ELEVENTH EDITION

i\

AT

Principles and Concepts

International Student Version

fieNorth Carolina State University

0s-

WILEY

John Wiley & Sons, Inc.

D investing is an Important Activity Worldwide, 1An Overall Perspective On Investing, 2Establishing a Framework for Investing, 3

Some Definitions, 3A Perspective on Investing in Financial Assets, 4

Why Do We Invest? 4

The Importance of Studying Investments, 5The Personal Aspects; 5

Investments as a Profession, 7

Understanding the Investment Decision Process, 8The Basis of Investment Decisions—Return and Risk, 9

Structuring the Decision Process, 13

Important Considerations in the Investment Decision Process for Today'sInvestors, 13

The Great Unknown, 13

The Global Investments Arena, 14

The Importance of the Internet, 15

Individual Investors vs. Institutional Investors, 15

Ethics in Investing, 16Organizing the Text, 17Summary, 18 \

2 investment Alternatives: Generic PrinciplesAll Investors Must Know, 20Organizing Financial Assets, 21

Direct Investing, 22

A Global Perspective, 23

Nonmarketable Financial Assets, 23Money Market Securities, 24

The Treasury Bill, 25

Money Market Rates, 26

Capital Market Securities, 27Fixed-Income Securities, 27

Bonds, 27

Types of Bonds, 30

Auction Rate Securities, 36

Asset-Backed Securities, 36

Rates on Fixed-Income Securities, 38

Equity Securities, 38Preferred Stock, 38

Common Stock, 39

Investing Internationally in Equities, 42

X CONTENTS

Derivative Securities, 43Options, 44

Futures Contracts, 45

A Final Note, 45Summary, 46

§ Indirect investing: A Global Activity, 50Investing Indirectly, 51What Is an Investment Company? 52Three Major Types of Investment Companies, 53

Closed-End Investment Companies, 54

Exchange-Traded Funds (ETFs), 54

Mutual Funds (Open-End Investment Companies), 56

Types of Mutual Funds, 58Money Market Funds, 59

Equity Funds, Bond Funds, and Hybrid Funds, 60

The Net Asset Value per Share, 63The Mechanics of Investing Indirectly, 64

Closed-End Funds, 64

Mutual Funds, 65

Exchange-Traded Funds, 69

Investment Company Performance, 69Measures of Fund Performance, 69

Morningstar Ratings, 71

Benchmarks, 72

How Important are Expenses in Affecting Performance? 72

Some Conclusions About Fund Performance, 73

Investing Internationally Through Investment Companies, 74Fund Categories for International Investing, 74

The Future of Indirect Investing, 76Fund Supermarkets, 76

HedgeFunds, 76Summary, 77

4} Securities Markets Matter to All Investors, 81The Importance of Financial Markets, 82The Primary Markets, 82

Initial Public Offerings (IPOs), 83

The Investment Banker, 83

Global Investment Banking, 85

Private Placements, 86

The Secondary Markets, 86U.S. Securities Markets for the Trading of Equities, 86The New York Stock Exchange, 88American Stock Exchange, 89The NASDAQ Stock Market, 89The OTC (Over-the-Counter) Market, 89Electronic Communications Networks (ECNs), 90

Foreign Markets, 90

Stock Market Indexes, 91The Dow J'ones Averages, 92Standard & Poor's Stock Price Indexes, 94Understanding a Capitalization-Weighted Index, 94NASDAQ Indexes, 95

CONTENTS xi

Other Indexes, 96Using the Correct Domestic Stock Indexes, 96

Foreign Stock Market Indicators, 97

Bond Markets, 97Individual Investors and Bond Trading, 97

Derivatives Markets, 98The Globalization of Securities Markets, 98Summary, 99

5 All Financial Markets Have Regulations andTrading Practices, 103Brokerage Transactions, 104

Brokerage Firms, 104

Brokerage Accounts, 105

How Orders Work, 107Trading on Today's Exchanges, 107

Orders in the NASDAQ Stock Market, 108

Types of Orders, 108

Clearing Procedures, 110

Investor Protection in the Securities Markets, 110Government Regulation, 111Self-Regulation, 113

Other Investor Protections, 114

Margin, 115How Margin Accounts Can be Used, 115

Margin Requirements and Obligations, 116

Margin Requirements on Other Securities, 118

Some Misconceptions About Margin, 118

Short Sales, 118Selling Short as an Investor, 121

Summary, 122 I

© (Return and Rosk: The Foundation of investing Worldwide, inAn Overview, 128Return, 128

The Two^Components of Return, 129

Measuring Returns, 130Total Return, 130

Return Relative, 133

Cumulative Wealth Index, 134

Taking a Global Perspective, 134International Returns and Currency Risk, 135

Summary Statistics for Returns, 137Arithmetic Mean, 137

Geometric Mean, 137

Arithmetic Mean Versus Geometric Mean, 139

Inflation-Adjusted Returns, 140

Risk, 142Sources of Risk, 142

Measuring Risk, 144Variance and Standard Deviation, 144

Risk Premiums, 146

Xli CONTENTS

Realized Returns and Risks from Investing, 148Total Returns and Standard Deviations for the Major Financial Assets, 148

Cumulative Wealth Indexes, 150

The Components of Cumulative Wealth and the Geometric Mean, 151

Compounding and Discounting, 152

Summary, 152

Portfolio Theory is Universal, 162Dealing with Uncertainty, 163

Using Probabilities, 164

Probability Distributions, 164 x,Calculating Expected Return for a Security, 166

Calculating Risk for a Security, 167

Introduction to Modern Portfolio Theory, 168Portfolio Return and Risk, 169

Portfolio Expected Return, 169

Portfolio Risk, 170

Analyzing Portfolio Risk, 170Risk Reduction—The Insurance Principle, 170

, Diversification, 172

The Components of Portfolio Risk, 173The Correlation Coefficient, 173

Covariance, 176

Relating the Correlation Coefficient and the Covariance, 177

The Importance of Covariance, 177

Calculating Portfolio Risk, 178The Two-Security Case, 178

The n-Security Case, 181

Obtaining the Data, 182Simplifying the Markowitz Calculations, 183

Summary, 184

Portfolio Selection for All Investors, 190Building a Portfolio Using Markowitz Principles, 191

Identifying Optimal Risk-Return Combinations, 191

Selecting an Optimal Portfolio of Risky Assets, 193

The Global Perspective—International Diversification, 195Some Important Conclusions about the Markowitz Model, 196Alternative Methods of Obtaining the Efficient Frontier, 196Selecting Optimal Asset Classes—The Asset Allocation Decision, 197

Some Major Asset Classes, 198Combining Asset Classes, 200Asset Classes and Correlation Coefficients, 202

Asset Allocation and the Individual Investor, 202

Asset Allocation Using Other Assets, 205

Life Cycle Analysis, 206

Other Approaches, 206

The Impact of Diversification on Risk, 207Systematic and Nonsystematic Risk, 207

How Many Securities are Needed to Fully Diversify? 208

The Implications of Reducing Risk by Holding Portfolios, 209Summary, 209

CONTENTS xiii

Asset Pricing Principles, 214Capital Market Theory, 215

Capital Market Theory Assumptions, 215

Introduction of the Risk-Free Asset, 216

Risk-Free Borrowing and Lending, 217

The Equilibrium Return-Risk Trade-Off, 218The Capital Market Line, 219

The Security Market Line, 223

Estimating the SML, 229"' Estimating Beta, 229

Tests of the CAPM, 232Arbitrage Pricing Theory, 233

The Law of One Price, 233

Assumptions of APT, 234

Factor Models, 234

Understanding the APT Model, 235

Identifying the Factors, 236

Using APT in Investment Decisions, 237

Some Conclusions about Asset Pricing, 238 ^Summary, 238

0 Common Stock Valuation: Lessons for All Investors, 245Overview, 246Discounted Cash Flow Techniques, 247

Two DCF Approaches, 248

The Dividend Discount Model, 248Applying the DDM, 249

The DDM Equation, 249

Implementing the DDM, 250

Growth Rate Cases for the DDM, 250The Zero-Growth Rate Model, 251The Constant Growth Rate Model, 252The Multiple-Growth Rate Model, 255

Dividends, Dividends—What About Capital Gains? 258

The Dividend Discount Model in Practice, 259

Other Discounted Cash Flow Approaches, 260Free Cash Flow to Equity, 260

Free Cash Flow to the Firm, 261

Intrinsic Value and Market Price, 262

The Target Price and Relative Valuation Approach, 262Price/Earnings Ratio (PIE), 263

Price/Book Value (P/B), 263

Price/Sales Ratio (PRS), 264

The Target Price Approach to Valuation, 265

EVA Analysis, 266

Which Approach to Use? 267Bursting the Bubble on New Economy Stocks—A Lessonin Valuation, 268Some Final Thoughts on Valuation, 269Summary, 270

xiv CONTENTS

] D Managing a Stock Portfolio: A Worldwide issue, 278Taking a Global Perspective, 279The Impact of the Overall Market on Stocks, 279Building Stock Portfolios, 281The Passive Strategy, 282

Buy-and-Hold Strategy, 282

Index Funds, 283 }

The Active Strategy, 285Security Selection, 286

The Importance of Earnings per Share (EPS) in Stock Selection, 287

Growth Stocks and Value Stocks, 287Security Analysts and Stock Selection, 287Sector Rotation, 290

Market Timing, 292

Rational Markets and Active Strategies, 294A Simple Strategy—the Coffeehouse Portfolio, 295Summary, 295

12 What happens if Markets Are Efficient—Or Mot?, 299Overview, 300The Concept of an Efficient Market, 300

What is an Efficient Market? 300Why the U.S. Stock Market can be Expected to be Efficient, 302The International Perspective, 303

Forms of Market Efficiency, 303

How to Test for Market Efficiency, 306Weak-Form Tests, 307

Semistrong-Form Tests, 307

Strong-Form Evidence, 309

Market Anomalies, 311Earnings Announcements, 311Low P/E Ratios, 313

The Size Effect, 314The fanuary Effect, 314

The Value Line Ranking System, 315

Other Anomalies, 317

Data Mining, 317

Behavioral Finance, 318Efficient Market vs. Behavioral Finance, 320

Behavioral Finance Implications for Investors, 320

Behavioral Finance Today, 320

Some Conclusions about Market Efficiency, 321Summary, 323

I S Economy/Market Analysis Must [Be Considered ByAll investors, 327Taking a Global Perspective, 328Assessing the Economy, 329

The Business Cycle, 330

Forecasts of the Economy, 332

The Stock Market and the Economy, 334The Economy and Stock Market Booms, 336

Economic Slowdowns and Bear Markets, 336

CONTENTS XV

Relating the Bond Market to the Stock Market, 336

Understanding the Stock Market, 337What Do We Mean by the "Market"? 337

What Determinants Aggregate Stock Prices? 338

Making Market Forecasts, 341Focus on the Important Variables, 342

Using the Business Cycle to Make Market Forecasts, 345

Other Approaches to Assessing the Market's Direction, 346

The E/P Ratio and the Treasury Bond Yield, 346

Summary, 349

04) Sector/Industry Analysis, 352What Is an Industry? 353

Classifying Industries, 354The NAICS Classification System, 354

Other Industry Classifications, 354

The Importance of Sector/Industry Analysis, 355Why Sector-/Industry Analysis is Important Over the Long Run, 355

Industry Performance Over Shorter Periods, 357

How One Industry Can Have a Major Impact on Investors—The Telecom Industry, 358

Cross-Sectional Volatility Has Increased, 358

Analyzing Sectors/Industries, 359The Industry Life Cycle, 359

Qualitative Aspects of Industry Analysis, 361

Using Sector/Industry Analysis as an Investor, 363Sector Rotation, 363

Evaluating Future Industry Prospects, 363

Business Cycle Analysis, 364

Picking Industries for Next Year, 365

Summary, 366

0 5 Company Analysis, 368Fundamental Analysis, 369The Accounting Aspects of Earnings, 370

The Financial Statements, 370

The Problems with EPS, 376

Has the Situation Improved? 377

Using the Financial Statements to Analyze a Company, 380Analyzing Return on Assets (ROA), 381

Analyzing Return on Equity (ROE), 381

The Accounting Determinants of EPS, 382

Estimating the Internal (Sustainable) Growth Rate, 383

Earnings Estimates, 384A Forecast of EPS, 384The Accuracy of Earnings Forecasts, 385Earnings Surprises, 385Earnings Guidance, 387The Earnings Game, 387Useful Information for Investors about Earnings Estimates, 388

Sales Growth—An Alternative to Earnings, 389

The P/E Ratio, 389Which P/E Ratio is Being Used? 389Why P/E Ratios Vary Among Companies, 390

XVI CONTENTS

Forward P/E Ratio, 390

The PEG Ratio, 391

Fundamental Security Analysis in Practice, 391Summary, 394

]© Technical Analysis, 399What Is Technical Analysis? 400

A Framework for Technical Analysis, 402

Stock Price and Volume Techniques, 403The Dow Theory, 403Charts of Price Patterns, 405Moving Averages, 409Relative Strength, 411

Using the Computer for Technical Analysis, 412

Technical Indicators, 412Breadth Indicators, 413

Sentiment Indicators, 413

Testing Technical Analysis Strategies, 415The EBB and Flow of Technical Analysis, 417Some Conclusions about Technical Analysis, 417Summary, 419

\V Fixed Income Securities Are Available Worldwide,422Bond Yields and Interest Rates, 423

The Basic Components of Interest Rates, 423

The Term Structure of Interest Rates, 425

Risk Premium (Yield Spreads), 428

Measuring Bond Yields, 429Current Yield, 430Yield to. Maturity, 430Yield to Call, 432

Realized Compound Yield, 433

Bond Prices, 438The Valuation Principle, 438

Bond Valuation, 439

Bond Price Changes, 441Bond Price Changes Over Time, 441

Bond Price Changes as a Result of Interest Rate Changes, 442

Summary, 445

I© Managing Bond Portfolios: Some Issues Affect All investors,451Why Buy Bonds? 452

Buying Foreign Bonds, 453

Important Considerations in Managing a Bond Portfolio, 454Understanding the Bond Market, 454

Global Factors and the U.S. Bond Markets, 455

Bond Strategies and Techniques, 455

Passive Management Strategies, 456Buy and Hold, 457

Indexing, 457

Active Management Strategies, 458Forecasting Changes in Interest Rates, 458

CONTENTS xvii

Yield Spread Analysis, 460Identifying Mispricings Among Bonds, 460

Managing Price Volatility, 461Duration, 461

Immunization, 468Summary, 472

Understanding Derivative Securities: Options, 476Why Have Derivative Securities? 477

Why Options Markets? 477Introduction to Options, 478

Long-Term Options, 478Understanding Options, 479

Options Terminology, 479How Options Work, 480The Mechanics of Trading, 481

Payoffs and Profits from Basic Option Positions, 483Calls, 483Puts, 486

Some Basic Options Strategies, 487Covered Calls, 488Protective Puts, 490Portfolio Insurance, 491

Option Valuation, 493A General Framework, 493Intrinsic Values and Time Values, 493Boundaries on Option Prices, 495The Black-Scholes Model, 497Put Option Valuation, 499Summarizing the Factors Affecting Options Prices, 500Hedge Ratios, 500 ,Using'the Black-Scholes Model, 501 I

An Investor ' s Perspect ive on Puts and Cal ls , 501What Puts and Calls Mean to Investors, 501The Evolutionary Use of Options, 502

Stock-Index Options, 503The Basics of Stock-Index Options, 503Strategies with Stock-Index Options, 504The Popularity of Stock-Index Options, 505

Summary, 506

Understanding Derivative Securities: Futures, 512An Overview of Futures Markets, 513

Why Futures Markets? 513What is Traded in the Futures Markets? 514

The Structure of Futures Markets, 515U.S. Futures Exchanges, 515Foreign Futures Markets, 516The Clearinghouse, 516

The Mechanics of Trading, 517Futures Contracts, 517Basic Procedures, 518

XVIII CONTENTS

Margin, 519

Using Futures Contracts, 521Hedgers, 522

How to Hedge with Futures, 522

Speculators, 523

Financial Futures, 524Interest Rate Futures, 524

Stock-Index Futures, 528

Single Stock Futures, 532Summary, 534

All investors Must Consider Portfolio Management, 537Portfolio Management as a Process, 538

Individual Investors, 539

Formulate an Appropriate Investment Strategy, 540Objectives, 540

Constraints and Preferences, 543

Some Practical Advice, 544Determine and Quantify Capital Market Expectations, 545

Forming Expectations, 545

Rate of Return Assumptions, 545

Developing and Implementing Investing Strategies, 548Asset Allocation, 548Portfolio Optimization, 550

Monitor Market Conditions and Investor Circumstances, 550' Monitoring Market Conditions, 551

Changes in Investor's Circumstances, 551

Rebalancing the Portfolio, 552Performance Measurement, 553The Asset Allocation Decision, 554Life-Cycle Funds, 555 ITax Advantaged Investing, 556 \Minimize Costs and Effort, and Improve Performance,

When Managing a Portfolio, 557Summary, 557

Evaluation of Investment Performance: A Global Concept, 562A Framework for Evaluating and Assessing Portfolio Performance, 563Performance Measurement Issues, 564

Three Questions to Answer in Measuring Portfolio Performance, 564

Return Calculations, 565

Risfe Considerations, 567

Performance Benchmarks and Performance Universes, 568

Performance Universes, 569

Performance Benchmarks, 569

Risk-Adjusted Measures of Performance, 570The Sharpe Ratio, 570

Treynor's Reward to Volatility, 572

Jensen's Alpha, 573

Ml, 576

Using the Sharpe Ratio Today, 577

CONTENTS xix

Style Analysis and Performance Attribution, 577Style Analysis, 578Performance Attribution, 579

Money Managers and Performance Presentations, 580An Overview on Performance Evaluation, 581Summary, 582

Glossary,589

index, 597