CHAPTER 1 INVESTMENTS: BACKGROUND AND ISSUES1.1 real assets versus financial assets Essential nature of investmentReduce current consumption in hopes of greater future consumption Real AssetsUsed to produce goods and services: Property, plant & equipment, human capital Financial AssetsClaims on real assets or claims on asset incomeEg: You may not have your own auto plant (a real asset), but you can still buy shares from Toyota (a financial asset) -> income comes from the production of Toyota. All financial assets (owner of claim) are offset by a financial liability (issuer of claim). These liabilities are used to purchase real asset for production. Therefore: + When we aggregate overall balance sheets, only real assets remain (claims cancel out) + The net wealth of an economy is the sum of its real assets.

1.2 A Taxonomy (CLASSIFICATION) of Financial Assets Fixed-income (debt) securities pay a specified cash flow over a specific periodMoney market instruments: short-term, very low riskEg: Bank certificates of deposit (CDs), U.S. Treasury billsCaptital market instrument: long-term, range from low to high risk (high yield or junk bonds)Eg: Treasury bonds (safe), bonds issued by corp, federal agencies Common stock+ Unlike fixed- income securities, common stock or equity represents an ownership share in the corporation. + Equity holders are not promised any particular payment, instead, they receive any dividends the firm may pay and have prorated ownership in the real assets of the company.+ The performance of equity investments is tied directly to the success of the firm and its real assets. If the firm is successful, the value of equity will increase, vice versa. Therefore, equity investments are riskier than fixed income securities. Derivative securities+ They are commonly options and futures contracts whose value is derived from some underlying market condition (provide payoffs which are determined by the prices of other assets such as bond or stock prices)+ Derivative securities are so named because their values derive from the prices of other assets.Eg: the value of the call option will depend on the price of Intel Stock.

1.3 Financial Markets and the EconomyFinancial MarketsReal assets determine the wealth of the economy while financial assets merely represent claims on real assets. Financial assets allow us to make the most of the economys real assets.Consumption TimingIn high-earnings periods, people are likely to invest their savings in financial assets such as stocks and bonds while in low-earnings periods they are likely to sell these assets to provide funds for their consumption needs. Financial assets help store your wealth, shift your purchasing power from high-earnings periods to low-earnings periods (providing the greatest satisfaction by allocating consumption)Allocation of RiskRisk can be allocated by investor:+ Risk-tolerant investors can buy shares of stock -> bear most of the business risk+ More conservative ones only buy bonds -> receive fixed payment -> safer

Separation of Ownership and Management+ Many businesses are owned and managed by the same individual. Small businesses are the most common example to this simple organization (also the most common form of business organization before the Industrial Revolution). + However, today, along with global markets and large scale production, it became very difficult to continue the same type of organizations. Therefore, in todays corporations ownership and management are separated since it also became impossible for an individual to run both duties.Corporate Governance and Corporate Ethics Business and market require trust to operate efficiently Without trust additional laws and regulations are required All laws and regulations are costly Governance and ethics failures have cost our economy billions if not trillions of dollars. Eroding public support and confidence in market based systems Accounting Scandals Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest Misleading Research Reports Citicorp, Merrill Lynch, others Auditors: Arthur Andersen and Enron Sarbanes-Oxley Act Increases the number of independent directors on company boards Requires the CFO to personally verify the financial statements Created a new oversight board for the accounting/audit industry Charged the board with maintaining a culture of high ethical standards

1.4 The Investment ProcessAn investors portfolio is simply his/her collection of investment assets. Once the portfolio is established, it is updated or rebalanced by selling or buying securities. Investors make 2 types of decisions in constructing their portfolios:1. The Asset Allocation decision is the choice among broad asset classes such as stocks, bonds, real estates, commodities, etc.2. The Security Selection decision is the choice of which particular securities to hold within each asset class.Security analysis involves the valuation of particular securities that might be included in the portfolio. For example, an investor might ask whether A or B is more attractively priced.1.5 Markets Are Competitive

1. The Risk-Return Trade -OffThe risk and return comparison should be made prior to making investment in financial assets. That means that cost-benefit analysis should be done prior to making investment in Money markets.2. Market efficiency: Securities should be neither underpriced nor overpriced on average Security prices should reflect all information available to investors Whether we believe markets are efficient or not affects our choice of appropriate investment management style.Efficient markets simply suggest that all the information about stocks, bonds and shares should be available to investors. This is called Efficient Market Hypothesis. -> Thus, this hypothesis concerns the choice between active and passive investment management strategies:a. PassiveManagement calls for holding highly diversified portfolios, without spending effort or other resources attempting to improve investment performance through security analysis (applied when existing EMH)b. Active-Management is the attempt to improve performance either by identifying mispriced securities or by timing the performance of broad asset classes.

1.6 The Players

Business Firms net borrowers Households net savers Governments can be both borrowers and savers Financial Intermediaries Connectors of borrowers and lenders Commercial Banks: make loans funded by deposits Investment companies: pool and manage money of investors, take advantage of economies of scale to make profit Insurance companies Pension funds / Hedge funds Investment Bankers Firms that specialize in the sale of new securities to the public, typically by underwriting the issue.+ Primary market: a market where newly issued securities are offered to the public. + Secondary market: a market where pre-existing securities are traded among investors.

1.7 Recent TrendsGlobalization Domestic firms compete in global markets Performance in one country or region depends on other regions Opportunities for better returns & implications for risk Managing foreign exchange International diversification reduces risk Instruments and vehicles continue to develop (ADRs and WEBs) Information and analysis improves ADR-American Depository Receipt: may be listed on an exchange or trade OTC in the U.S. + A broker purchases a block of foreign shares, deposits them in a trust and issues ADRs in the U.S. + They trade in dollars, receive dividends in dollars and have the same commissions as any other stock (You can buy ADRs on Sony for example) WEBS are World Equity Benchmark Shares, these are the same as ADRs but are for portfolios of stocks. Typically WEBS track the performance of an index of foreign stocks. The investment world is moving forward rapidly and embracing new technology. News is available virtually instantaneously. On-line trading has made trading faster and cheaper.Securitization Loans of a given type such as mortgages are placed into a pool and new securities are issued that use the loan payments as collateral. Mortgages now can be traded just like other securities (being marketable and are purchased by many institutions) End result is more investment opportunities for purchasers, and spreading loan credit risk among more institutions Securitization has grown rapidly due to Changes in financial institutions and regulation permitting its growth, particularly lower capital requirements on securitized loans, Improvement in information capabilities, Credit enhancement provided by pool issuers has improved marketability.The Shadow banking system refers to the end result of securitization. Namely that many institutions now provide the ultimate financing for loans that banks traditionally financed.Financial Engineering Repackaging cash flows of a security to enhance marketability Bundling and unbundling of cash flows Bundling: combining more than one security into a composite security Unbundling: allocating the cash flows from 1 security to create several new securitiesA CMO is a collateralized mortgage obligation. It is a type of mortgage backed security that takes payments from a mortgage pool and separates them into separate classes of payments that investors can buy. A CDO is also an unbundling example. A simpler version of unbundling would be a Treasury Strip.

Computer Networks Online low cost trading Information made cheaply and widely available Direct trading among investors via electronic communication networks Computerization has pressured profit margins of Wall Street firms. Similarly technological advances that promoted widespread securitization changed the business model of commercial banks. Both responded by engaging in riskier trading activities and increasing leverage to bolster rates of return. It could be argued this helped set up the financial crisis of 2007-2008.The Future Globalization will continue and investors will have far more investment opportunities than the past Securitization will continue to grow after the crisis Continued development of derivatives and exotics, more regulation for OTC derivatives Strong fundamental foundation of understanding is critical Understanding corporate finance requires understanding investmentsCHAPTER TWO ASSET CLASSES AND FINANCIAL INSTRUMENTSChapter 2 features different asset classes and some of the instrument within asset class:+ Money market: short-term (one year or less); marketable (c th tiu th c); liquid; low risk. Also called cash instrument+ Capital market: long-term debt / equity / derivatives2.1 The Money Market Treasury bills (tn phiu) Issued by Federal Government Denomination (mnh gi) $1000, commonly $100,000 Maturity 4, 13, 26, or 52 weeks Liquidity Highly liquid Default risk None Interest type Discount (at maturity, investors collect earning- the difference between discounted price and face value of the bill) Taxation taxable at the federal level, exempt from state and local taxes Certificates of Deposit (chng nhn tin gi) Issued by Depository Institutions Denomination Any, $100,000 or more are marketable Maturity Varies, typically 14 day minimum Liquidity 3 months or less are liquid if marketable Default risk First $100,000 is insured Interest type Add on Taxation Interest income is fully taxable Commercial Paper Issued by Large creditworthy corporations and financial institutions Maturity Maximum 270 days, usually 1 to 2 months Denomination Minimum $100,000 Liquidity 3 months or less are liquid if marketable Default risk fairly safe (the firms condition can be predicted in one month) Interest type Discount Taxation Interest income is fully taxableNew Innovation: Asset backed commercial paper is backed by a loan or security. In summer 2007 asset backed CP market collapsed when subprime collateral values fell. Bankers Acceptances Originates when a purchaser of goods authorizes its bank to pay the seller for the goods at a date in the future (time draft). When the purchasers bank accepts the draft it becomes a contingent liability of the bank and becomes a marketable security. Eurodollars Dollar denominated (time) deposits held outside the U.S. Pay a higher interest rate than U.S. deposits. Federal Funds Depository institutions must maintain deposits with the Federal Reserve Bank. Federal funds represents trading in reserves held on deposit at the Federal Reserve. Key interest rate for the economy

LIBOR (London Interbank Offer Rate) Rate at which large banks in London (and elsewhere) lend to each other. Base rate for many loans and derivatives.

Repurchase Agreements (RPs or repos) and Reverse RPs Short term sales of securities arranged with an agreement to repurchase the securities a set higher price. A RP is a collateralized loan; many are overnight, although Term RPs may have a one month maturity. A Reverse Repo is lending money and obtaining security title as collateral. Haircuts may be required depending on collateral quality

Call Money Rate Investors who buy stock on margin borrow money from their brokers to purchase stock. The borrowing rate is the call money rate. The loan may be called in by the broker.

Money Market Instrument Yields Yields on money market instruments are not always directly comparableFactors influencing quoted yields Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Simple vs. Compound Interest

2.2 The Bond MarketTreasury Notes and BondsMaturities Notes maturities up to 10 years Bonds maturities in excess of 10 yearsPar Value - $1,000Quotes percentage of parFederal Agency DebtMajor issuers Federal Home Loan Bank Federal National Mortgage Association Government National Mortgage Association Federal Home Loan Mortgage CorporationMunicipal BondsIssued by state and local governmentsTypes General obligation bonds Revenue bondsIndustrial revenue bondsMaturities range up to 30 years

Municipal Bond Yields Interest income on municipal bonds is not subject to federal and sometimes state and local tax To compare yields on taxable securities a Taxable Equivalent Yield is constructed

Corporate BondsIssued by private firms Semi-annual interest paymentsSubject to larger default risk than government securitiesOptions in corporate bonds Callable Convertible

Mortgages and Mortgage-backed Securities Developed in the 1970s to help liquidity of financial institutions Proportional ownership of a pool or a specified obligation secured by a pool Market has experienced very high rates of growth

2.3 Equity Securities+ Common stock Residual claim Limited liability+ Preferred stock Fixed dividends - limited Priority over common Tax treatment Preferred & common dividends are not tax deductible to the issuing firm Corporate tax exclusion on 70% dividends earned+ Depository receiptsAmerican Depository Receipts (ADRs) also called American Depository Shares (ADSs) are certificates traded in the U.S. that represent ownership in a foreign security.

2.4 STOCK AND BOND MARKET INDEXESThere are several indexes worldwide such as: Dow Jones Industrial Average (DJIA) Nikkei AverageOffer ways of comparing performance of managersBase of derivativesExamples of Indexes - International Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes EAFE Far East United Kingdom

2.5 Derivative Markets Listed Call Option: Holder the right to buy 100 shares of the underlying stock at a predetermined price on or before some specified expiration date. Listed Put Option: Holder the right to sell 100 shares of the underlying stock at a predetermined price on or before some specified expiration date.

OptionsBasic Positions Call (Buy) Put (Sell)Terms Exercise Price Expiration Date Assets

Futures Basic Positions Long (Buy) Short (Sell)Terms Delivery Date Assets

Chap 3 SECURITIES MARKETS

3.1. How firms issue securitiesSECURITIES MARKETS- Primary Market: Market in which corporation raise funds through new issues of securities.- Secondary Market: The market in which stocks, once issued, are traded rebought and resold.- Common Stock: Initial Public Offerings first issue Seasoned Offerings other issues- Bonds: Public Offerings issues to public Private Placements issues to private groups of investorsPrivate placements do not trade in secondary markets -> reduce liquidity & thereby pricesUNDERWRITERS Investment Banks- Underwriters: purchasing securities from the issuing company and resell them. Earn profit using firm commitment Organize road shows ( travel around the country to publicize the imminent offering)to generate interests among investors & provide information about the priceThe process of polling potential investors is called bookbuilding Determine the preliminary offering price & the number of shares to be sold Provide analysts to increase the likelihood that there will be a liquid secondary market for the stock and that its price will reflect the companys true value.Underpriced in IPO, causing cost for the issuance- Shelf registration: allow firms to register securities and gradually sell them to the public for 2 years following the initial registration.- Red Herring: a preliminary version of the prospectus (the statement is in its final form and be approved by SEC) describing a new security issuance distributed to potential buyers prior to the security registration.IPO >< PRIVATE OFFERINGS: no advertisement / no registration required

3.2. How securities are traded :1. Types of Markets:- Direct markets is the market in which buyers and sellers must seek each other out directly. Least organized market Characterized by sporadic (intermittent) participation / low-priced / nonstandard goods- Brokered markets is the market in which trading in a good is active, and brokers find it profitable to offer search services to buyers and sellers.- Dealers market is the market in which traders specializing in particular assets buy and sell for their own account.- Auction market is a market where all traders meet at one place to buy and sell an asset. Costly -> limit the shares to ones frequently traded Act as secondary market where investors trade their existing securities

1. Types of orders :- Market orders are buy or sell orders that are to be executed immediately. Bid price is the price at which a dealer or other traders are willing to purchase a security. Ask price is the price at which a dealer or other traders are willing to sell a security. Bid-ask spread is the difference between a dealers bid and asked price -> profit source- Price-contingent orders are orders specifying prices at which investors are willing to buy or sell a security. Limit buy order: is an order at which or below which an investor is willing to buy a security Limit sell order: is an order at which or above which an investor is willing to sell a security Limit order book: a collection of limit orders waiting to be executed Stop order is an order at which trade is not to be executed unless stock hits a price limit+ Stop-loss order: the stock is to be sold if its price fall below a stipulated level (to prevent further losses from accumulating)+ Stop-buy order: the stock is to be bought when its price rises above a limit1. Trading Mechanisms :- Over-the-counter market an informal network of brokers and dealers who negotiate sales of securities.- ECNs computer networks that allow direct trading without the need for market makers. Orders match from one against another = crossed Advantages: cheap / quick / offer anonymity- Specialist a trader who makes a market in the share of one or more firms and who maintains a fair and orderly market (by dealing personally in the market with their own portfolio) Role: brokers / dealers / facilitators (in an auction market) Responsibility: strive to maintain a narrow bid-ask spread

1. TRADING COSTExplicit costs (Commission) - fee that is paid to the broker for making the transaction. Full Service: Full-service brokers usually depend on a research staff that prepares analyses and fore- casts of general economic as well as industry and company conditions and often makes specific buy or sell recommendationsDiscount: They buy and sell securi- ties, hold them for safekeeping, offer margin loans, facilitate short sales, and that is allImplicit costs - fee collected in the form of the bid-ask spread when trading with dealers.1. BUY ON MARGINDEFINITIONBrokers call loans - a source of debt financing provided by brokers.Buying on Margin - the act of purchasing securities with part of the purchasing price borrowed from brokers.Collateral - the securities purchased The part contributed by the investor (NOT the part borrowed) is called Margin. Initial margin requirement - 50% (set by Fed)

Purchasing price $10,000 (for 100 shares)Initial payment $6,000Borrow $4,000

Initial Balance Sheet PositionStock $10,000 Borrowed $4,000 Equity $6,000

if the stock value falls to $7,000.Balance Sheet Position:Stock $7,000 Borrowed $4,000 Equity $3,000

- if the stock price falls beyond $4,000?The stocks purchased are no longer a sufficient collateral to cover the loan. Brokers set up a Maintenance Margin Maintenance Margin - the lowest accepted level of the Margin.Margin call - broker requiring investor to put more cash or securities to the margin account.1. SHORT SALES :Borrow stock through a dealer. (deposit cash or securities in an account as collateral) and Sell it. Buy the stock and return to the party from which is was borrowed.Purpose - to make profit from a decline of a stock or security

CONDITIONS OF SHORT SALESShort sales are permitted only when the last recorded change in the stock price is positive.Short-sellers must not only replace the shares but also pay the lender of the security any dividends paid during the short sale.Cash or collateral is required to cover possible losses in case the stock price goes up.

1. REGULATION OF SECURITIES MARKETSecurities Acts of 1933 Securities Acts of 1934Securities Investor Protection Act of 1970REGULATION RESPONSE TO RECENT SCANDALSSarbanes-Oxley ActCreation of a Public accounting company to oversee the auditing of public firms.CEOs and CFOs must be held responsible for misleading and distorted information of their companies.Board of Directors must be composed of independent directors and regular meeting is not accompanied by company managers.INSIDER TRADINGInsider trading - the act of transacting securities to profit from inside information. (Nonpublic information of a firm that can only be accessed by privileged individuals).

CHAP 4INVESTMENT COMPANIES1. INVESTMENT COMPANIES:Investment companies are financial intermediaries that collect funds from individual inves- tors and invest those funds in a potentially wide range of securities or other assetsInvestment companies perform several important functions for their investors:- Record keeping and administration. Investment companies issue periodic status reports.- Diversification and divisibility : enable investors to hold fractional shares of many different securities- Professional management : have full-time staffs of security analysts and portfolio managers who attempt to achieve superior investment results for their investors.- Lower transaction costs: trade large blocks of securities.

Investors buy shares in investment companies, and ownership is proportional to the number of shares purchased. The value of each share is called the net asset value, or NAV.

1. TYPES OF INVESTMENT COMPANIES :

Unit Investment Trust (UITs)Open-end fund (mutual fund)Closed-end fund(publicly-traded fund)

Issue redeemable securities (or "units")

Investors sell back at its approximatenet asset value or NAV.Its shares are redeemable

At its current NAV per share, minus any fees the fund may chargeIts shares are not redeemable.

Must sell to other investors, just like common stock with the prices could be differ from NAV

Make a one-time "public offering" of only a specific, fixed number of units.

(like closed-end funds)

Does not actively trade its investment portfolio.Investors purchase shares from the fund itself; only trade at the end of the day.

Cannot purchase on a secondary market.To create the liquidity of the fund, investors can buy or sell shares through secondary market.

Trade in secondary market all day.

Does not have a BOD, or an investment adviser to render advice during the life of the trust.Managed by investment adviser that are registered with the SEC.Managed by investment adviser that are registered with the SEC.

Other Investment Organizations.Commingled funds are partnerships of investors that pool their funds. The management firm that organizes the partnership, for example, a bank or insurance company, manages the funds for a fee. Typical partners in a commingled fund might be trust or retirement accounts that have portfolios much larger than those of most individual investors but are still too small to warrant managing on a separate basis.Real Estate Investment Trusts (REITs) is similar to a closed-end fund. REITs invest in real estate or loans secured by real estate. Besides issuing shares, they raise capital by borrowing from banks and issuing bonds or mortgages. Most of them are highly leveraged, with a typical debt ratio of 70%. There are two principal kinds of REITs. REITs generally are established by banks, insurance companies, or mortgage companies, which then serve as investment managers to earn a fee. REITs are exempt from taxes as long as at least 95% of their taxable income is distributed to shareholders. For shareholders, however, the dividends are taxable as personal income.Hedge funds. A private investment pool, open to wealthy or institutional investors, that is exempt from SEC regulation and can therefore pursue more speculative policies than mutual funds.

1. MUTUAL FUND :The common name of for an open-end investment company and Account for more than 90% of investment company assets in the US - $10 trillion in US mutual funds - $9 trillion in non-US sponsor mutual funds

Investment PoliciesEach mutual fund has a specified investment policy, which is described in the funds prospectus. For example, money market mutual funds hold the short-term, low-risk instruments of the money market, while bond funds hold fixed- income securities. Some funds have even more narrowly defined mandates.Some of the more important fund types, classified by investment policyMoney market fundsInvesting in money market securities: commercial paper, repurchase agreement, CDs.Asset maturity: mostly 1-3 monthsNet asset value (NAV) is fixed at $1 per shareNo tax implications for capital gain or losses due to redemption of share.Bond fundsInvesting in fixed income sector: corporate bonds, Treasury bonds, mortgage-backed securities, municipal bondsSome bond funds specialize in:Maturity: from intermediate to long-termIssuers credit risk: from very safe to high yield bondsEquity fundsInvesting primarily in stockCommonly holding 5% of total assets in money market securities in case of share redemptionIncome funds: focus on high dividendGrowth funds: focus on capital gainsSpecialized funds: equity funds concentrate on particular industries/ particular countries

International funds have international focusGlobal funds: securities worldwideInternational funds: securities of non-US firmsRegional funds: securities in a particular part of the worldEmerging market funds: securities in developing countriesBalanced funds hold both equities and fixed income securitiesLife-cycle funds: - Aggressive asset mix (for young investors) - Conservative asset mix (for older investors) - Static allocation: stable mix across stocks and bonds - Targeted maturity funds: gradually become more conservative as investors ageallocated to stocks and bonds change significantly in accord with portfolio managers forecast of sectors performanceIndex funds try to match the performance of a broad market index (both equity and non-equity index). It is low cost, passive investment without securities analysis

How Funds Are SoldMost mutual funds have an underwriter that has exclusive rights to distribute shares to investors. Mutual funds are generally marketed to the public Indirect- marketing through brokers acting on behalf of the underwriter. Direct-marketed funds are sold through the mail, various offices of the fund, over the phone, and, increasingly, over the Internet. Investors contact the fund directly to purchase shares.About half of fund sales today are distributed through a sales force.

1. COST OF INVESTING IN MUTUAL FUNDS Fee Structure: Operating expenses: deducted periodically from funds assets - administrative expenses - advisory fees for investment managers - marketing and distribution costs for brokers) Front-end load (usually less than 6%): commission charged when shares are purchased, paid to brokers selling the funds - Low-load funds: less than 3% loads - No-load funds: no front-end load (accounted for half of all funds today) Back-end load: redemption fee incurred when shares are sold, typically reduced by 1% for every year investors hold the shares

12b-1 charges : SEC allows managers to use fund assets to pay for distribution costs - Limited to 1% of funds net assets per year - Must be added to operating expense to obtain true annual expense ratio. ownership in the same portfolio of securities but with different combination of feesMutual fund returnsGross return = Rate of return = Gross return Total expense ratioLate Trading and Market Timing:Late trading: accepting buy or sell orders after the market closed and NAV is determined. Market timing: taking advantage of different time-zone to buy or sell a now-stale NAV funds (because the international markets are closed) for a likely profit the next day Regulations: - 4:00 PM hard cutoff - Fair value pricing - Redemption fees

1. TAXATION ON MUTUAL FUND :A fund with a high portfolio turnover rate can be particularly tax inefficient. Turnover is the ratio of the trading activity of a portfolio to the assets of the portfolio. It measures the fraction of the portfolio that is replaced each year.

Measures the fraction of the portfolio that is replaced each year Turnover rate = High turnover rate capital gains/losses are being realized constantly investors cannot time the realizations to manage overall tax obligation Since 2000, SEC required funds to disclose tax impact of portfolio turnover

1. EXCHANG- TRADED FUND :

Fund tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. It does not have its net asset value (NAV) calculated every day. bought and sold during the day like stocks on a securities exchange purchased through brokers lower management fees sell the shares on the open market gather enough shares of the ETF to form a creation unit and then exchange the creation unit for the underlying securities.Advantages : Traded continuously Can be sold short or purchased on margin Tax saving for the funds Lower management fees for the fundsDisadvantages : Price can depart by small amount from NAV arbitrage Investors must buy an ETF from brokers with fees.

1. MUTUAL FUND INVESTMENT PERFORMANCE

The evidence on mutual fund performance does not show a consistent superior performance to broad market indexes. Evidence shows a tendency for some persistence in superior performance by funds but the evidence is far from conclusive. Mutual fund marketing literature emphasizes past performance but the evidence indicates that historical performance is not a good predictor of future performance. There is some evidence that funds with higher expense ratios are more likely to be poorer performers.

1. INFORMATION FOR MUTUAL FUND As the popularity of mutual funds has grown in recent years, nearly all major business publications feature some reporting on performance of mutual funds. Several agencies or publications rank mutual fund performance, including Morningstar. However fund rankings which are based on historical data are not necessarily good predictors of future fund performance

CHAPTER 5:RISK AND RETURN: Past and Prologue

I. Rates of ReturnA key measure of investors success is the rate at which their funds have grown during the investment period. The total holding-period return (HPR) of a share of stock depends on the increase (or decrease) in the price of the share over the investment period as well as on any dividend income the share has provided. The rate of return is defined as dollars earned over the investment period (price appreciation as well as dividends) per dollar invested:

Measuring Investment Returns over Multiple PeriodsArithmetic average. The sum of returns in each period divided by the number of periods. The arithmetic average is useful, though, because it is the best forecast of performance in future.Geometric average. The single per-period return that gives the same cumulative performance as the sequence of actual returns. The geometric return is also called a time-weighted average return because it ignores the quarter-to-quarter variation in funds under management.Dollar-weighted return. The dollar-weighted average return is the internal rate of return (IRR) of the project. The IRR is the interest rate that sets the present value of the cash flows realized on the portfolio equal to the initial cost of establishing the portfolio.

Conventions for Quoting Rates of ReturnReturns on assets with regular cash flows, such as mortgages (with monthly payments) and bonds (with semiannual coupons), usually are quoted as annual percentage rates, or APRs, which annualize per-period rates using a simple interest approach, ignoring compound inter- est. The APR can be translated to an effective annual rate (EAR) by remembering that:APR = Per-period rate Periods per year APR = [ (1 + EAR)1/ n 1] nWith continuous compounding, the relationship between the APR and EAR becomes:APR = ln(1 + EAR)

II. Risk and Risk PremiumsScenario Analysis and Probability DistributionsScenario analysis is the process of devising a list of possible economic scenarios and specifying the likelihood of each one, as well as the HPR that will be realized in each case. The list of possible HPRs with associated probabilities is called the probability distribution of HPRs. The probability distribution lets us derive measurements for both the reward and the risk of the investment. The reward from the investment is its expected return, The mean value of the distribution of HPRs.Uncertainty surrounding the investment is a function of the magnitudes of the possible surprises. To summarize risk with a single number we first define the variance as the expected value of the squared deviation from the mean.

Risk Premiums and Risk AversionRisk premium is an expected return in excess of that on risk-free securities. In contrast, risk aversion is an investors reluctance to accept risk.

The Sharpe (Reward-to-Volatility) Measureo

Risk aversion implies that investors will accept a lower reward (as measured by their portfolio expected return) in exchange for a sufficient reduction in risk (as measured by the standard deviation of their portfolio return). A statistic commonly used to rank portfolios in terms of this risk-return trade-off is the Sharpe (or reward-to-volatility) measure, defined as:

III. The historical recordAnnual Holding Period Returns Statistics 1926-2008

The geometric mean is the best measure of the compound historical rate of return. Nevertheless the arithmetic average is the best measure of the expected return. Notice the greater divergence of the GAR and AAR for small stocks. This is because of the high variance and the higher proportion of negative returns in the small stock portfolio. Although we dont have statistical significance it appears that some of the portfolios exhibit kurtosis. Kurtosis of the normal distribution is zero. The world stock, US small stock and world bond portfolio appear to exhibit kurtosis. This indicates a higher percentage of observations in the tails that is predicted by the normal distribution. Non-zero value of skewness are also apparent, although we cant tell if they are significant. The world stock and US large stock portfolios may exhibit negative skewness. This indicates a higher probability of extreme negative returns than is predicted in a normal distribution.If returns are normally distributed then the following relationship among geometric and arithmetic averages holds: Arithmetic Average Geometric Average = 2

IV. Inflation and Real Rates of ReturnIf prices have changed, the increase in your purchasing power will not equal the increase in your dollar wealth. At any time, the prices of some goods may rise while the prices of other goods may fall; the general trend in prices is measured by examining changes in the consumer price index, or CPI. The CPI measures the cost of purchasing a bundle of goods that is considered representative of the consumption basket of a typical urban family of four. Increases in the cost of this standardized consumption basket are indicative of a general trend toward higher prices. The inflation rate, or the rate at which prices are rising, is measured as the rate of increase of the CPI.We need to distinguish between a nominal interest rate - the growth rate of your money, and a real interest rate - the growth rate of your purchasing power. If we call R the nominal rate, r the real rate, and i the inflation rate, then we conclude:r R iIn fact, the exact relationship between the real and nominal interest rate is given by:

The Equilibrium Nominal Rate of InterestBecause investors should be concerned with their real returnsthe increase in their purchasing powerwe would expect that as inflation increases, investors will demand higher nominal rates of return on their investments. This higher rate is necessary to maintain the expected real return offered by an investment.

V. Asset Allocation Across Risky and Risk-free PortfoliosInvestors can choose to hold risky and riskless assets. We may consider investments in a money market mutual fund as a proxy for the riskless investments that an investor might actually engage in.Asset allocation is the portfolio choice among broad investment classes, rather than among the specific securities within each asset class.

The Risky AssetWhen we shift wealth from the risky portfolio (P) to the risk-free asset, we do not change the relative proportions of the various securities within the risky portfolio. Rather, we reduce the relative weight of the risky portfolio as a whole in favour of risk-free assets.The complete portfolio is the entire portfolio including risky and risk- free assets.

The Risk-Free AssetThe power to tax and to control the money supply lets the government, and only the government, issue default-free (Treasury) bonds. The default-free guarantee by itself is not sufficient to make the bonds risk-free in real terms, since inflation affects the purchasing power of the proceeds from the bonds. The only risk-free asset in real terms would be a price-indexed government bond. Even then, a default-free, perfectly indexed bond offers a guaranteed real rate to an investor only if the maturity of the bond is identical to the investors desired holding period.

Portfolio Expected Return and RiskNow that we have specified the risky portfolio and the risk-free asset, we can examine the risk-return combinations that result from various investment allocations between these two assets.To generalize, the risk premium of the complete portfolio, C, will equal the risk premium of the risky asset times the fraction of the portfolio invested in the risky asset:E(rC ) rf = y[E(rP ) rf ]The standard deviation of the complete portfolio will equal the standard deviation of the risky asset times the fraction of the portfolio invested in the risky asset:oC = y*oPIn sum, both the risk premium and the standard deviation of the complete portfolio increase in proportion to the investment in the risky portfolio.

The Capital Allocation LineThe capital allocation line is the plot of risk-return combinations available by varying portfolio allocation between a risk-free asset and a risky portfolio. The slope, S, of the CAL equals the increase in expected return that an investor can obtain per unit of additional standard deviation. In other words, it shows extra return per extra risk.FIGURE 5.5The investment opportunity set with a risky asset and a risk-free assetE(r)CAL = Capitalallocation linePy = 1.25

E(rP) r = 8%E(rP) = 15%y = .50S = 8/22r = 7% FP = 22%

In fact, the reward-to-volatility ratio is the same for all complete portfolios that plot on the capital allocation line. While the risk-return combinations differ, the ratio of reward to risk is constant.

Risk Tolerance and Asset AllocationIndividual investors with different levels of risk aversion, given an identical capital allocation line, will choose different positions in the risky asset. Specifically, the more risk-averse investors will choose to hold less of the risky asset and more of the risk-free asset.The investors asset allocation choice also will depend on the trade-off between risk and return. If the reward-to-volatility ratio increases, then investors might well decide to take on riskier positions.

VI. Passive Strategies and the Capital Market LineA passive strategy is based on the premise that securities are fairly priced and it avoids the costs involved in undertaking security analysis.To avoid the costs of acquiring information on any individual stock or group of stocks, we may follow a neutral diversification approach. A natural strategy is to select a diversified portfolio of common stocks that mirrors the corporate sector of the broad economy. Such strategies are called indexing. The investor chooses a portfolio with all the stocks in a broad market index such as the Standard & Poors 500 index. The rate of return on the portfolio then replicates the return on the index. We call the capital allocation line provided by one-month T- bills and a broad index of common stocks the capital market line (CML). That is, a passive strategy based on stocks and bills generates an investment opportunity set that is represented by the CML.

Historical Evidence on the Capital Market LineThe notion that one can use historical returns to forecast the future seems straightforward but actually is somewhat problematic. On one hand, you wish to use all available data to obtain a large sample. But when using long time series, old data may no longer be representative of future circumstances. Another reason for weeding out sub periods is that some past events simply may be too improbable to be given equal weight with results from other periods.

Costs and Benefits of Passive InvestingFirst, the alternative active strategy entails costs. The passive portfolio requires only small commissions on purchases of U.S. T-bills (or zero commissions if you purchase bills directly from the government) and management fees to a mutual fund company that offers a market index fund to the public. An index fund has the lowest operating expenses of all mutual stock funds because it requires the least effort.A second argument supporting a passive strategy is the free-rider benefit. A well-diversified portfolio of common stock will be a reasonably fair buy, and the passive strategy may not be inferior to that of the average active investor. To summarize, a passive strategy involves investment in two passive portfolios: virtually risk-free short-term T-bills (or a money market fund) and a fund of common stocks that mimics a broad market index.

Chapter 6EFFICIENT DIVERSIFICATION6.1 Diversification and portfolio riskTwo broad sources of uncertainty:The first is the risk that has to do with general economic conditions, such as the business cycle, the inflation rate. interest rates, exchange rates, and so forth. In addition, consider naive diversification strategy, adding another security to the risky portfolio. _ The risk that remains even after diversification is called market risk, risk that attributable to marketwide risk sources. Other names are systematic risk or nondiversifiable risk. The risk that can be eliminated by diversification is called unique risk, firm-specific risk, nonsystematic risk, or diversifiable risk.

6.2 Asset allocation with two risky assets. Correlation and Covariance_ Portfolio risk denpends on the correlation between the returns of the assets in the portfolio. The variance is the probability weighted average across all scenarios of the squared deviation, between the actual return of the fund and its expected return; the standard deviation is the square root of the variance._ The covariance is calculated in a manner similar to the variance. A measure of the extent to which the returns tend to vary with each other is called the covariance. The formular for the covariance of the returns on the stock and bond portfolio is given in the following equation: Cov(rs, rB) = SB sB_ Using Historical Data is common alternative approach to produce the inputs such as means, variance,etc. The three rules od two-risky assets portfolios:Rule 1: The rate of return on the portfolio is a weighted average of the returns on the component securities, with the investment proportions as weights. rp = wBrB + wSrS ( 4)Rule 2: The expected rate of return on the portfolio is a weighted average of the expected returns on the component securities, with the same portfolio proportions as weights. E(rp) = wBE(rB) + wSE(rS) (5)Rule 3: The variance of the rate of return on thee two risky assets portfolio is 2p = (wBB)2 + ( wSS )2 + 2( wBB) (wss) BSWhere BS is the correlation soefficient between the returns on the stock and bond funds.The variance of the portfolio is a sum of the contributions of the component security variances plus a term that involves the correlation coefficient ( and hence, covariance) between the returns on the component securities. The risk-return trade off with two risky assets portfoliosA correlation coefficient of zero means that stock and bond returns vary independentl of each other.Investment opportunity set: set of available portfolio risk-return combination. This is the set of all attainable combination of risk-return combinations. The mean-variance criterion

6.3 The optimal risky portfolio with a risk free asset Optimal risky portfolio :The best combination of risky assets to be mixed with safe assets to form the complete portfolio.1. Efficient Diversification with Many Risky Assets The extension to include a risk-free asset results in a single combination of stock and bonds that is optimal when that portfolio is combined with the risk-free asset. Efficient frontier is the graph representing a aset of portfolio that maximizes expected return at each level of portfolio risk.The second step of the optimization plan involves the risk-free asset. Using the current riskfree rate, we search for the capital allocation line with the highest reward-to-variability ratio (the steepest slope).Free asset with the efficient frontier as depicted below:CAL(P) = Capital Market Line or CML dominates other lines because it has the largest slope or equivalently, the largest Sharpe ratio Slope = (E(rp) - rf) / sp That is, the CML maximizes the slope or the return per unit of risk or it equivalently maximizes the Sharpe ratio. Regardless of risk preferences some combinations of P & F will dominate all other combinations. All investors complete portfolio will fall on the CML.Finally, in the third step, the investor chooses the appropriate mix between the optimal risky portfolio ( O ) and T-bills. A portfolio manager will offer the same risky portfolio ( O ) to all clients, no matter what their degrees of risk aversion. Risk aversion comes into play only when clients select their desired point on the CAL. More risk-averse clients will invest more in the risk-free asset and less in the optimal risky portfolio O than less risk-averse clients, but both will use portfolio O as the optimal risky investment vehicle. Separation property: the property that implies portfolio choice can be separated into 2 independent tasks: (1) determination of the optimal risky portfolio, which is a purely technical problem, and (2) the personal choice of the best mix of the risky portfolio and the risk free asset.1. A Single factor asset market Systematic risks is largely macroeconomic, affecting all securities, while firm- specific risk factors affect only one particular firm or. perhaps, its industry. Factor model are statistical models designed to estimate these two components of risk for a particular security or portfolio. Excess return: Rate of return in excess of risk free rate. Beta: The sensitivity of a securitys returns to the systematic or market factor.Ri = E(Ri ) + iM + eiE ( R i ) is the expected excess holding-period return (HPR) at the start of theholding period. The next two terms reflect the impact of two sources of uncertainty. M quantifies the market or macroeconomic surprises (with zero meaning that there is no surprise) during the holding period. i is the sensitivity of the security to the macroeconomic factor. Finally, e i is the impact of unanticipated firm-specific events. Both M and e i have zero expected values because each represents the impact of unanticipated events, which by definition must average out to zero. The beta, ( i ) denotes the responsivenessof security. Specification of a Single-Index Model of Security ReturnsA factor model description of security returns is of little use if we cannot specify a way to measure the factor that we say affects security returns. One reasonable approach is to use the rate of return on a broad index of securities, such as the S&P 500, as a proxy for the common macro factor. With this assumption, we can use the excess return on the market index, R M , to measure the direction of macro shocks in any period.

Therefore, the total variability of the rate of return of each security depends on two components:The variance attributable to the uncertainty common to the entire market. This systematic risk is attributable to the uncertainty in R M . Notice that the systematic risk of each stock depends on both the volatility in R M and the sensitivity of the stock to fl uctuations in R M . That sensitivity is measured by i .The variance attributable to fi rm-specifi c risk factors, the effects of which are measured by e i . This is the variance in the part of the stocks return that is independent of market performance.This single-index model is convenient. It relates security returns to a market index that investors follow. Moreover, as we soon shall see, its usefulness goes beyond mere convenience. Diversification in a Single-Factor Security MarketThe systematic component of each security return is fully determined by the market factor and therefore is perfectly correlated with the systematic part of any other securitys return. Hence, there are no diversification effects on systematic risk no matter how many securities are involved. As far as market risk goes, a single-security portfolio with a small beta will result in a low market-risk portfolio. The number of securities makes no difference.It is quite different with firm-specific or unique risk. If you choose securities with small residual variances for a portfolio, it, too, will have low unique risk. But you can do even better simply by holding more securities, even if each has a large residual variance. Because the firm-specific effects are independent of each other, their risk effects are offsetting. This is the insurance principle applied to the firm-specific component of risk. The portfolio ends up witha negligible level of nonsystematic risk.

In sum, when we control the systematic risk of the portfolio by manipulating the average beta of the component securities, the number of securities is of no consequence. But in the case of nonsystematic risk, the number of securities involved is more important than the firm-specific variance of the securities. Sufficient diversification can virtually eliminate firmspecific risk. Understanding this distinction is essential to understanding the role of diversification in portfolio construction.

6.4 Risk of long term investment Are Stock Returns Less Risky in the Long Run?Advocates of the notion that investment risk is lower over longer horizons apply the logic of diversification across many risky assets to an investment in a risky portfolio over many years. Because stock returns in successive years are almost uncorrelated, they conclude that (1) the annual standard deviation of an investment in stocks falls with the investment horizon, and hence, (2) investment risk in a stock portfolio declines with the investment horizon. The Fly in the Time Diversification Ointment (or More Accurately, the Snake Oil)The flaw in the logic is the use of the annualized standard deviation to gauge the risk of a long-term investment. Annualized standard deviation is an appropriate measure of risk only for short-term (annual horizon) portfolios! It cannot serve to measure risk when comparing investments of different horizons and different scales.

Chapter 7Capital Asset Pricing and Arbitrage Pricing Theory 7.1 Capital Asset Pricing Model (CAPM)Introduction of CAPM Developed by Treynor, Sharpe, Lintner and Mossin in the early 1960s To predict the relationship between the risk and equilibrium expected returns on risky assets

CAPMs assumptions1. Investors cannot affect prices by their individual trades. 1. All investors plan for one identical holding period.1. Portfolios are formed with a universe of public traded financial assets and investors have unlimited access to risk-free borrowing or lending opportunities.1. Investors pay neither taxes nor transaction costs.1. All investors attempt to construct efficient frontier portfolios.1. All investors analyze securities in the same way and share the same economic view of the world. Therefore, they all calculate the same figures about expected return, standard deviation, correlation, etc. (homogeneous expectations)

Implications1. All investors will choose to hold the market portfolio (M), which includes all assets of the security universe.The proportion of each stock in M equals the market value of the stock divided by the total market value of all stocks.1. The market portfolio will be on the efficient frontier, at which CAL touches the efficient frontier. 1. The risk premium on the market portfolio will be proportional to the variance of the market portfolio and investors typical degree of risk aversion or:

1. The risk premium on individual assets will be proportional to the risk premium on the market portfolio and to the beta coefficient of the security on the market portfolio. =

Passive strategy The CAPM suggest that a passive strategy is a powerful alternative to an active one. A passive investor can easily benefit from the efficiency of the market portfolio while an active investor will end on a CAL that is less than the CML used by passive investor.

Applications of CAPM Investment management industry Capital budgeting decision

7.2 The CAPM and the Index In 1963, William Sharpe has launched the single index model (SIM) refers to a linear relationship between the excess return on the asset and the excess return on the market. SIM is a risk analysis tool: Simple Easy to apply The single-index equation: - = + ( - ) + Assumptions: E() = 0 The expected return of security i: () = + + - The expected return of security i in the CAPM: () = + -

Compare SIM with CAPMSIMCAPM

Uses realized returnUses expected return

Relies on the index portfolioRelies on the theoretical portfolio

0=0

Steps to conduct the analysis Collecting and processing data Estimation results What we learn from this regression The variance of the excess return Required rate

The variance of the excess returnVariance () = Variance () + Variance ()= Systematic risk + Firm-specific risk

Required rateRequired rate = Risk-free rate + x Expected excess return of index

Predicting Betas In order to forecast the rate of return of an asset: > 1: tend to exhibit a lower in the future < 1: tend to exhibit a higher in the future Use a weighting average of the sample estimate with the value 1.0

7.4 Multifactor Models and the CAPMMultifactor Models Multifactor Models: Models of security returns positing that returns respond to several systematic factors (business-cycle risk, interest or inflation rate risk, energy price risk,...) Multifactor Models can provide better descriptions of security returns. Suppose two sources of risk: Market index Treasury-bond portfolio The excess rate of return on stock i in some time period t will be:Ri = ai + iMRMt + iTBRTBt + ei

Two-factor security market line for security IE(ri ) = rf + iM [E(rM) - rf ] + iTB [E(rTB) - rf ]

Fama-French Three-factor Model In 1996, Fama and French proposed a three-factor model. Market index Firm size (SMB small minus big) Book-to-market ratio (HML high minus low)Ri = ai + M(rM rf )+ HML * rHML + SMB * rSMB + ei

7.5 Factor Models and The Arbitrage Pricing TheoryArbitrage Pricing Theory (APT) Arbitrage: Arises if an investor can construct a zero investment portfolio with a sure profit Zero investment: Since no net investment outlay is required, an investor can create arbitrarily large positions to secure large levels of profit Efficient markets: With efficient markets, profitable arbitrage opportunities will quickly disappear APT: A theory of risk-return relationships derived from no-arbitrage considerations in large capital markets. In single form, the excess rate of return on each security using the APT is:Ri = ai + iRM + ei A well-diversified porfolio has zero firm-specific risk, so its return is:Rp = ap + pRM

If the portfolio beta is 0, then:Rp = ap This portfolio has a return higher than the risk-free rate by the amount of ap ap must be equal to 0, or else an immediate arbitrage opportunity opens up. We will prove that ap must = 0, even if the beta is not 0.

The arbitrage strategy works We combine 2 portfolios into a zero-beta riskless portfolio with a rate of return not equal to the risk-free rate. Assumptions: Portfolio V has a beta of v , and an alpha of av Portfolio U has a beta of u , and an alpha of au Our objective is to buy portfolio V and sell portfolio U in chosen proportions so that the combination (V + U) will have a beta of zero. The portfolio weights will be chosen as:Wv = - u /(v - u )Wu = v /(v - u) We can easily point out: Wv + Wu = 1Beta (V + U) = 0R (V + U) # 0 In conclusion, unless av and au equal 0, the new portfolio has a rate of return differs from the risk-free rate an arbitrage opportunity.

The expected return-beta relationship model of APT APT equation setting alpha is zero:Rp = pRM rp - rf = p (rM - rf )E(rp ) = rf + p [E(rM) - rf ] The same expected return-beta relationship as the CAPM.

The APT and the CAPM APT applies to well diversified portfolios and not necessarily to individual stocks. With APT it is possible for some individual stocks to be mispriced (not lie on the SML). APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. APT and CAPM both can be extended to multifactor models.

Multifactor Generalization of the APT Suppose we generalize the single-factor model to a two-factor model: Ri = ai + i1Rm1 + i2Rm2 + ei Factor Portfolios: Portfolios that have a beta of 1.0 on one factor and a beta of 0 on all others.

CHAPTER EIGHT THE EFFICIENT MARKET HYPOTHESIS8. 1 Random Walks and the Efficient Market HypothesisDefinitions of informational and allocational efficiency are provided. Implications of efficiency are then discussed and the idea of random walk is introduced and illustrated. Note that we actually expect there to be a positive trend in stock prices albeit with random movements about those positive trends. The reason that we would expect to see price changes that are random is related to efficiency. If information that has importance for stock values arrives or occurs in a random fashion, price changes will occur randomly. If the market is efficient in its analysis, the change in prices will reflect that information in a timely basis. The result will be random price changes. The concept of market efficiency is related to the concept of competition. In efficient markets, once information becomes available, participants will trade quickly on that information. Competition assures that prices will reflect that information very quickly. If the information does not become incorporated into price very quickly, market participants would act to eliminate the inefficiency. Questions arise about efficiency due to possible unequal access to information, structural market problems and the psychology of investors (Behavioralism). Structural market problems refers to market imperfections such as transaction costs limiting arbitrage, constraints on short sales doing the same and recognizing that in volatile markets, most arbitrage strategies are really risky arbitrage, not riskless arbitrage. We will have more to say on this later.The forms of the efficient market are presented. In a weak form efficient market, prices will reflect all information that can be derived from trading data such as prices and volumes. In a semi-strong form market prices will reflect all publicly available information regarding the firms prospects. In a strong form market, prices would reflect all information relevant to the firms' prospects, even inside information. It is important that students understand the following Venn diagram.Many students struggle with this concept so it is worth taking the time to point out the relationships among the different forms of efficiency.8.2 Implications of the EMH (for Security Analysis)Technical and fundamental analyses are defined in this section as well as the implications of the different forms of market efficiency with respect to security analysis. If markets are weak form efficient, technical analysis, such as charting, should not result in superior profits. If markets are semi-strong form efficient, fundamental analysis should not result in consistent superior profits. Fundamental analysis involves using information on the economy as well as information such as earning trends and profit trends to find undervalued securities. If markets are at least semi-strong efficient, investors would tend to employ passive strategies such as buying indexed funds or employing a diversified buy and hold strategy. Active management such as security analysis or attempting to time the market would not result in consistently superior profits if markets are efficient.Even when markets are efficient portfolio management is required. For one thing, the appropriate risk level will vary over an investor's life. Tax considerations will call for different types of securities to be included in the portfolio. Other considerations could be related to reinvestment risk associated with cash flow or considerations related to diversifying employment related risk.8.3 Are Markets Efficient?Over time stock prices tend to follow a sub martingale. This has nothing to do with efficiency, per se. It does however have serious implications for tests of efficiency. This implies that a randomly chosen portfolio of stocks can be expected to have a positive return. In practice this means that when trying to figure out if some portfolio manager is earning abnormal returns we must compare their performance to the performance of a randomly chosen portfolio. That is they must outperform the random portfolio or in practice they must beat some benchmark rate of return. The PPT illustrates the idea of an event study and how an event study might look in an efficient and in an inefficient market and introduces a market model to provide the expected return that is needed to assess whether the investor earns an abnormal return. The magnitude, selection bias and lucky event issues are also covered as well as possible model misspecification. Because a model of expected return is needed to assess whether an investor or an investment rule earns excess return, tests of market efficiency are joint tests of the model used to estimate expected returns and market efficiency. Hence, even when an anomaly is discovered we have to be careful in interpreting the results. Some apparent anomalies are discussed including the Fama-French results, the Keim and Stambaugh findings and the Campbell and Shiller work. Note that each of these results may also be consistent with changing risk premiums and may have nothing to say about market efficiency. Periodically stock prices appear to undergo a speculative bubble. A speculative bubble is said to occur if prices do not equal the intrinsic value of the security. Does this imply that markets are not efficient? There is no definitive answer to this question. However we can make some observations: It is very difficult to predict if you are in a bubble and when the bubble will burst. I have been through two bubbles now and you cant understate the significance of this point. Stock prices are estimates of future economic performance of the firm and these estimates can change rapidly. Risk premiums can change rapidly and dramatically. Nevertheless, with hindsight there appear to be times when stock prices decouple from intrinsic or fundamental value, sometimes for years. What does this imply? Prices eventually conform once more to intrinsic value. Many who dont believe in efficient markets anyway have jumped on this result to pronounce the death of market efficiency. However, the bubbles bring into question the allocational efficiency of the markets more than the informational efficiency. Very few people will be able to consistently predict the extent and duration of a bubble. Some claim the bubbles imply that investors are irrational. Perhaps, but think about what determines the price of gold. Is it irrational to buy an asset for more than its fundamental value if you believe that you can sell it for more than you paid for it? It is indeed risky to engage in this type transaction, but is it irrational? Bubbles seem to occur during two periods: 1) when technology is changing rapidly and 2) during periods of cheap capital when interest rates are low for extended periods. In the first case values will be more heavily determined by future growth prospects rather than the value of assets in place. During periods of cheap capital, new investments will be undertaken based on future growth prospects as well. In both situations, new investors with less investment knowledge and experience are likely to enter the markets, making a bubble even more likely. When the bubble bursts, there will appear to be a return to hardnosed rationality as investors look carefully to invest according to their beliefs about fundamental values and will employ higher risk premiums. For more on thoughts on this topic (and more history about bubbles) read Burton Malkeils book, A Random Walk Down Wall Street to learn how Castles in the Air sometimes outweigh fundamental values in price setting.Some of the major types of tests that researchers have done on market efficiency are described. If markets are inefficient, then professionals who spend considerable resources in investment should secure superior performance. The tests are broken down in terms tests of the forms of efficiency. Tests have uncovered some inefficiency in pricing but many possible interpretations of results are possible. Tests of weak-form efficiency show small magnitudes of positive correlation for very short term tests; hence prices do not strictly conform to a random walk. Studies of returns for periods of 3 to 12 months offer evidence of positive momentum. Longer horizon tests have uncovered some pronounced negative correlation. Tests do document tendencies for long-term reversals in results. This may be because of information flow in competitive markets. People rush to buy recent winners and in so doing drive up the price enough so that future returns are not abnormal. This does not imply inefficiency unless the same investors can consistently do this. Attempting to interpret the results of test of efficiency has led to various explanations that arrange from model misspecification to data mining.8.4 Mutual Fund and Analyst PerformanceSome recent studies on mutual funds have documented some persistence in positive and negative performance. Some researchers question whether the performance is abnormal or whether the studies have measurement errors or model biases. The overall test results are mixed at best but the evidence shows that some superstars exist. Note that Warren Buffets portfolio, (Buffet is one of the postulated superstars) took quite a beating in the financial crisis of 2008. Although the evidence isnt conclusive it appears safe to state that the ability to consistently earn abnormal returns greater than one should for the risk level undertaken is very rare. I also include a wrap up summary in this section to drive home the main points of the chapter. I did this because students seem to have some trouble with the implications of market efficiency and because in some cases it is difficult to get them past their own prior beliefs in spite of what the evidence reveals.

CHAPTER NINE BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS9.1 The Behavioral CritiqueBehavioral Finance Investors do not always process information correctly Investors often make inconsistent or systematically suboptimal decisions Models of financial markets emphasize potential implications of psychological factors affecting investor behavior The irrationalities fall into two categories: Information Processing Problems: Investors do not always process information correctly Behavioral Biases: Investors often make inconsistent or suboptimal decisionsInformation Processing Forecasting errors People make forecasts based on the uncertainty inherent in their information De Bondt and Thaler (1990) employ this notion to explain the P/E ratio effect. Overconfidence People tend to overestimate the precision of their beliefs or forecasts, i.e., they tend to overestimate their abilities to predict future returns For overconfident investors, trading volume may be relatively high adjust their portfolio very frequently Overconfident individuals often exhibit risk-seeking behavior Conservatism A conservatism bias means that investors are too slow (or said too conservative) in updating their beliefs in response to new evidence This under-reaction to news leads to momentum effect in stock returns Investors may underreact to news, so market prices, determined by the consensus belief of investors, reflect news gradually Representativeness bias Definition: People are too prone to believe that a small sample is representative of a population and thus infer patterns too quickly based on small samples Example: A short-lived good earning reports would lead investors think about the bright future performance, they will invest more money in the firm, exaggerating the price of stock The forecasting errors (memory bias) can be viewed as a type of representativeness biasBehavioral Bias Framing effect Investment decisions are critically dependent on the decision-makers reference point. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented Mental accounting Is a specific form of framing, when people segregate certain decisions Investors have a safe part of their portfolio that they will not risk, and a risky part of their portfolio that they can have fun with Investors segregate funds into mental accounts (e.g., dividends and capital gains), maintain a set of separate mental accounts, and do not combine outcomes; a loss in one account is treated separately from a loss in another account Regret avoidance Regret Prospect of regret generates avoidance behavior Disposition effect: investors try to avoid regret by selling stocks that have gone down in value, rush to sell those that have gone up Prospect theory We have an irrational tendency to be less willing to gamble with profits than with losses. This means selling quickly when we earn profits but not selling if we are running lossesTvede (1999, p. 169) The most important theory in behavioral finance They design some psychological experiments to examine how people make decisions when they face different kinds of gambles1. The results show that what affects people's decisions is not their wealth level after the gamble, but the amount of gains or losses from the gamble2. Loss averse attitude: people are more sensitive about the losses than the gains The decrease of the utility from $1 loss is larger than the increase of the utility from $1 gain In traditional economics, people are assumed to be risk averse and with a concave utility function (in Diagram A) In Prospect Theory, people are risk averse (thus with concave utility function) when facing gains and risk loving (thus with convex utility function) when facing losses (in Diagram B)Limits to Arbitrage Fundamental risk The distortion could get worse or maintain for a long enough horizon such that the exploitation of that distortion to profit is limited (e.g., a trader may run out of his capital or a fund manager may lose his job before the prices go back to the fair level) Implementation costs The short sell constraint for mutual fund managers Or short-sellers may have to return the borrowed securities soon after the notification from the broker, that makes the horizon of the short sale uncertain Model risk Shares of closed-end funds are traded at substantial discounts or premiums from their net asset values Siamese twin companies In 1907, Royal Dutch Petroleum (RDP) and Shell Transport (ST) merged their operations into one firm RDP receives 60% cash income, and ST receives 40% cash income, so it can be expected that the price of a RDP share is 1.5 times as high as the price of a ST share (see the figure on the next slide)Bubbles & Behavioral EconomicsFrom 1995 to 2001, the Nasdaq index increased by a factor of more than 6. This dot-com boom development could be explained by some irrationalities in the behavioral finance Investors were increasingly confident of their forecasts and apparently extrapolate short-term patterns into the distant future ( representativeness bias) The overconfidence arises from the situation in which investors always earn huge capital gains regardless of what to buy and when to buy( overconfidence bias) The interaction of these two biases can explain the bubble from 1995 to 2001Evaluating the Behavioral Critique Try to explain anomalies but does not give guidance of how to exploit these irrationalities Explain each anomaly by some subjective combination of irrationalities from the list of behavioral biases. There is not a unified behavioral theory to explain a range of anomalies It is possible to have conflicts between different theories, e.g., overreaction vs. underreaction 9.2 Technical Analysis & Behavioral FinanceTrends and CorrectionsDow Theory TrendsThree forces simultaneously affecting stock price: Primary trend: long-term movements, continuing from months to years Intermediate trend (swing): short-term deviations from the underlying primary trend, these deviations are eliminated via corrections (when prices come back to trend value) Minor trend (swing): daily fluctuations which are with little importance in the trend analysis of the Dow theorySentiment IndicatorsTrin StatisticTrin: TRading Index

Trin > 1: Bear market Trin investors should be bullish Away from 100% => investors should be bearishShort Interest Short interest : total number of shares that are sold-short in the market Short sale: the sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan 2 ways of interpretation: High volume => investors should be bearish. Low volume => investors should be bullish.Or: High volume: investors should be bullish. Low volume: investors should be bearish.Put/Call Ratio Call option: the right to buy a stock at a fixed exercise price A way of betting on stock price increases Put option: the right to sell a stock at a fixed price A way of betting on stock price decreases Put/call ratio: ratio of put options to call options outstanding on a stock Put options do well in falling markets while call options do well in rising market Give a signal market sentiment and predictive of market movements: Rising ratio: bearish Declining ratio: bullish

Chapter 10 Bond prices and yields

10.1 Bond characteristicsDefinition: a security that obligates the issuer to make specified payments to the holder over a period of time.Related terminologies Face value, par value: the payment to the bondholder at the maturity of the bond. Coupon rate: A bonds annual interest payment per dollar of par value. Zero-coupon bond: A bond paying no coupons that sells at a discount and provides only a payment of par value at maturity.1. Treasury Bonds and NotesBoth bonds and notes are issued in denominations of $1,000 or more and make semiannual coupon payments. Accrued interest and quoted bond prices If a bond is purchased between coupon payments, the buyer must pay the seller for accrued interest, the prorated share of the upcoming semiannual coupon. The amount the buyer actually pays would equal the stated price plus the accrued interest.1. Corporate bondsCallable bondCall provision allows the issuer to repurchase the bond at a specified call price before the maturity date. The option to call the bond is valuable to the firm, allowing it to buy back the bonds and refinance at lower interest rates when market rates fall. However it is also the investors burden. Hence callable bonds are issued with higher coupons and promised yields to maturity than non-callable bonds.Convertible bondConvertible bonds give bondholders an option to exchange each bond for a specified number of shares of common stock of the firm. Conversion ratio: the number of shares for which each bond may be exchanged. Market conversion value: the current value of the shares for which the bonds may be exchanged. At the $20 stock price, for example, the bonds conversion value is $800. Conversion premium: the excess of the bond price over its conversion value.Convertible bondholders benefit from price appreciation of the companys stock.Puttable bonds While the callable bond gives the issuer the option to extend or retire the bond at the call date, the extendable or put bond gives this option to the bondholder. If the bonds coupon rate exceeds current market yields, for instance, the bondholder will choose to extend the bonds life. If the bonds coupon rate is too low, it will be optimal not to extend; the bondholder instead reclaims principal, which can be invested at current yields.Floating-rate bonds Floating-rate bonds make interest payments that are tied to some measure of current market rates. For example, the rate might be adjusted annually to the current T-bill rate plus 2%. If the one-year T-bill rate at the adjustment date is 4%, the bonds coupon rate over the next year would then be 6%. This arrangement means that the bond always pays approximately current market rates.1. Preferred stockPreferred stock commonly pays a fixed dividend. Dividends on preferred stock are not considered tax-deductible expenses to the firm. But a corporation pays taxes on only 30% of the dividend received when it buys preferred stock of another corporation.In the event of bankruptcy, the claim of preferred stockholders to the firms assets has lower priority than that of bondholders, but higher priority than that of common stockholders.1. International bondsInternational bonds are divided into two categories: foreign bonds and Eurobonds. Foreign bonds: E.g. foreign bonds sold in U.S. are called Yankee bonds. They are denominated in USD and the issuers can be whatever country in the world except for U.S.Foreign bonds sold in Japan are called Samurai bonds. They are denominated in Yen and the issuers are non-Japanese ones. Eurobonds: bonds issued in the currency of one country but sold in other national markets. E.g. the Eurodollar market refers to dollar-denominated bonds sold outside the U.S. (not just in Europe), although London is the largest market for Eurodollar bonds.1. Innovation in the bond marketInverse floaters: it is similar to the floating-rate bonds we described earlier, except that the coupon rate on these bonds falls when the general level of interest rates rises. Investors in these bonds suffer doubly when rates rise. Not only does the present value of each dollar of cash flow from the bond fall as the discount rate rises but the level of those cash flows falls as well. Of course investors in these bonds benefit doubly when rates fall.Asset-backed bonds: Bonds with coupon rates tied to the financial performance of several of its films. The income from a specified group of assets is used to service the debt. More conventional asset-backed securities are mortgage-backed securities or securities backed by auto or credit card loans.Pay-in-kind bonds: Issuers of pay-in-kind bonds may choose to pay interest either in cash or in additional bonds. If the issuer is short on cash, it will likely choose to pay with new bonds rather than scarce cash.Catastrophe bonds: Bonds that have final payment depends on whether the catastrophe sticking on it happens or not. These bonds are a way to transfer catastrophe risk from insurance companies to the capital markets. Investors in these bonds receive compensation in the form of higher coupon rates for taking on the risk. But in the event of a catastrophe, the bondholders will give up all or part of their investments. Indexed bonds Indexed bonds make payments that are tied to a general price index or the price of a particular commodity. For example, Mexico has issued bonds with payments that depend on the price of oil.0. Bond pricing Bond value = Present value of coupons + Present value of par value

If the interest rate increases, the bond price decreases.Bond pricing between coupon dates)

10.2 Bond yield Yield to maturity (YTM) It is the discount rate that makes the present value of a bonds payments equal to its price. This rate is often viewed as a measure of the average rate of return that will be earned on a bond if it is bought now and held until maturity.Yield to call It is used to calculated yield in callable bond. Callable bond could be retired prior to the maturity date.If price of bond is higher than call price seller will call that bond and sell them to the market for profit.Calculate Yield to Call:

Where:t: number of period payment till the call date

Price: price of that bond at the call date

We use financial calculator or excel application to solve YTCRealized Compound Return versus Yield to MaturityRealized compound return: Compound rate of return on a bond with all coupons reinvested until maturity.With a reinvestment rate equal to the yield to maturity, the realized compound return equals yield to maturity. If the reinvestment rate is not at yield to maturity, there will be two circumstances. Firstly, if the coupon can be invested at more than YTM, funds will grow larger, and the realized compound return will exceed YTM. Secondly, if the reinvestment rate is less than YTM, investors will gain less. Hence, as interest rates change, bond investors are actually subject to two sources of offsetting risk. On the one hand, when rates rise, bond prices fall, which reduces the value of the portfolio. On the other hand, reinvested coupon income will compound more rapidly at those higher rates. This reinvestment rate risk will offset the impact of price risk.

10.3 Bond price over timeInterest rate and bond price have long-term negative relationship for all maturity. A bond will be sold above its face value when the coupon rate is higher than the discount rate (market interest rate), at the face value when the coupon rate is equal to the market interest rate, and below its face value when the coupon rate is lower than the market interest rate. Yield to Maturity versus Holding-Period ReturnIf the yield to maturity is unchanged over the period, the rate of return on the bond will equal that yield.When the yields fluctuate, a bonds rate of returns will change accordingly. An increase in the bonds yield to maturity will reduce its price, which means that the holding-period return will be less than the initial yield. Equivalently, a decline in the bonds yield to maturity results in the holding-period return greater than the initial yield.Zero-Coupon Bonds and Treasury STRIPSZero coupon bonds carry no coupons and present all its return in the form of price appreciation. When a Treasury fixed-principal note or bond (or a TIPS) is stripped, each interest payment and the principal payment becomes a separate zero-coupon security. Example: a Treasury note with 10 years remaining to maturity consists of a single principal payment at maturity and 20 interest payments (paid semiannually). When this note is converted to STRIPS form, each of the 20 interest payments and the principal payment becomes a separate security. STRIPS are also called zero-coupon securities because the only time an investor receives a payment during the life of a STRIP is when it matures.

10.4 Default risk and bond pricingBond default risk is measured by Moodys Investor Services, Standard & Poors Corporation, and Fitch Investors Service, all of which provide financial information on firms as well as the credit risk of large corporate and municipal bond issues.Bond Ratings

Very High QualityHigh QualitySpeculativeVery Poor

Standard & PoorsAAAAAABBBBBBCCCD

MoodysAaaAaABaaBaBCaaC

Investment grade bond A bond rated BBB and above by Standard & Poors, or Baa and above by Moodys.Speculative grade or junk bond A bond rated BB or lower by Standard & Poors, or Ba or lower by Moodys, or an unrated bond.Junk Bonds: they are also known as high-yield bonds and are nothing more than speculative grade (low- rated or unrated) bonds.Determinants of Bond Safety1. Coverage ratios. Ratios of company earnings to xed costs. For example, the TIE ratio is the ratio of earnings before interest payments and taxes to interest obligations. The fixed-charge coverage ratio includes lease payments and sinking fund payments with interest obligations to arrive at the ratio of earnings to all xed cash obligations. Low or falling coverage ratios signal possible cash ow difculties.1. Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the rm will be unable to earn enough to satisfy the obligations on its bonds.1. Liquidity ratios. These are current ratio (current assets/ current liabilities) and the quick ratio (current assets excluding inventories/current liabilities). These ratios measure the rms ability to pay bills coming due with its most liquid assets.1. Profitability ratios. Measures of rates of return on assets or equity. Protability ratios are indicators of a rms overall performance. The return on assets (earnings before interest and taxes divided by total assets) or return on equity (net income/equity) are the most popular of this measure.1. Cash flow-to-debt ratio. This is the ratio of total cash ow to outstanding debt.Bond Indentures: Bond indenture is the document defining the contract between the bond issuer and the bondholder.Protection Against Default: Sinking funds Issuer may repurchase a given fraction of the outstanding bonds each year Issuer may either repurchase at the lower of open market price or at a pre-specified price, usually par; bonds are chosen randomly Serial bonds Staggered maturity dates Subordination of future debt: Senior debt holders must be paid in full before junior debt holders. Dividend restrictions: Limit on liquidating dividends Col