CONTENTS
IN BRIEF
Preface xvii
PART ONE
BACKGROUND
1 Introduction to Modern Investment Theory
2 Securities and Markets
3 Some Statistical Concepts
PART TWO
PORTFOLIO MANAGEMENT
4 Combining Individual Securities into Portfolios
5 Finding the Efficient Set
6 Factor Models
PART THREE ___
RISK, EXPECTED RETURN, AND PERFORMANCE MEASUREMENT
7 The Capital Asset Pricing Model
8 Empirical Tests of the Capital Asset Pricing Model
9 The Arbitrage Pricing Theory
10 The Tracking Power of Markowitz Portfolio Optimization
11 Measuring Portfolio Performance
PART FOUR
INTEREST RATES AND BOND MANAGEMENT
12 The Level oflnterest Rates
13 The Term Structure of Interest Rates
14 Bond Portfolio Management
15 Interest Immunization
PART FIVE
THE PRICING OF DERIVATIVE SECURITIES
16 European Option Pricing
17 American Option Pricing
18 Additional Issues in Option Pricing
19 Financial Forward and Futures Contracts
PART SIX
ISSUES IN INVESTMENT MANAGEMENT
20 The Effect ofTaxes on Investment Strategy
and Securities Prices
21 Stock Valuation
22 Issues in Estimating Future Earnings and Dividends
23 Market Efficiency: The Concept
24 Market Efficiency: The Evidence
Appendix 10: Additional Properties ofthe Minimum
Variance Set
Appendix 11: Invest Software
Glossary
Index
CONTENTS
PREFACE xvii
PART ONE
BACKGROUND
2
INTRODUCTION TO MODERN INVESTMENT THEORY
THE DEVELOPMENT OF MODERN INVESTMENT THEORY
WHY SHOULD YOU LEARN MODERN INVESTMENT THEORY?
SECURITIES AND MARKETS
SECURITIES Govemment Bonds Corporate Fixed Income Securities
Corporate Stock Options and Warrants Forward and Futures
Contracts The Sharcs of Investment Companies and Mutual Funds
THE FINANCIAL MARKETS The Difference Between Primary and
Secondary Markets Organized Exchanges for Common Stock and Bonds
Organized Exchanges for Options Organized Exchanges for Futures
Contracts The Over-the-Counter Market Computerized Trading
Techniques SUMMARY
3 SOME STATISTICAL CONCEPTS
THE SIMPLE OR MARGINAL PROBABILITY DISTRIBUTION The
Population Expected Value and Variance The Sample Mean and Variance
THE JOINT PROBABILITY DISTRIBUTION The Sample Covariance
The Population Covariance The Correlation Coefficient The Coefficient
of Determination THE RELATIONSHIP BETWEEN A STOCK AND THE
MARKET PORTFOLIO The Characteristic Line The Beta Factor
Residual Variance SUMMARY
PART TWO
PORTFOLIO MANAGEMENT
4 COMBINING INDIVIDUAL SECURITIES INTO PORTFOLIOS
THE RISK AND EXPECTED RETURN OF A PORTFOLIO The Portfolio's
Rate of Return The Portfolio's Expected Rate of Retum The Portfolio's
Variance COMBTNATION LINES The Cases of Perfect Positive and
Negative Correlation Borrowing and Lending at a Risk-Free Rate
SUMMARY APPENDIX 1: FORMULAS FOR THE EXPECTED RATE OF
RETURN AND VARIANCE OF A PORTFOLIO
5 FINDING THE EFFICIENT SET
THE MINIMUM VARIANCE AND EFFICIENT SETS FINDING THE
EFFICIENT SET WITH SHORT SELLING The Isoexpected Retum Lines
The Isovariance Ellipses The Critical Line FINDING THE
MINIMUM VARIANCE WITHOUT SHORT SELLING TWO IMPORTANT
PROPERTIES OF THE MINIMUM VARIANCE SET SUMMARY
APPENDIX 2: A THREE-DIMENSIONAL APPROACH TO FINDING THE
EFFICIENT SET APPENDIX 3: USING LAGRANGIAN MULTIPLIERS
TO FIND THE MINIMUM VARIANCE SET APPENDIX 4: PROOF OF
PROPERTY 11 APPENDIX 5: UTILITY AND RISK AVERSION
6 FACTOR MODELS
FACTOR MODELS TO ESTIMATE VOLATILITY OF RETURN The
Single-Factor Model The Single-Factor Model's Simplified Formula for
Portfolio Variance An Example Where the Single-Factor Model Works
An Example of a Potential Problem with the Single-Factor Model Multifactor
Models Estimating Portfolio Variance Using a Multifactor Model: An
Example MODELS FOR ESTIMATING EXPECTED RETURN
Firm Characteristics (Factors) That Induce Differentials in Expected Retums
Estimating and Projecting Factor Payoffs A Test of the Accuracy of Expected
Retum Factor Models Simulating the Performance of the Expected Retum
Factor Model SUMMARY
PART THREE
RISK, EXPECTED RETURN, AND PERFORMANCE MEASUREMENT
7 THE CAPITAL ASSET PRICING MODEL
THE ASSUMPTIONS OF THE CAPITAL ASSET PRICING MODEL
Assumption 1: Investors Can Choose Between Portfolios on the Basis of Expected
Retum and Variance Assumption 11: All Investors Are in Agreement
Regarding the Planning Horizon and the Distributions of Security Retums
Assumption III: There Are No Frictions in the Capital Market THE
CAPITAL ASSET PRICING MODEL WITH UNLIMITED BORROWING AND
LENDING AT A RISK-FREE RATE The Capital Market Line
Measuring the Risk of an Individual Asset The Relationship Between the
Risk of an Asset and Its Expected Rate of Retum The Positioning of
Characteristic Lines under the Capital Asset Pricing Model The Positions of
Individual Assets in Expected Return, Standard Deviation Space Market
Pressure to Assume Equilibrium Prices THE CAPITAL ASSET PRICING
MODEL WITH NO RISK-FREE ASSET THE CAPITAL ASSET PRICING
MODEL WHEN A RISK-FREE ASSET EXISTS BUT WE CAN'T SELL IT
SUMMARY
8 EMPIRICAL TESTS OF THE CAPITAL ASSET PRICING MODEL
EARLY TESTS OF THE CAPITAL ASSET PRICING MODEL The Black,
Jensen, and Scholes Test (1972) The Fama-MacBeth Study (1974)
ROLL'S CRITIQUE OF TESTS OF THE CAPITAL ASSET PRICING MODEL
Previous Tests as Tautologies Can the Capital Asset Pricing Model Ever Be
Tested? THE OTHER SIDE OF THE ISSUE Tautologies Can't
Predict the Future Can You Reject the CAPM ifYou Find No Efficient
Portfolios with Positive Portfolio Weights? Testing a Contained CAPM
Sensitivity Analysis to Alemative Market Indices MORE RECENT TESTS
OF THE CAPM SUMMARY
9 THE ARBITRAGE PRICING THEORY
DERIVING THE ARBITRAGE PRICING THEORY The APT with an
Infinite Number of Securities The APT with a Finite Number of
10
Securities EMPIRICAL TESTS OF THE APT Initial Empirical
Tests Is the APT Testable in Principle? THE CONSISTENCY OF
THE APT AND THE CAPM SUMMARY
THE TRACKING POWER OF MARKOWITZ PORTFOLIO
OPTIMIZATION
CONDITIONS REQUIRED FOR THE EFFICIENCY OF CAP-WEIGHTED
PORTFOLIOS WHEN CAP-WEIGHTED PORTFOLIOS ARE
EFFICIENT WHEN CAP-WEIGHTED PORTFOLIOS ARE
INEFFICIENT What If We Disagree? What If Some of Us Can't Sell
Short? Tax Avoidance Human Capital Foreign Investors
The Benefits of Portfolio Optimization A SIMPLE TEST OF THE
EFFICIENCY OF THE CAP-WEIGHTED INDEX TRACKING TARGETS
WITH STOCK PORTFOLIOS Tracking Targets with Factor Models
Tracking a Target with the Markowitz Bullet TRACKING THE RATE OF
INFLATION WITH THE MARKOWITZ BULLET SUMMARY
APPENDIX 6: FINDING THE PORTFOLIO WITH THE MINIMUM VOLATILITY
OF DIFFERENCES
1 1 MEASURING PORTFOLIO PERFORMANCE
MEASURING THE RATE OF RETURN TO A PORTFOLIO THE NEED
FOR RISK-ADJUSTED PERFORMANCE MEASURES RISK-ADJUSTED
PERFORMANCE MEASURES BASED ON THE CAPITAL ASSET PRICING
MODEL The Jensen Ihdex The Treynor Index The Sharpe
Index PITFALLS IN MEASURING PERFORMANCE WITH THE JENSEN,
TREYNOR, AND SHARPE INDICES Misspecifying the Market Pricing
Structure Misspecification of the Market Index MEASURING
PERFORMANCE USING THE ARBITRAGE PRICING THEORY
MEASURING PERFORMANCE WITHOUT THE USE OF AN ASSET PRICING
MODEL SUMMARY
PART FOUR
INTEREST RATES AND BOND MANAGEMENT
1 2 THE LEVEL OF INTEREST RATES
THE REAL AND NOMINAL RATES OF INTEREST INTEREST RATES
AND THE SUPPLY AND DEMAND FOR MONEY The Transactions
Demand for Money The Speculative Demand for Money The Total
Demand for Money The Supply of Money and the Equilibrium Interest
Rate INVESTMENT, SAVING, AND NATIONAL INCOME THE
EFFECT OF A CHANGE IN THE MONEY SUPPLY ON REAL AND NOMINAL
INTEREST RATES THE EFFECT OF A CHANGE IN FISCAL
POLICY A Tax Cut Monetizing the Deficit
SUMMARY
13 THE TERM STRUCTURE OF INTEREST RATES
THE NATURE AND HISTORY OF THE TERM STRUCTURE DRAWING
THE TERM STRUCTURE METHODS OF COMPUTING THE YIELD TO
MATURITY The Arithmetic Mean Yield to Maturity The Geometric
Mean Yield to Maturity The Intemal Yield to Maturity A BRIEF
OVERVIEW OF THE THREE THEORIES OF THE TERM STRUCTURE
THE MARKET EXPECTATIONS THEORY OF THE TERM STRUCTURE
THE LIQUIDITY PREFERENCE THEORY OF THE TERM STRUCTURE
THE MARKET SEGMENTATION THEORY OF THE TERM STRUCTURE
DERIVING THE MARKET'S FORECAST OF FUTURE INTEREST RATES
FROM THE TERM STRUCTURE Finding the Market's Forecast from
Arithmetic Mean Yields Finding the Market's Forecast with Intemal
Yields SUMMARY APPENDIX 7: AVERAGING MULTIPLE
RATES OF RETURN
14 BOND PORTFOLIO MANAGEMENT
ESTIMATING THE EXPECTED RETURN OF A BOND FOR PORTFOLIO
ANALYSIS Forecasting Expected Retums on Treasury Bonds
Forecasting Expected Retums on Corporate Bonds A DURATION-BASED
APPROACH TO ESTIMATING THE RISK OF A BOND PORTFOLIO A
MARKOWITZ APPROACH TO BOND RISK MANAGEMENT DIVIDING
THE PORTFOLIO BETWEEN BONDS AND STOCK SUMMARY
15 INTEREST IMMUNIZATION
CASH MATCHING AND INTEREST IMMUNIZATION ALTERNATIVE
MEASURES OF DURATION Macaulay's Duration Fisher-Weil
Duration Duration and Yield Elasticity Duration and the Response of
the Value of a Stream of Payments or Receipts to a Change in Discount Rates
Cox, Ingersoll, Ross Duration IMMUNIZING WITH MACAULAY'S
DURATION: THE CASE OF A SINGLE-PAYMENT LIABILITY The Effect
of Interest Rate Changes on Present Values The Effect of Interest Rate
Changes on Terminal Values COMPUTING THE MACAULAY DURATION
AND INTERNAL YIELD OF A BOND PORTFOLIO Combination Lines
xii CONTENTS
for Intemal Yield and Duration IMMUNIZING WITH THE MACAULAY
DURATION: THE CASE OF A MULTIPLE-PAYMENT LIABILITY A
TEST OF THE RELATIVE EFFECTIVENESS OF THE THREE DURATION
MEASURES SUMMARY
PART FIVE
THE PRICING OF DERIVATIVE SECURITIES
16 EUROPEAN OPTION PRICING
PRICING OPTIONS UNDER RISK NEUTRALITY AND UNIFORM
PROBABILITY DISTRIBUTIONS Valuing a Call Option Valuing a
Put Option The Relationship Between Option Values and Stock Values
The Effect of a Change in Stock Variance on Option Values BINOMIAL
OPTION PRICING Binomial Call Option Pricing over a Single Period
Binomial Put Option Pricing over a Single Period Binomial Option Pricing
over Multiple Periods VALUING OPTIONS USING THE BLACK-
SCHOLES FRAMEWORK The Black-Scholes Value for a Call Option
Estimating the Variance of the Stock's Retum The Black-Scholes Value for a
Put Option The Relationship Between Black-Scholes Put and Call Values and
Underlying Stock Prices Using the Black-Scholes Framework to Value
Options on Stocks That Pay Dividends PUT-CALL PARITY
SUMMARY APPENDIX 8: PROOF THAT IS THE
PROBABILITY OF EXERCISE FOR A CALL OPTION ON A STOCK WITH A
UNIFORM DISTRIBUTION
17 AMERICAN OPTION PRICING
THE LOWER LIMITS TO THE VALUE OF AMERICAN OPTIONS Floors
Supporting American Call Options Market Forces Supporting the Hard
Floor Market Forces Supporting the Soft Floor Floors Supporting
American Put Options THE VALUE OF EARLY EXERCISE When
the Right to Exercise Early Has No Value How Dividend Payments May
Induce Early Exercise of American Call Options Early Exercise of American
Put Options THE BINOMIAL MODEL AS AN AMERICAN OPTION-
PRICING MODEL SUMMARY APPENDIX 9: THE GESKE-
ROLL-WHALEY AMERICAN OPTION-PRICING MODEL
18 ADDITIONAL ISSUES IN OPTION PRICING
USING THE OPTION-PRICING FORMULAS TO FIND THE MARKET'S
ESTIMATE OF THE STOCK'S VARIANCE BIAS PROBLEMS IN
19
OPTION-PRICING MODELS Changing Volatility as a Source of Bias in
Option-Pricing Models Bias from Using European Models to Value American
Options Pricing Bias Resulting from Error in the Model's Inputs
OPTION STRATEGIES The Straddle The Butterfly Spread
Computing the Expected Retum on an Option Strategy Delta, Gamma, and
Theta Getting Delta Neutral Portfolio Insurance COMPLEX
SECURITIES AS PORTFOLIOS OF OPTIONS Common Stock as an
Option Bonds as Portfolios of Options and Option Complements
SUMMARY
FINANCIAL FORWARD AND FUTURES CONTRACTS
CHARACTERISTICS OF FORWARD AND FUTURES CONTRACTS
THE DETERMINATION OF FORWARD PRICES The Relationship Between
the Forward Price and the Current Commodity Price The Relationship
Between the Forward Price and the Expected Commodity Price The
Consistency of the Two Expressions for the Forward Price Market Value of
Previously Issued Forward Contracts DETERMINATION OF FUTURES
PRICES The Sign of the Premiums for Various Financial Futures
The Significance of the Premiums to Investors and Financial Managers
THE SECURITY UNDERLYING A FUTURES CONTRACT TO BUY
TREASURY BONDS HEDGING WITH BOND FUTURES
CONTRACTS USES OF STOCK INDEX FUTURES FULL
COVARIANCE APPROACH TO CONSTRUCTING A FUTURES OVERLAY
SUMMARY
PART SIX
ISSUES IN INVESTMENT MANAGEMENT
20 THE EFFECT OF TAXES ON INVESTMENT STRATEGY
AND SECURITIES PRICES
THE TAX STRUCTURE What Investment Income Is Taxed? 574
Capital Gains and Losses TAXES AND INVESTMENT STRATEGY 575
Computing After-Tax Rates of Retum The Locked-In Effect 577
Dividend Clienteles THE EFFECT OF TAXES ON SECURITIES
PRICES The Effect of Dividends on Expected Stock Retums 581
Relative Expected Retums on Taxable and Tax-Exempt
Securities SUMMARY
21 STOCK VALUATION
A FRAMEWORK FOR VALUING COMMON STOCKS Dividends versus
Eamings The Constant Growth Model The Multistage Growth
Model COMPUTERIZED THREE-STAGE STOCK VALUATION
PRICE-EARNINGS RATIO What Determines the Level of the Price-
Eamings Ratio? Changes That Can Be Expected in the Price-Eamings Ratio
overTime SUMMARY
22 ISSUES IN ESTIMATING FUTURE EARNINGS
AND DIVIDENDS
PAYING IN ADVANCE FOR GROWTH THE LINK BETWEEN GROWTH
AND STOCK VALUATION AND RISK AND EXPECTED RETURN THE
ACCURACY OF PREDICTIONS OF GROWTH IN EARNINGS AND
DIVIDENDS Is Past Growth a Reliable Guide to Future Growth?
The Accuracy of Growth Forecasts Made by Professional Analysts The
Accuracy of Short-Term Professional Forecasts The Accuracy of Long-Term
Professional Forecasts The Accuracy of Market Forecasts of the Growth in
Eamings Per Share IMPLICATIONS FOR INVESTMENT STRATEGY
SUMMARY
23 MARKET EFFICIENCY: THE CONCEPT
FORMS OF THE EFFICIENT MARKET HYPOTHESIS THE
SIGNIFICANCE OF THE EFFICIENT MARKET HYPOTHESIS RISK
AND EXPECTED RETURN IN AN EFFICIENT MARKET QUICK
AND ACCURATE RESPONSE TO NEW INFORMATION SYSTEMATIC
PATTERNS IN STOCK PRICES RELATED ONLY TO TIME-VARYING
INTEREST RATES AND RISK PREMIA FAILURE OF SIMULATED
TRADING STRATEGIES MEDIOCRITY IN THE PERFORMANCE
OF INFORMED INVESTORS SUMMARY
24 MARKET EFFICIENCY: THE EVIDENCE
DO SECURITY PRICES RESPOND RAPIDLY AND ACCURATELY TO THE
RECEIPT OF NEW INFORMATION? Measuring Stock Price Response
The Response of Stock Prices to the Announcement of a Stock Split The
Reaction of Stock Prices to Quarterly Earnings Reports Further Evidence on
the Reaction of Stock Prices to Positive and Negative Events THE
BEHAVIOR OF CHANGES IN STOCK PRICES Studies of Serial
Correlation The Day-of-the-Week Effect Studies of Seasonality
DO TRADING RULES FAIL UNDER SIMULATION? ARE
PROFESSIONAL INVESTORS DISTINCTIVE IN TERMS OF THEIR
PERFORMANCE? SUMMARY
APPENDIX 10: ADDITIONAL PROPERTIES OF THE MINIMUM
VARIANCE SET
APPENDIX 11: INVEST SOFTWARE
GLOSSARY
INDEX
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