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Part1 Introduction3

Chapter1 A Brief History of Risk and Return3

1.1 Returns4

Dollar Returns4

Percentage Returns6

1.2 The Historical Record7

A First Look7

A Look Overseas9

A Longer Range Look9

A Closer Look10

1.3 Average Returns: The First Lesson13

Calculating Average Returns14

Average Returns: The Historical Record14

Risk Premiums14

Risk Premiums: An International Perspective14

The First Lesson15

1.4 Return Variability: The Second Lesson16

Frequency Distributions and Variability16

The Historic Variance and Standard Deviation17

The Historical Record19

The Second Lesson19

1.5 Risk and Return20

The Risk-Return Trade-Off20

A Look Ahead21

1.6 Summary and Conclusions22

Chapter2 Buying and Selling Securities31

2.1 Getting Started32

Choosing a Broker32

Online Brokers33

Security Investors Protection Corporation34

Broker-Customer Relations34

2.2 Brokerage Accounts35

Cash Accounts35

Margin Accounts35

Initial Margin37

Maintenance Margin37

The Effects of Margin38

Hypothecation and Street Name Registration39

Hypothecation40

Street Name Registration40

Other Account Issues40

2.3 Short Sales41

Basics of a Short Sale41

Short Sales: Some Details42

2.4 Investor Objectives, Constraints, and Strategies48

Risk and Return48

Investor Constraints49

Resources49

Horizon49

Liquidity49

Taxes49

Special Circumstances50

Strategies and Policies50

Investment Management50

Market Timing51

Asset Allocation51

Security Selection51

2.5 Summary and Conclusions53

Chapter3 Security Types63

3.1 Classifying Securities64

3.2 Interest-Bearing Assets64

Money Market Instruments65

Fixed-Income Securities65

Examples of Fixed-Income Securities65

Fixed-Income Price Quotes66

3.3 Equities68

Common Stock68

Preferred Stock68

Common and Preferred Stock Price Quotes69

3.4 Derivatives70

Futures Contracts71

Futures Price Quotes71

Gains and Losses on Futures Contracts72

3.5 Option Contracts73

Option Terminology73

Options versus Futures74

Option Price Quotes74

Gains and Losses on Option Contracts75

3.6 Summary and Conclusions76

Chapter4 Mutual Funds83

4.1 Investment Companies and Fund Types84

Open-End versus Closed-End Funds84

Net Asset Value85

4.2 Mutual Fund Operations86

Mutual Fund Organization and Creation86

Taxation of Investment Companies87

The Fund Prospectus and Annual Report87

4.3 Mutual Fund Costs and Fees87

pes of Expenses and Fees88

Sales Charges88

12b-1 Fees88

Management Fees89

Trading Costs89

Expense Reporting89

Why Pay Loads and Fees?92

4.4 Short-Term Funds92

Money Market Mutual Funds92

Money Market Fund Accounting93

Taxes and Money Market Funds93

Money Market Deposit Accounts93

4.5 Long-Term Funds94

Stock Funds95

Capital Appreciation versus Income95

Company Size-Based Funds96

International Funds96

Sector Funds96

Other Fund Types and Issues97

Taxable and Municipal Bond Funds98

Short-Term and Intermediate-Term Funds98

General Funds98

High-Yield Funds98

Mortgage Funds98

World Funds98

Insured Funds98

Single-State Municipal Funds99

Stock and Bond Funds99

Balanced Funds99

Asset Allocation Funds99

Convertible Funds100

Income Funds100

4.6 Mutual Fund Performance100

Mutual Fund Performance Information100

How Useful are Fund Performance Ratings?102

4.7 Closed-End Funds103

Closed-End Funds Performance Information103

The Closed-End Fund Discount Mystery103

4.8 Summary and Conclusions105

Part2 Stock Mmarkets113

Chapter5 The Stock Market113

5.1 Who Owns Stocks?114

5.2 The Primary and Secondary Stock Markets115

The Primary Market for Common Stock115

The Secondary Market for Common Stock118

Dealers and Brokers119

5.3 The New York Stock Exchange120

NYSE Membership120

Types of Members121

NYSE-Listed Stocks122

5.4 Operation of the New York Stock Exchange123

NYSE Floor Activity123

Special Order Types125

5.5 Nasdaq127

Nasdaq Operations127

The Nasdaq System128

5.6 NYSE and Nasdaq Competitors129

5.7 Stock Market Information130

The Dow Jones Industrial Average130

Stock Market Indexes130

More on Price-Weighted Indexes134

The Dow Jones Divisors135

5.8 Summary and Conclusions136

Chapter6 Common Stock Valuation145

6.1 Security Analysis: Be Careful Out There146

6.2 The Dividend Discount Model147

Constant Dividend Growth Rate Model148

Constant Perpetual Growth149

Applications of the Constant Perpetual Growth Model150

The Sustainable Growth Rate151

6.3 The Two-Stage Dividend Growth Model152

Discount Rates for Dividend Discount Modeis155

Observations Dividend Discount Models156

6.4 Price Ratio Analysis157

Price-Earnings Ratios157

Price-Cash Flow Ratios158

Price-Sales Ratios159

Price-Book Ratios160

Applications of Price Ratio Analysis161

6.5 An Analysis of the McGraw-Hill Company164

6.6 Summary and Conclusions169

Chapter7 Earnings and Cash Flow Analysis179

7.1 Sources of Financial Information180

7.2 Financial Statements180

The Balance Sheet181

The Income Statement184

The Cash Flow Statement185

Performance Ratios and Price Ratios186

7.3 Financial Statement Forecasting187

The Pro Forma Income Statement188

The Pro Forma Cash Flow Statement189

The Pro Forma Balance Sheet190

Projected Profitability and Price Ratios190

7.4 Adolph Coors Company Case Study192

7.5 Summary and Conclusions197

Chapter8 Stock Price Behavior and Market Efficiency207

8.1 Technical Analysis208

Dow Theory208

Support and Resistance Levels208

Technical Indicators209

Charting211

Relative Strength Charts211

Moving Average Charts212

Hi-Lo-Close and Candlestick Charts213

Point-and-Figure Charts214

Chart Formations215

Other Technical Indicators216

8.2 Market Efficiency217

What Does “Beat the Market” Mean?217

Forms of Market Efficiency218

Why Would a Market Be Efficient?219

Are Financial Markets Efficient?219

Some Implications of Market Efficiency222

8.3 Stock Price Behavior and Market Efficiency224

The Day-of-the-Week Effect224

The Amazing January Effect224

The October 1987 Crash227

Performance of Professional Money Managers228

8.4 Summary and Conclusions230

Part3 Interest Pates and Bond Markets241

Chapter9 Interest Rates241

9.1 Interest Rate History and Money Market Rates242

Interest Rate History242

Money Market Rates243

9.2 Money Market Prices and Rates247

Bank Discount Rate Quotes247

Treasury Bill Quotes248

Bank Discount Yields versus Bond Equivalent Yields250

Bond Equivalent Yields, APRs, and EARS251

9.3 Rates and Yields on Fixed-Income Securities253

The Treasury Yield Curve254

Rates on Other Fixed-Income Investments255

9.4 The Term Structure of Interest Rates256

Treasury STRIPS256

Yields for U.S. Treasury STRIPS258

9.5 Nominal versus Real Interest Rates259

Real Interest Rates259

The Fisher Hypothesis260

9.6 Traditional Theories of the Term Structure261

Expectations Theory261

Expectations and Forward Rates262

Expectations Theory and the Fisher Hypothesis263

Maturity Preference Theory263

Market Segmentation Theory264

9.7 Determinants of Nominal Interest Rates: A Modern Perspective264

Problems with Traditional Theories264

Modern Term Structure Theory265

Liquidity and Default Risk266

9.8 Summary and Conclusions266

Chapter10 Bond Prices and Yields275

10.1 Bond Basics276

Straight Bonds276

Coupon Rate and Current Yield276

10.2 Straight Bond Prices and Yield to Maturity277

Straight Bond Prices277

Premium and Discount Bonds279

Relationships among Yield Measures281

10.3 More on Yields281

Calculating Yields281

Yield to Call282

10.4 Interest Rate Risk and Malkiel's Theorems284

Promised Yield and Realized Yield284

Interest Rate Risk and Maturity284

Malkiel's Theorems285

10.5 Duration287

Macaulay Duration287

Modified Duration288

Calculating Macaulay's Duration289

Properties of Duration291

10.6 Dedicated Portfolios and Reinvestment Risk292

Dedicated Portfolios292

Reinvestment Risk293

10.7 Immunization294

Price Risk versus Reinvestment Rate Risk294

Immunization by Duration Matching295

Dynamic Immunization296

10.8 Summary and Conclusions296

Chapter11 Corporate Bonds305

11.1 Corporate Bond Basics306

11.2 Types of Corporate Bonds307

11.3 Bond Indentures310

Bond Seniority Provisions310

Call Provisions311

Graphical Analysis of Callable Bond Prices312

Put Provisions313

Bond-to-Stock Conversion Provisions313

Graphical Analysis of Convertible Bond Prices316

Bond Maturity and Principal Payment Provisions317

Sinking Fund Provisions319

Coupon Payment Provisions320

11.4 Protective Covenants321

11.5 Event Risk322

11.6 Bonds without Indentures322

11.7 Preferred Stock323

11.8 Adjustable-Rate Bonds and Adjustable-Rate Preferred Stock324

11.9 Corporate Bond Credit Ratings326

Why Bond Ratings Are Important327

11.10 Junk Bonds328

11.11 Bond Market Trading329

11.12 Summary and Conclusions332

Chapter12 Government Bonds339

12.1 Government Bond Basics340

12.2 U.S. Treasury Bills, Notes, Bonds, and STRIPS340

Treasury Bond and Note Prices344

Inflation-Indexed Treasury Securities346

12.3 U.S. Treasury Auctions347

12.4 U.S. Savings Bonds348

Series EE Savings Bonds348

Series I Savings Bonds348

12.5 Federal Government Agency Securities349

12.6 Municipal Bonds351

Municipal Bond Features353

pes of Municipal Bonds356

Municipal Bond Credit Ratings357

Municipal Bond Insurance358

12.7 Equivalent Taxable Yield359

12.8 Taxable Municipal Bonds360

12.9 Summary and Conclusions360

Chapter13 Mortgage-Backed Securities369

13.1 A Brief History of Mortgage-Backed Securities370

13.2 Fixed-Rate Mortgages370

Fixed-Rate Mortgage Amortization372

Fixed-Rate Mortgage Prepayment and Refinancing375

13.3 Government National Mortgage Association357

GNMA Clones377

13.4 Public Securities Association Mortgage Prepayment Model378

13.5 Cash Flow Analysis of GNMA Fully Modified Mortgage Pools380

Macaulay Durations for GNMA Mortgage-Backed Bonds381

13.6 Collateralized Mortgage Obligations383

Interest-Only and Principal-Only Mortgage Strips384

Sequential Collateralized Mortgage Obligations386

Protected Amortization Class Bonds388

13.7 Yields for Mortgage-Backed Securities and Collateralized Mortgage Obligations390

13.8 Summary and Conclusions391

Part4 Options and Futures401

Chapter14 Stock Options401

14.1 Options on Common Stock402

Option Basics402

Option Price Quotes403

14.2 Why Options?405

14.3 Options Payoffs and Profits407

Option Writing407

Option Payoffs407

Payoff Diagrams408

Options Profits410

14.4 Option Strategies410

The Protective Put Strategy410

The Covered Call Strategy412

Straddles412

14.5 Option Prices, Intrinsic Values, and Arbitrage413

The Upper Bound for a Call Option Price413

The Upper Bound for a Put Option413

The Lower Bounds on Option Prices414

14.6 Stock Index Options416

Index Options: Features and Settlement416

Index Option Price Quotes416

14.7 The Options Clearing Corporation419

14.8 Summary and Conclusions419

Chapter15 Option Valuation431

15.1 Put-Call Parity432

15.2 The Black-Scholes-Merton Option Pricing Model434

15.3 Varying the Option Price Input Values436

Varying the Underlying Stock Price437

Varying the Option's Strike Price438

Varying the Time Remaining until Option Expiration438

Varying the Volatility of the Stock Price438

Varying the Interest Rate439

Varying the Dividend Yield439

15.4 Measuring the Impact of Input Changes on Option Prices440

Interpreting Option Deltas440

Interpreting Option Etas441

Interpreting Option Vegas441

Interpreting an Option's Gamma, Theta, and Rho441

15.5 Implied Standard Deviation442

15.6 Hedging a Stock Portfolio with Stock Index Options443

15.7 Implied Volatility Skews445

15.8 Summary and Conclusions447

Chapter16 Futures Contracts455

16.1 Futures Contracts Basics456

History of Futures Trading456

Futures Contract Features457

Futures Prices458

16.2 Why Futures?460

Speculating with Futures462

Hedging with Futures463

16.3 Futures Trading Accounts464

16.4 Cash Prices versus Futures Prices466

Cash Prices466

Cash-Futures Arbitrage468

Spot-Futures Parity469

More on Spot-Futures Parity470

16.5 Stock Index Futures471

Basics of Stock Index Futures471

Index Arbitrage471

Hedging Stock Market Risk with Futures472

Hedging Interest Rate Risk with Futures474

Futures Contract Delivery Options475

16.6 Summary and Conclusions475

Part5 Portfolio Management487

Chapter17 Diversification and Asset Allocation487

17.1 Expected Returns and Variances488

Expected Returns488

Calculating the Variance490

17.2 Portfolios491

Portfolio Weights491

Portfolio Expected Returns492

Portfolio Variance493

17.3 Diversification and Portfolio Risk495

The Effect of Diversification: Another Lesson from Market History495

The Principle of Diversification496

17.4 Correlation and Diversification497

Why Diversification Works497

Calculating Portfolio Risk499

More on Correlation and the Risk-Return Trade-Off504

17.5 The Markowitz Efficient Frontier506

Risk and Return with Multiple Assets506

17.6 Summary and Conclusions507

Chapter18 Return, Risk, and the Security Market Line517

18.1 Announcements, Surprises, and Expected Returns518

Expected and Unexpected Returns518

Announcements and News519

18.2 Risk: Systematic and Unsystematic520

Systematic and Unsystematic Risk521

Systematic and Unsystematic Components of Return521

18.3 Diversification, Systematic Risk, and Unsystematic Risk522

Diversification and Unsystematic Risk522

Diversification and Systematic Risk523

18.4 Systematic Risk and Beta523

The Systematic Risk Principle523

Measuring Systematic Risk524

Portfolio Betas525

18.5 The Security Market Line526

Beta and the Risk Premium526

The Reward-to-Risk Ratio527

The Basic Argument527

The Fundamental Result528

The Security Market Line530

Market Portfolios530

The Capital Asset Pricing Model531

18.6 More on Beta534

A Closer Look at Beta534

Where Do Betas Come From?535

Why Do Betas Differ?537

18.7 Summary and Conclusions538

Chapter19 International Finance and Investments547

19.1 Currency Exchange Rates548

19.2 Exchange Rate Changes551

19.3 Triangular Arbitrage553

19.4 Forward Currency Contracts554

19.5 Interest Rate Parity555

19.6 Purchasing Power Parity557

19.7 International Diversification558

19.8 American Depository Receipts563

19.9 World Equity Benchmark Shares565

19.10 Summary and Conclusions566

Appendices574

Appendix A574

Answers to Test Your Investment Quotient Questions574

Appendix B577

Answers to Selected Problems577