Interactive Spreadsheets, that accompany the Appendices in the book

n A searchable, online Glossary of key investments terminology

n Interactive Flashcards that allow you to check definitions against the

key terms during revision

n Full list of web links, directing you to key online sources of material on

investments.

n Learning Objectives from every chapter

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We work with leading authors to develop the strongest

educational materials in finance, bringing cutting-edge

thinking and best learning practice to a global market.

Under a range of well-known imprints, including

Financial Times Prentice Hall, we craft high-quality print

and electronic publications which help readers to

understand and apply their content, whether studying or

at work.

To find out more about the complete range of our

publishing, please visit us on the World Wide Web at:

www.pearsoned.co.uk

Dedication:

Haim Levy: To my family

Thierry Post: In memory of my father, Rudi Post

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INVESTMENTS

Haim Levy

Hebrew University of Jerusalem

and

Thierry Post

Erasmus University Rotterdam

Assisted by

Deborah L. Murphy, University of Tennessee

Philippe Versijp, Erasmus University Rotterdam

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Pearson Education Limited

Edinburgh Gate

Harlow

Essex CM20 2JE

England

and Associated Companies throughout the world

Visit us on the World Wide Web at:

www.pearsoned.co.uk

First published by South-Western College Publishing

This edition first published 2005

© Pearson Education Limited 2005

The rights of Haim Levy and Thierry Post to be identified as authors of

this work have been asserted by them in accordance with the Copyright,

Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in

a retrieval system, or transmitted in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without either the prior

written permission of the publisher or a licence permitting restricted copying

in the United Kingdom issued by the Copyright Licensing Agency Ltd,

90 Tottenham Court Road, London W1T 4LP.

All trademarks used herein are the property of their respective owners. The use of

any trademark in this text does not vest in the author or the publisher any trademark

ownership rights in such trademarks, nor does the use of such trademarks imply

any affiliation with or endorsement of this book by such owners.

ISBN-13: 978-0-273-65164-2

ISBN-10: 0-273-65164-1

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication Data

Levy, Haim.

Investments / Haim Levy and Thierry Post.

p. cm.

Includes bibliographical references and index.

ISBN 0-273-65164-1 (pbk.)

1. Investments. 2. Securities. 3. Capital market. 4. Portfolio management. I. Post,

Thierry. II. Title.

HG4521.L632 2005

332.6––dc22

2004043194

10 9 8 7 6 5 4 3 2

08 07 06 05 04

Typeset in 10/12pt Minion by 35

Printed and bound by Ashford Colour Press Ltd., Gosport. Hants.

The publisher’s policy is to use paper manufactured from sustainable forests.

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Brief contents

Preface xiv

Acknowledgements xviii

Guided tour to the book xxii

About the authors xxiv

1 Introduction 1

Part 1 THE INVESTMENT ENVIRONMENT 17

2 Bonds, stocks and other securities 19

3 Security markets 53

4 Institutional investors 94

5 Security regulation and investment ethics 121

Part 2 RETURN AND RISK 157

6 Rates of return 159

7 Fundamentals of portfolio analysis 203

8 Mean–variance analysis 234

9 Portfolio diversification 259

Part 3 CAPITAL MARKETS IN EQUILIBRIUM 287

10 The capital asset-pricing model 289

11 The arbitrage pricing theory 340

12 Efficient markets: theory and evidence 374

Part 4 SECURITY ANALYSIS 411

13 Interest rates and bond valuation 413

14 Bonds: analysis and management 455

15 Stocks: valuation and selection 491

16 Financial statement analysis 536

17 Macroeconomic analysis 566

18 Technical analysis 594

v

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BRIEF CONTENTS

vi

Part 5 DERIVATIVE SECURITIES 621

19 Futures, options and other derivatives 623

20 Derivatives valuation 678

Part 6 PORTFOLIO MANAGEMENT 725

21 Risk management 727

22 Performance evaluation 761

Appendix A Introduction to regression analysis 801

Appendix B Excel spreadsheet applications 822

Appendix C Answers to review questions 845

Glossary 881

Name index 898

Subject index 902

..

Visit the Investments Companion Website at www.booksites.net/levy

to access a rich, free resource of valuable teaching and learning material,

including the following content:

For the lecturer

n A secure, password-protected site offering downloadable teaching support

n Customisable PowerPoint slides, including key figures and tables from the

main text

n Extensive Instructor’s Problem Set, including review and practice problems

with solutions

For the student

n Multiple Choice Questions for every chapter, with instant feedback

n Interactive Spreadsheets, that accompany the Appendices in the book

n A searchable, online Glossary of key investments terminology

n Interactive Flashcards that allow you to check definitions against the key terms

during revision

n Learning Objectives from every chapter

Also

This site has a syllabus manager, search functions and email results functions.

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vii

Contents in detail

Preface xiv

Acknowledgements xviii

Guided tour to the book xxii

About the authors xxiv

1 Introduction 1

Learning objectives 2

1.1 The difference between corporate finance and investments 4

1.2 The benefits of studying investments 5

1.3 The investment process 6

1.4 Recent developments in investments 9

1.5 Where do we go from here? A brief overview of the book 11

Summary 13

Key terms 14

Review questions 14

Selected references 15

Part 1 THE INVESTMENT ENVIRONMENT

2 Bonds, stocks and other securities 19

Learning objectives 20

2.1 The nature of securities 21

2.2 Fixed-income securities 22

2.3 Stocks 33

2.4 Investment companies 40

2.5 International investment 41

2.6 Derivative securities 42

2.7 Investment risks 44

Summary 49

Key terms 50

Review questions 51

Selected references 52

3 Security markets 53

Learning objectives 54

3.1 The primary security market 55

3.2 The secondary security market 66

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CONTENTS IN DETAIL

viii

Summary 89

Key terms 90

Review questions 91

Selected references 92

4 Institutional investors 94

Learning objectives 95

4.1 Institutionalisation 95

4.2 Insurance companies 97

4.3 Pension funds 102

4.4 Investment companies 108

Summary 117

Key terms 118

Review questions 118

Selected references 119

5 Security regulation and investment ethics 121

Learning objectives 122

5.1 The need for security regulation 123

5.2 Securities regulation 126

5.3 Ethics 140

Summary 148

Key terms 149

Review questions 150

Selected references 150

Appendix 5 IMR Code of Ethics and Standards of Professional Conduct 152

Part 2 RETURN AND RISK

6 Rates of return 159

Learning objectives 160

6.1 Calculating rates of return 162

6.2 Adjustments for tax, inflation and exchange rates 172

6.3 Indices 177

6.4 Sample return statistics 187

6.5 The historical record 194

Summary 196

Key terms 198

Review questions 198

Selected references 200

Appendix 6 Annual US rates of return, 1926–2002 201

7 Fundamentals of portfolio analysis 203

Learning objectives 204

7.1 The portfolio possibilities set 205

..

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CONTENTS IN DETAIL

7.2 The probability distribution 208

7.3 The utility function 218

7.4 The expected utility criterion 219

7.5 Risk-aversion, diversification and risk premiums 224

7.6 Looking forward: from expected utility to mean–variance analysis 227

Summary 228

Key terms 229

Review questions 229

Selected references 230

Appendix 7 Cumulative standard normal distribution 232

8 Mean–variance analysis 234

Learning objectives 235

8.1 Fundamentals of mean–variance analysis 236

8.2 The mean and variance of a portfolio 242

8.3 Efficient and inefficient investment strategies 247

Summary 256

Key terms 257

Review questions 257

Selected references 258

9 Portfolio diversification 259

Learning objectives 260

9.1 Finding uncorrelated assets 261

9.2 International diversification 264

9.3 A little diversification goes a long way 269

9.4 Barriers to diversification 273

9.5 Estimation error 277

9.6 Human capital and property holdings 279

9.7 Actual diversification by households and mutual funds 280

Summary 282

Key terms 283

Review questions 283

Selected references 284

Part 3 CAPITAL MARKETS IN EQUILIBRIUM

10 The capital asset-pricing model 289

Learning objectives 290

10.1 The theory 292

10.2 Empirical tests of the capital asset-pricing model 314

10.3 Conclusion: dead or alive? 328

Summary 331

Key terms 333

Review questions 333

..

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CONTENTS IN DETAIL

x

Selected references 334

Appendix 10 A formal proof of the capital asset-pricing model 337

11 The arbitrage pricing theory 340

Learning objectives 342

11.1 Factor risk models 343

11.2 The arbitrage pricing theory 351

11.3 The arbitrage pricing theory and the capital asset-pricing model 362

11.4 Empirical tests of the arbitrage pricing theory 364

Summary 367

Key terms 368

Review questions 369

Selected references 369

Appendix 11 A formal proof of the arbitrage pricing theory 372

12 Efficient markets: theory and evidence 374

Learning objectives 376

12.1 Efficient market defined 377

12.2 What constitutes the appropriate information set? 378

12.3 Investment strategy in an efficient market 383

12.4 Investment strategy in an inefficient market 387

12.5 Empirical evidence related to the efficient market theory 389

12.6 Market anomalies 396

12.7 Behavioural finance 401

Summary 404

Key terms 405

Review questions 406

Selected references 406

Part 4 SECURITY ANALYSIS

13 Interest rates and bond valuation 413

Learning objectives 414

13.1 Bond prices and yields 415

13.2 The yield curve 419

13.3 Spreads over Treasuries 429

13.4 The impact of embedded options 441

Summary 444

Key terms 445

Review questions 445

Selected references 446

Appendix 13A Simple equations for bond pricing 448

Appendix 13B Incorporating accrued interest and partial periods 449

Appendix 13C Methods of compounding interest rates 452

..

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CONTENTS IN DETAIL

14 Bonds: analysis and management 455

Learning objectives 456

14.1 Bond-pricing principles 456

14.2 Duration 466

14.3 Convexity 477

14.4 Passive bond-management strategies 480

14.5 Active bond-management strategies 484

Summary 485

Key terms 486

Review questions 486

Selected references 487

Appendix 14A Computational equation for duration 489

Appendix 14B Duration as the holding period that minimises interest-rate risk:

a formal proof 489

15 Stocks: valuation and selection 491

Learning objectives 492

15.1 The intrinsic value of stocks 493

15.2 The constant dividend growth model 498

15.3 Normal-growth and super-growth firms 502

15.4 Multiple-stage growth models 508

15.5 Implementing discounted cash flow models in practice 511

15.6 The free cash flow model 514

15.7 Valuation multiples 517

15.8 How analysts value stocks 526

Summary 531

Key terms 532

Review questions 532

Selected references 533

Appendix 15 The two-stage growth model: a single valuation equation 535

16 Financial statement analysis 536

Learning objectives 537

16.1 Financial statements 538

16.2 Financial ratio analysis 552

16.3 Quality of earnings 558

Summary 562

Key terms 562

Review questions 563

Selected references 564

17 Macroeconomic analysis 566

Learning objectives 567

17.1 Macroeconomic evaluation 568

17.2 The economy and the financial markets 579

17.3 International parity relationships 583

..

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CONTENTS IN DETAIL

xii

Summary 591

Key terms 592

Review questions 592

Selected references 593

18 Technical analysis 594

Learning objectives 595

18.1 The logic behind technical analysis 596

18.2 Tools for technical analysis 601

18.3 Empirical evidence regarding technical analysis 615

Summary 618

Key terms 618

Review questions 619

Selected references 619

Part 5 DERIVATIVE SECURITIES

19 Futures, options and other derivatives 623

Learning objectives 624

19.1 Reasons for using derivatives 625

19.2 Forward contracts 628

19.3 Swaps 631

19.4 Futures contracts 636

19.5 Options 650

19.6 Investment strategies using derivatives 665

19.7 Financial engineering 672

Summary 673

Key terms 675

Review questions 675

Selected references 676

20 Derivatives valuation 678

Learning objectives 679

20.1 Static and dynamic hedges 681

20.2 Valuation of futures 681

20.3 Option valuation: bounds 688

20.4 The binominal model 694

20.5 Black–Scholes option-valuation model 706

Summary 720

Key terms 721

Review questions 722

Selected references 723

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xiii

CONTENTS IN DETAIL

Part 6 PORTFOLIO MANAGEMENT

21 Risk management 727

Learning objectives 728

21.1 Market risk 730

21.2 Credit risk 743

21.3 Operational risk 748

21.4 Instruments for risk control 753

Summary 757

Key terms 758

Review questions 759

Selected references 759

22 Performance evaluation 761

Learning objectives 763

22.1 Toolbox for performance evaluation 764

22.2 Risk-adjusted performance measures 768

22.3 Style analysis 780

22.4 Performance attribution 788

22.5 Empirical evidence for the performance of open-end mutual funds 791

22.6 A word of caution 795

Summary 796

Key terms 797

Review questions 798

Selected references 798

Appendix A Introduction to regression analysis 801

Appendix B Excel spreadsheet applications 822

Appendix C Review questions: answers 845

Glossary 881

Name index 898

Subject index 902

..

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xiv

Preface

This book offers a general introduction to investment in security markets. To some people,

security markets are like casinos and investing is about predicting security prices and speculating

that those predictions will come true. This book will be of little use to those people. Reading

this book won’t enable you to make predictions about security prices that are any better than

simply flipping a coin or reading a horoscope. That is not to say that this book won’t help

you to become a better investor. Indeed, one of the basic insights that you will obtain from

reading this book is that good investments generally do not require forecasting skills. Rather,

in many cases, good investments require the matching of the investments with the objectives

and constraints of the investor. Frequently, this can be achieved by means of spreading the

investments over many, preferably unrelated, securities (diversification), selecting securities

whose risks offset the risks of the investors’ liabilities (immunisation) and/or using derivative

securities to protect against downside risk (hedging). These strategies do not require any fore￾casting ability whatsoever. However, they do require a thorough understanding of securities,

securities markets and investment strategies. This is exactly what this book aims to achieve.

Intended audience

This book is geared to both undergraduate and graduate students. The subject matter can

be covered in a two-semester course, but the text can also be used for a one-semester course

by selecting the chapters considered most important. Generally, this course is taken after

principles of finance have been studied. However, all concepts needed for this book are

discussed here, in order to achieve a self-contained text. With regard to mathematics, no

more than high-school-level algebra is assumed.

Special features and ancillary material

This text and its special features were carefully developed by the authors and evaluated by a

dedicated panel of reviewers. The goal throughout has been to spark the interest of students

and enhance their motivation to learn about the field of investments. Some of the material

is placed on the accompanying Levy–Post investment website to allow for regular updates.

The URL of the website is: www.booksites.net/levy

The following special features are included in this book:

Up-to-date coverage of investment practice and academic research

Throughout the book, we have attempted to give an up-to-date coverage of current invest￾ment practice and academic research. For example, the table below gives a small sample of ten

key words that are found in this book but would not have appeared in a typical investment

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