Fundamentals of Investments: Valuation and Management, Eighth Edition
By Bradford D. Jordan, Thomas W. Miller Jr. and Steven D. Dolvin
Contents:
PART ONE Introduction 1
1. A Brief History of Risk and Return 1
1.1 Returns 2
Dollar Returns 2
Percentage Returns 4
A Note on Annualizing Returns 5
1.2 The Historical Record 7
A First Look 7
A Longer Range Look 8
A Closer Look 9
2008: The Bear Growled and Investors
Howled 12
1.3 Average Returns: The First Lesson 14
Calculating Average Returns 15
Average Returns: The Historical
Record 15
Risk Premiums 15
The First Lesson 16
1.4 Return Variability: The Second Lesson 17
Frequency Distributions and Variability 17
The Historical Variance and Standard
Deviation 18
The Historical Record 20
Normal Distribution 20
The Second Lesson 22
1.5 More on Average Returns 24
Arithmetic Versus Geometric
Averages 24
Calculating Geometric Average
Returns 25
Arithmetic Average Return or Geometric
Average Return? 27
Dollar-Weighted Average Returns 28
1.6 Risk and Return 30
The Risk-Return Trade-Off 30
A Look Ahead 31
1.7 Summary and Conclusions 31
- The Investment Process 41
2.1 The Investment Policy Statement 42
Objectives: Risk and Return 42
Investor Constraints 42
Strategies and Policies 45
2.2 Investment Professionals 47
Choosing a Broker/Advisor 47
Online Brokers 48
Investor Protection 48
Broker–Customer Relations 49
2.3 Types of Accounts 50
Cash Accounts 50
Margin Accounts 50
Annualizing Returns on a Margin
Purchase 54
Hypothecation and Street Name
Registration 55
Retirement Accounts 56
2.4 Types of Positions 57
Basics of a Short Sale 57
Short Sales: Some Details 58
Short-Sale Constraints 61
2.5 Forming an Investment Portfolio 63
Some Risk Tolerance Scores 63
Risk and Return 63
Investor Constraints 64
Strategies and Policies 64
More on Asset Allocation 65
Reits 65
2.6 Summary and Conclusions 66
- Overview of Security Types 75
3.1 Classifying Securities 76
3.2 Interest-Bearing Assets 76
Money Market Instruments 76
Fixed-Income Securities 78
3.3 Equities 80
Common Stock 80
Preferred Stock 81
Common Stock Price Quotes 82
3.4 Derivatives 85
Futures Contracts 85
Futures Price Quotes 86
Gains and Losses On Futures Contracts 88
3.5 Option Contracts 88
Option Terminology 88
Options Versus Futures 89
Option Price Quotes 89
Gains and Losses on Option
Contracts 90
Investing In Stocks Versus Options 91
3.6 Summary and Conclusions 92
- Mutual Funds and Other Investment
Companies 100
4.1 Advantages and Drawbacks of Mutual
Fund Investing 101
Advantages 101
Drawbacks 102
4.2 Investment Companies and Fund
Types 102
Open-End Versus Closed-End Funds 102
Net Asset Value 103
4.3 Mutual Fund Operations 104
Mutual Fund Organization and
Creation 104
Taxation of Investment Companies 105
The Fund Prospectus and Annual
Report 105
Mutual Fund Transactions 105
4.4 Mutual Fund Costs and Fees 106
Types of Expenses And Fees 106
Expense Reporting 108
Why Pay Loads and Fees? 110
The Impact of Fees on Portfolio
Values 110
4.5 Short-Term Funds 111
Money Market Mutual Funds 111
Money Market Deposit Accounts 113
4.6 Long-Term Funds 113
Stock Funds 113
Taxable and Municipal Bond Funds 115
Stock and Bond Funds 117
Mutual Fund Objectives: Recent
Developments 118
4.7 Mutual Fund Performance 121
Mutual Fund Performance
Information 121
How Useful Are Fund Performance
Ratings? 121
4.8 Closed-End Funds, Exchange-Traded
Funds, and Hedge Funds 124
Closed-End Funds Performance
Information 124
The Closed-End Fund Discount
Mystery 125
Exchange-Traded Funds 125
Hedge Funds 130
4.9 Summary and Conclusions 133
PART TWO Stock Markets 142
- The Stock Market 142
5.1 Private Equity versus Selling Securities
to the Public 143
Private Equity 143
The Structure of Private Equity Funds 143
Types of Private Equity Funds 144
Selling Securities to The Public 145
The Primary Market for Common
Stock 145
The Secondary Market for Common
Stock 148
Dealers and Brokers 148
5.2 The New York Stock Exchange 151
NYSE Membership History 151
Designated Market Makers 151
Other NYSE Participants 152
The NYSE Hybrid Market 152
NYSE-Listed Stocks 153
5.3 Operation of the New York Stock
Exchange 153
NYSE Floor Activity 154
Special Order Types 155
5.4 NASDAQ 158
Nasdaq Operations 159
Nasdaq Participants 159
5.5 NYSE and NASDAQ Competitors 160
5.6 Stock Market Information 160
The Dow Jones Industrial Average 160
Stock Market Indexes 162
More on Price-Weighted Indexes 166
The Dow Jones Divisors 167
More on Index Formation: Base-Year
Values 167
5.7 Summary and Conclusions 168
- Common Stock Valuation 177
6.1 Security Analysis: Be Careful Out
There 178
6.2 The Dividend Discount Model 178
Constant Perpetual Growth 179
Historical Growth Rates 181
The Sustainable Growth Rate 183
Analyzing Roe 184
6.3 The Two-Stage Dividend Growth
Model 186
Nonconstant Growth in the First Stage 188
The H-Model 190
Discount Rates for Dividend Discount
Models 190
Observations on Dividend Discount
Models 191
6.4 The Residual Income Model 191
Residual Income 192
The Rim versus the Constant Growth
Ddm 192
6.5 The Free Cash Flow Model 194
Free Cash Flow 194
The FCF Model versus the Constant
Growth Ddm 195
6.6 Price Ratio Analysis 197
Price-Earnings Ratios 197
Price-Cash Flow Ratios 198
Price-Sales Ratios 198
Price-Book Ratios 198
Applications of Price Ratio Analysis 199
Enterprise Value Ratios 200
6.7 An Analysis of the E. I. du Pont Company 201
Using the Dividend Discount Model 202
Using the Residual Income Model 204
Using the Free Cash Flow Model 204
Using Price Ratio Analysis 206
6.8 Summary and Conclusions 208
- Stock Price Behavior and Market Efficiency 220
7.1 Introduction to Market Efficiency 221
7.2 What Does “Beat the Market” Mean? 221
7.3 Foundations of Market Efficiency 221
7.4 Forms of Market Efficiency 222
7.5 Why Would a Market Be Efficient? 223
7.6 Some Implications of Market
Efficiency 224
Does Old Information Help Predict Future
Stock Prices? 224
Random Walks and Stock Prices 224
How Does New Information Get Into Stock Prices? 225
Event Studies 225
7.7 Informed Traders and Insider
Trading 228
Informed Trading 228
Insider Trading 228
7.8 How Efficient Are Markets? 230
Are Financial Markets Efficient? 230
Some Implications of Market
Efficiency 231
7.9 Market Efficiency and the Performance
of Professional Money Managers 232
7.10 Anomalies 235
The Day-of-the-Week Effect 235
The Amazing January Effect 235
Turn-of-the-Year Effect 238
Turn-of-the-Month Effect 238
The Earnings Announcement Puzzle 239
The Price-Earnings (P/E) Puzzle 239
7.11 Bubbles and Crashes 239
The Crash of 1929 239
The Crash of October 1987 241
The Asian Crash 243
The “Dot-Com” Bubble and Crash 243
The Crash of October 2008 244
7.12 Summary and Conclusions 246
- Behavioral Finance and the Psychology
of Investing 254
8.1 Introduction to Behavioral Finance 255
8.2 Prospect Theory 255
Frame Dependence 256
Loss Aversion 257
Mental Accounting and House
Money 258
8.3 Overconfidence 259
Overconfidence and Trading
Frequency 259
Overtrading and Gender: “It’s (Basically) a Guy Thing” 260
What Is a Diversified Portfolio to the
Everyday Investor? 260
Illusion of Knowledge 260
Snakebite Effect 261
8.4 Misperceiving Randomness and
Overreacting to Chance Events 262
The “Hot-Hand” Fallacy 264
The Gambler’s Fallacy 265
8.5 More on Behavioral Finance 266
Heuristics 266
Herding 266
How Do We Overcome Bias? 267
8.6 Sentiment-Based Risk and Limits to
Arbitrage 268
Limits to Arbitrage 268
The 3Com/Palm Mispricing 268
The Royal Dutch/Shell Price Ratio 269
8.7 Technical Analysis 270
Why Does Technical Analysis Continue
to Thrive? 270
Dow Theory 271
Elliott Waves 272
Support and Resistance Levels 272
Technical Indicators 273
Relative Strength Charts 275
Charting 276
Fibonacci Numbers 281
Other Technical Indicators 282
8.8 Summary and Conclusions 283
PART THREE Interest Rates and Bond
Valuation 295
- Interest Rates 295
9.1 Interest Rate History and Money Market
Rates 296
Interest Rate History 296
Money Market Rates 298
9.2 Money Market Prices and Rates 301
Bank Discount Rate Quotes 302
Treasury Bill Quotes 303
Bank Discount Yields versus Bond
Equivalent Yields 304
Bond Equivalent Yields, APRs, and
EARs 306
9.3 Rates and Yields on Fixed-Income
Securities 308
The Treasury Yield Curve 308
Rates on Other Fixed-Income
Investments 309
9.4 The Term Structure of Interest Rates 312
Treasury Strips 312
Yields For U.S. Treasury Strips 314
9.5 Nominal versus Real Interest Rates 315
Real Interest Rates 315
The Fisher Hypothesis 315
Inflation-Indexed Treasury Securities 316
9.6 Traditional Theories of the Term
Structure 317
Expectations Theory 317
Maturity Preference Theory 320
Market Segmentation Theory 320
9.7 Determinants of Nominal Interest Rates:
A Modern Perspective 321
Problems with Traditional Theories 321
Modern Term Structure Theory 321
Liquidity and Default Risk 323
9.8 Summary and Conclusions 323
- Bond Prices and Yields 332
10.1 Bond Basics 333
Straight Bonds 333
Coupon Rate and Current Yield 333
10.2 Straight Bond Prices and Yield to
Maturity 334
Straight Bond Prices 334
Premium and Discount Bonds 336
Relationships among Yield
Measures 338
A Note on Bond Price Quotes 338
10.3 More on Yields 340
Calculating Yields 340
Yield to Call 341
Using a Financial Calculator 343
10.4 Interest Rate Risk and Malkiel’s
Theorems 345
Promised Yield And Realized Yield 345
Interest Rate Risk and Maturity 345
Malkiel’s Theorems 346
10.5 Duration 348
Macaulay Duration 348
Modified Duration 348
Calculating Macaulay Duration 349
Properties of Duration 351
10.6 Bond Risk Measures Based on
Duration 352
Dollar Value of An 01 352
Yield Value of A 32nd 352
10.7 Dedicated Portfolios and Reinvestment
Risk 353
Dedicated Portfolios 353
Reinvestment Risk 354
10.8 Immunization 356
Price Risk versus Reinvestment Rate
Risk 356
Immunization by Duration Matching 356
Dynamic Immunization 357
10.9 Summary and Conclusions 358
PART FOUR Portfolio Management 368
- Diversification and Risky Asset
Allocation 368
11.1 Expected Returns and Variances 369
Expected Returns 369
Calculating the Variance of Expected
Returns 371
11.2 Portfolios 372
Portfolio Weights 372
Portfolio Expected Returns 373
Portfolio Variance of Expected
Returns 374
11.3 Diversification and Portfolio Risk 375
The Effect of Diversification: Another
Lesson From Market History 375
The Principle of Diversification 377
The Fallacy of Time Diversification 377
11.4 Correlation and Diversification 380
Why Diversification Works 380
Calculating Portfolio Risk 381
The Importance of Asset Allocation,
Part 1 383
More On Correlation and the Risk-Return
Trade-Off 385
11.5 The Markowitz Efficient Frontier 387
The Importance of Asset Allocation,
Part 2 387
11.6 Summary and Conclusions 390
- Return, Risk, and the Security Market
Line 401
12.1 Announcements, Surprises, and Expected
Returns 402
Expected and Unexpected Returns 402
Announcements and News 402
12.2 Risk: Systematic and Unsystematic 404
Systematic and Unsystematic Risk 404
Systematic and Unsystematic Components
Of Return 405
12.3 Diversification, Systematic Risk, and
Unsystematic Risk 406
Diversification and Unsystematic
Risk 406
Diversification and Systematic Risk 406
12.4 Systematic Risk and Beta 407
The Systematic Risk Principle 407
Measuring Systematic Risk 407
Portfolio Betas 409
12.5 The Security Market Line 410
Beta And The Risk Premium 410
The Reward-To-Risk Ratio 411
The Basic Argument 411
The Fundamental Result 413
The Security Market Line 415
12.6 More on Beta 417
A Closer Look At Beta 418
Where Do Betas Come From? 419
Another Way to Calculate Beta 421
Why Do Betas Differ? 423
12.7 Extending CAPM 424
A (Very) Brief History of Testing
CAPM 424
The Fama-French Three-Factor
Model 425
12.8 Summary and Conclusions 426
- Performance Evaluation and Risk
Management 435
13.1 Performance Evaluation 436
Performance Evaluation Measures 436
The Sharpe Ratio 437
The Treynor Ratio 438
Jensen’s Alpha 438
Another Method to Calculate Alpha 439
Information Ratio 442
R-Squared 442
13.2 Comparing Performance Measures 443
Global Investment Performance
Standards 445
Sharpe-Optimal Portfolios 446
13.3 Investment Risk Management 448
Value-at-Risk 449
13.4 More on Computing Value-at-Risk 450
13.5 Summary and Conclusions 452
PART FIVE Futures and Options 460
- Futures Contracts 460
14.1 Futures Contracts Basics 461
Modern History of Futures
Trading 461
Futures Contract Features 462
Futures Prices 463
14.2 Why Futures? 466
Speculating with Futures 466
Hedging with Futures 467
14.3 Futures Trading Accounts 471
14.4 Cash Prices versus Futures Prices 473
Cash Prices 473
Cash-Futures Arbitrage 473
Spot-Futures Parity 475
More on Spot-Futures Parity 476
14.5 Stock Index Futures 477
Basics of Stock Index Futures 477
Index Arbitrage 478
Hedging Stock Market Risk With
Futures 479
Hedging Interest Rate Risk With
Futures 480
Futures Contract Delivery Options 481
14.6 Summary and Conclusions 482
- Stock Options 491
15.1 Options on Common Stocks 492
Option Basics 492
Option Price Quotes 493
15.2 The Options Clearing Corporation 495
15.3 Why Options? 496
15.4 Stock Index Options 497
Index Options: Features and
Settlement 498
Index Option Price Quotes 498
15.5 Option Intrinsic Value and
“Moneyness” 499
Intrinsic Value for Call Options 499
Intrinsic Value for Put Options 500
Time Value 500
Three Lessons About Intrinsic Value 501
Show Me The Money 501
15.6 Option Payoffs and Profits 502
Option Writing 502
Option Payoffs 503
Option Payoff Diagrams 503
Option Profit Diagrams 504
15.7 Using Options to Manage Risk 506
The Protective Put Strategy 506
Credit Default Swaps 507
The Protective Put Strategy and Corporate
Risk Management 508
Using Call Options in Corporate Risk
Management 508
15.8 Option Trading Strategies 509
The Covered Call Strategy 509
Spreads 510
Combinations 511
15.9 Arbitrage and Option Pricing Bounds 512
The Upper Bound for Call Option
Prices 512
The Upper Bound for Put Option
Prices 512
The Lower Bounds for Call and Put Option
Prices 513
15.10 Put-Call Parity 515
Put-Call Parity with Dividends 517
What Can We Do with Put-Call
Parity? 517
15.11 Summary and Conclusions 519
PART SIX Topics in Investments 529
- Option Valuation 529
16.1 A Simple Model to Value Options before
Expiration 530
16.2 The One-Period Binomial Option Pricing
Model 531
The One-Period Binomial Option Pricing
Model—The Assumptions 531
The One-Period Binomial Option Pricing
Model—The Setup 531
The One-Period Binomial Option Pricing
Model—The Formula 532
What Is Delta? 534
16.3 The Two-Period Binomial Option Pricing
Model 534
Step 1: Build a Price Tree for Stock Prices
Through Time 535
Step 2: Use the Intrinsic Value Formula
to Calculate the Possible Option Prices at
Expiration 535
Step 3: Calculate The Fractional Share
Needed to Form Each Risk-Free Portfolio
at the Next-to-Last Date 536
Step 4: Calculate All Possible Option
Prices at the Next-to-Last Date 537
Step 5: Repeat This Process by Working
Back to Today 537
16.4 The Binomial Option Pricing Model with
Many Periods 538
16.5 The Black-Scholes Option Pricing
Model 540
16.6 Varying the Option Price Input Values 542
Varying the Underlying Stock Price 543
Varying the Option’s Strike Price 543
Varying the Time Remaining Until Option
Expiration 543
Varying the Volatility of the Stock
Price 544
Varying the Interest Rate 544
16.7 Measuring the Impact of Stock Price
Changes on Option Prices 545
Interpreting Option Deltas 546
16.8 Hedging Stock with Stock Options 547
Hedging Using Call Options—The
Prediction 548
Hedging Using Call Options—The
Results 548
Hedging Using Put Options—The
Prediction 548
Hedging Using Put Options—The
Results 549
16.9 Hedging a Stock Portfolio with Stock
Index Options 549
16.10 Implied Standard Deviations 551
CBOE Implied Volatilities for Stock
Indexes 552
16.11 Employee Stock Options 553
ESO Features 553
ESO Repricing 553
ESOs at the Gap, Inc. 554
Valuing Employee Stock Options 554
16.12 Summary and Conclusions 555
- Projecting Cash Flow and Earnings 565
17.1 Sources of Financial Information 566
17.2 Financial Statements 566
The Balance Sheet 567
The Income Statement 569
The Cash Flow Statement 570
Performance Ratios and Price Ratios 571
17.3 Financial Statement Forecasting 573
The Percentage of Sales Approach 573
The Pro Forma Income Statement 573
The Pro Forma Balance Sheet 574
Scenario One 576
Scenario Two 576
Projected Profitability and Price
Ratios 579
17.4 Starbucks Corporation Case Study 579
Pro Forma Income Statement 581
Pro Forma Balance Sheet 582
Valuing Starbucks Using Ratio
Analysis 585
Valuing Starbucks Using a Two-Stage
Dividend Growth Model 586
Valuing Starbucks: What Does the Market
Say? 587
17.5 Summary and Conclusions 587
- Corporate and Government Bonds 599
18.1 Corporate Bond Basics 600
18.2 Corporate Bond Indentures 601
Bond Seniority Provisions 602
Call Provisions 602
Put Provisions 605
Bond-to-Stock Conversion Provisions 605
Graphical Analysis of Convertible Bond
Prices 607
Bond Maturity and Principal Payment
Provisions 608
Sinking Fund Provisions 609
Coupon Payment Provisions 609
Protective Covenants 610
Adjustable-Rate Bonds 610
18.3 Government Bond Basics 611
18.4 U.S. Treasury Bills, Notes, Bonds,
and STRIPS 612
Treasury Bond and Note Prices 615
Treasury Inflation-Protected
Securities 617
18.5 U.S. Treasury Auctions 619
18.6 Federal Government Agency
Securities 619
18.7 Municipal Bonds 621
Municipal Bond Features 622
Types of Municipal Bonds 622
Municipal Bond Insurance 624
Equivalent Taxable Yield 624
Taxable Municipal Bonds 625
18.8 Bond Credit Ratings 625
Why Bond Ratings Are Important 627
An Alternative to Bond Ratings 627
Junk Bonds 628
18.9 Summary and Conclusions 630
- Global Economic Activity and Industry
Analysis 640
19.1 Top-Down Analysis 641
19.2 Global Macroeconomic Activity 642
Real GDP 642
Business Cycles 643
Economic Indicators 645
The Global Economy and Stock Return
Correlations 645
The Effects of Exchange Rates on Global
Investments 646
19.3 Monitoring Jobs and the Price Level 647
Labor Market Indicators 647
The Consumer Price Index 648
19.4 Monetary and Fiscal Policy 649
Monetary Policy 649
Fiscal Policy 651
19.5 Industry Analysis 652
Identifying Sectors 652
Porter’s Five Forces 655
19.6 Summary and Conclusions 656
- Mortgage-Backed Securities 663
20.1 A Brief History of Mortgage-Backed
Securities 664
20.2 Fixed-Rate Mortgages 664
Fixed-Rate Mortgage Amortization 665
Fixed-Rate Mortgage Prepayment
and Refinancing 667
20.3 Government National Mortgage
Association 671
GNMA Clones 671
20.4 Public Securities Association Mortgage
Prepayment Model 672
20.5 Cash Flow Analysis of GNMA Fully
Modified Mortgage Pools 674
Macaulay Durations for GNMA
Mortgage-Backed Bonds 675
20.6 Collateralized Mortgage Obligations 677
Interest-Only and Principal-Only Mortgage
Strips 678
Sequential Collateralized Mortgage
Obligations 680
Protected Amortization Class Bonds 682
20.7 Yields for Mortgage-Backed Securities and
Collateralized Mortgage Obligations 684
20.8 Summary and Conclusions 685
APPENDICES
A Answers to Test Your Investment Quotient
Questions 693
B Answers to Selected Questions and
Problems 697
C Key Equations 699
Name Index 703
Equations Index 705
Subject Index 708