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T H I R T E E N T H
E D I T I O N
ZVI BODIE
Boston University
ALEX KANE
University of California, San Diego
ALAN J. MARCUS
Boston College
Final PDF to printer
INVESTMENTS, THIRTEENTH EDITION
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Library of Congress Cataloging-in-Publication Data
Names: Bodie, Zvi, author. | Kane, Alex, 1942- author. | Marcus, Alan J.,
author.
Title: Investments / Zvi Bodie, Boson University, Alex Kane, University of
California, San Diego, Alan J. Marcus, Boston College.
Description: Thirteenth edition. | New York, NY : McGraw Hill LLC, [2024] |
Includes index.
Identifiers: LCCN 2022048517 (print) | LCCN 2022048518 (ebook) |
ISBN 9781264412662 (hardcover) | ISBN 9781266837227 (ebook)
Subjects: LCSH: Investments. | Portfolio management.
Classification: LCC HG4521 .B564 2024 (print) | LCC HG4521 (ebook) |
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bod12665_fm_i-xxviii.indd iv
10/26/22 04:10 PM
About the Authors
ZVI BODIE
Boston University
Zvi Bodie is Professor ­Emeritus at Boston University. He holds a PhD from the ­Massachusetts Institute of
Technology and has served on the finance faculty at the Harvard Business School and MIT’s Sloan School
of ­Management. He has ­published widely in scholarly and professional journals on pension investment strategy
and life-cycle asset-liability matching. In 2007 the ­Retirement Income Industry Association gave him its ­Lifetime
Achievement Award for applied research.
ALEX KANE
University of California, San Diego
Alex Kane holds a PhD from the Stern School of Business of New York University and has been Visiting
­Professor at the Faculty of Economics, University of Tokyo; Graduate School of Business, Harvard; Kennedy
School of Government, Harvard; and Research Associate, National Bureau of Economic Research. An author
of many articles in finance and management ­journals, Professor Kane’s research is mainly in corporate finance,
portfolio management, and capital markets.
ALAN J. MARCUS
Boston College
Alan Marcus is the Mario J. Gabelli Professor of Finance in the Carroll School of Management at Boston
­College. He received his PhD in economics from MIT. Professor Marcus has been a visiting professor at the
Athens Laboratory of Business Administration and at MIT’s Sloan School of Management and has served as a
research associate at the National Bureau of Economic Research. Professor Marcus has published widely in the
fields of capital markets and portfolio management. He also spent two years at the Federal Home Loan Mortgage
Corporation (Freddie Mac), where he developed models of mortgage pricing and credit risk. He currently serves
on the Research Foundation Advisory Board of the CFA Institute.
Special Contributor
Nicholas Racculia, Saint Vincent College
Nicholas Racculia holds a PhD from Princeton University and serves as Professor of Finance at St. Vincent
­College. Professor Racculia teaches a wide range of classes in Corporate Finance and Investments. He has
­significantly participated in the expansion of Chapter 26 on Alternative Assets. His contributions also play a key
role in the development of online content for the text.
v
Brief Contents
Preface
xvi
PART III
Equilibrium in Capital
Markets 283
PART I
Introduction 1
9
1
The Investment Environment
The Capital Asset Pricing Model
1
10
2
Asset Classes and Financial Instruments
3
How Securities Are Traded
Arbitrage Pricing Theory and Multifactor
Models of Risk and Return 315
31
11
61
The Efficient Market Hypothesis
4
Behavioral Finance and Technical
Analysis 381
13
PART II
Empirical Evidence on Security Returns
Portfolio Theory and
Practice 125
5
Risk, Return, and the Historical Record
6
Capital Allocation to Risky Assets
7
Efficient Diversification
Index Models
341
12
Mutual Funds and Other Investment
Companies 99
8
283
409
PART IV
Fixed-Income Securities 439
125
14
Bond Prices and Yields
167
439
15
The Term Structure of Interest Rates
201
16
Managing Bond Portfolios
251
vi
509
481
Brief Contents
PART V
PART VII
Security Analysis 551
Applied Portfolio
Management 827
17
Macroeconomic and Industry Analysis
18
551
24
Portfolio Performance Evaluation
Equity Valuation Models 583
19
Financial Statement Analysis
25
International Diversification
629
26
Alternative Assets
The Theory of Active Portfolio
Management 935
Options, Futures, and Other
Derivatives 673
20
Options Markets: Introduction
21
Option Valuation
715
Futures Markets
763
22
23
28
Investment Policy and the Framework of the
CFA Institute 959
673
Futures, Swaps, and Risk Management
867
895
27
PART VI
827
REFERENCES TO CFA PROBLEMS 995
GLOSSARY
G-1
NAME INDEX
I
SUBJECT INDEX I-4
791
NOTATION, FORMULAS F-1
vii
Contents
Preface
xvi
Chapter 2
Asset Classes and Financial Instruments
PART I
Introduction
2.1
1
The Investment Environment 1
Real Assets versus Financial Assets
1.2
Financial Assets 3
1.3
Financial Markets and the Economy
2
2.2
The Investment Process
1.5
Markets Are Competitive
2.3
The Players
10
11
2.4
2.5
54
End of Chapter Material
The Financial Crisis of 2008–2009 19
56–60
Chapter 3
Antecedents of the Crisis / Changes in Housing Finance /
Mortgage Derivatives / Credit Default Swaps / The Rise
of Systemic Risk / The Shoe Drops / The Dodd–Frank
Reform Act
How Securities Are Traded 61
3.1
How Firms Issue Securities 61
Privately Held Firms / Publicly Traded Companies / Shelf
Registration / Initial Public Offerings / SPACs versus
­Traditional IPOs
Outline of the Text 27
End of Chapter Material
Derivative Markets
Options / Futures Contracts
Robo Advice / Blockchains / Cryptocurrencies /
Digital Tokens / Digital Currency
1.8
Stock and Bond Market Indexes 47
Stock Market Indexes / Dow Jones Industrial Average
/ The Standard & Poor’s 500 Index / Russell Indexes /
Other U.S. Market-Value Indexes / Equally Weighted
Indexes / Foreign and International Stock Market Indexes
/ Bond Market Indicators
13
Financial Intermediaries / Investment Bankers /
Venture Capital and Private Equity / Fintech,
Financial Innovation, and Decentralized
Finance
1.7
Equity Securities 44
Common Stock as Ownership Shares / Characteristics of
Common Stock / Stock Market Listings / Preferred Stock /
Depositary Receipts
The Risk–Return Trade-Off / Efficient Markets
1.6
The Bond Market 37
Treasury Notes and Bonds / Inflation-Protected Treasury
Bonds / Federal Agency Debt / International Bonds /
Municipal Bonds / Corporate Bonds / Mortgage and
Asset-Backed Securities
5
The Informational Role of Financial Markets /
Consumption Timing / Allocation of Risk / Separation of
Ownership and Management / Corporate Governance
and Corporate Ethics
1.4
The Money Market 31
Treasury Bills / Certificates of Deposit / Commercial
Paper / Bankers’ Acceptances / Eurodollars / Repos and
Reverses / Federal Funds / Brokers’ Calls / LIBOR and
Its Replacements / Yields on Money Market Instruments /
Money Market Funds
Chapter 1
1.1
31
27–30
viii
Contents
3.2
How Securities Are Traded
67
4.6
Exchange-Traded Funds 112
4.7Mutual Fund Investment Performance:
A First Look 115
Types of Markets
Direct Search Markets / Brokered Markets / Dealer
­Markets / Auction Markets
4.8
Information on Mutual Funds
End of Chapter Material
Types of Orders
116
119–124
Market Orders / Price-Contingent Orders
PART II
Trading Mechanisms
Portfolio Theory
and Practice 125
Dealer Markets / Electronic Communication Networks
(ECNs) / Specialist/DMM Markets
3.3
The Rise of Electronic Trading
3.4
U.S. Markets
72
74
Chapter 5
NASDAQ / The New York Stock Exchange / ECNs
3.5
New Trading Strategies
Risk, Return, and the Historical
Record 125
76
Algorithmic Trading / High-Frequency Trading / Dark
Pools / Internalization / Bond Trading
3.6
Globalization of Stock Markets
3.7
Trading Costs
3.8
Buying on Margin
3.9
Short Sales
5.1Measuring Returns over Different Holding Periods 126
Annual Percentage Rates / Continuous Compounding
5.2 Interest Rates and Inflation Rates 129
Real and Nominal Rates of Interest / The Equilibrium
Real Rate of Interest / Interest Rates and Inflation /
Taxes and the Real Rate of Interest / Treasury Bills and
Inflation, 1926–2021
5.3 Risk and Risk Premiums 133
Holding-Period Returns / Expected Return and Standard
Deviation / Excess Returns and Risk Premiums / The
Reward-to-Volatility (Sharpe) Ratio
5.4 The Normal Distribution 137
5.5 Deviations from Normality and Tail Risk 140
Value at Risk / Expected Shortfall / Lower Partial
Standard Deviation and the Sortino Ratio / Relative
Frequency of Large, Negative 3-Sigma Returns
5.6 Learning from Historical Returns 143
Time Series versus Scenario Analysis / Expected Returns
and the Arithmetic Average / The Geometric (TimeWeighted) Average Return / Estimating Variance and
Standard Deviation / Mean and Standard Deviation
Estimates from Higher-Frequency Observations
5.7 Historic Returns on Risky Portfolios 147
A Global View of the Historical Record
5.8 Normality and Long-Term Investments 156
Short-Run versus Long-Run Risk / Forecasts for the
Long Haul
End of Chapter Material 160–166
80
81
82
85
3.10 Regulation of Securities Markets
89
Self-Regulation / The Sarbanes-Oxley Act /
Insider Trading
End of Chapter Material
93–98
Chapter 4
Mutual Funds and Other Investment
Companies 99
4.1
Investment Companies
4.2
Types of Investment Companies
99
100
Unit Investment Trusts / Managed Investment
Companies / Exchange-Traded Funds / Other Investment
Organizations
Commingled Funds / Real Estate Investment Trusts
(REITs) / Hedge Funds
4.3
Mutual Funds
104
Investment Policies
Money Market Funds / Equity Funds / Sector
Funds / Bond Funds / International Funds /
Balanced Funds / Asset Allocation and Flexible
Funds / Index Funds
How Funds Are Sold
4.4
Costs of Investing in Mutual Funds
107
Chapter 6
Fee Structure
Capital Allocation to Risky Assets
Operating Expenses / Front-End Load / Back-End
Load / 12b-1 Charges
6.1
Fees and Mutual Fund Returns
4.5
Taxation of Mutual Fund Income
167
Risk and Risk Aversion 168
Risk, Speculation, and Gambling / Risk Aversion and
Utility Values / Estimating Risk Aversion
111
ix
Contents
6.2Capital Allocation across Risky and Risk-Free
Portfolios 173
6.3
8.5Portfolio Construction Using the Single-Index
Model 268
The Risk-Free Asset 176
Alpha and Security Analysis / The Index Portfolio as an
Investment Asset / The Single-Index Model Input List /
The Optimal Risky Portfolio in the Single-Index Model /
The Information Ratio / Summary of Optimization
Procedure / An Example / Correlation and Covariance
Matrix
6.4Portfolios of One Risky Asset and a Risk-Free
Asset 176
6.5
Risk Tolerance and Asset Allocation
179
Non-normal Returns
6.6
Passive Strategies: The Capital Market Line 185
End of Chapter Material
Risk Premium Forecasts / The Optimal Risky Portfolio /
Is the Index Model Inferior to the Full-Covariance
Model?
187–195
Appendix A: Risk Aversion, Expected Utility, and the
St. Petersburg Paradox 196
End of Chapter Material
Chapter 7
PART III
Efficient Diversification 201
7.1
Diversification and Portfolio Risk 202
7.2
Portfolios of Two Risky Assets 203
7.3
Asset Allocation with Stocks, Bonds, and Bills 211
7.4
The Markowitz Portfolio Optimization Model 216
Equilibrium in Capital
Markets 283
Chapter 9
Asset Allocation with Two Risky Asset Classes
The Capital Asset Pricing Model 283
Security Selection / Capital Allocation and the
Separation Property / The Power of Diversification /
Asset Allocation and Security Selection
9.1
Risk Sharing versus Risk Pooling / Time Diversification
9.2
228–238
Appendix B: Review of Portfolio Statistics 243
9.3
Chapter 8
8.1
9.4
251
A Single-Factor Security Market
The Single-Index Model
252
Issues in Testing the CAPM 304
The CAPM and the Investment Industry
305
306–314
Arbitrage Pricing Theory
and Multifactor Models of Risk
and Return 315
254
10.1 Multifactor Models: A Preview
316
Factor Models of Security Returns
10.2 Arbitrage Pricing Theory
Estimating the Single-Index Model 261
318
Arbitrage, Risk Arbitrage, and Equilibrium / Diversification
in a Single-Factor Security Market / Well-Diversified
Portfolios / The Security Market Line of the APT
The Security Characteristic Line for U.S. Steel / The
Explanatory Power of U.S. Steel’s SCL / The Estimate of
Alpha / The Estimate of Beta / Firm-Specific Risk
Individual Assets and the APT
Well-Diversified Portfolios in Practice
Typical Results from Index Model Regressions
8.4
294
Chapter 10
The Regression Equation of the Single-Index Model /
The Expected Return–Beta Relationship / Risk and
Covariance in the Single-Index Model / The Set of
Estimates Needed for the Single-Index Model / The Index
Model and Diversification
8.3
Assumptions and Extensions of the CAPM
End of Chapter Material
The Input List of the Markowitz Model / Systematic
versus Firm-Specific Risk
8.2
283
Identical Input Lists / Risk-Free Borrowing and the
Zero-Beta Model / Labor Income and Other Nontraded
Assets / A Multiperiod Model and Hedge Portfolios / A
Consumption-Based CAPM / Liquidity and the CAPM
Appendix A: A Spreadsheet Model for Efficient
Diversification 238
Index Models
The Capital Asset Pricing Model
The Market Portfolio / The Passive Strategy Is Efficient
/ The Risk Premium of the Market Portfolio / Expected
Returns on Individual Securities / The Security Market
Line / The CAPM and the Single-Index Market
7.5Risk Pooling, Risk Sharing, and Time
Diversification 225
End of Chapter Material
277–282
The Industry Version of the Index Model 265
10.3 The APT and the CAPM 326
Predicting Betas
10.4 A Multifactor APT
x
326
Contents
10.5 The Fama-French (FF) Three-Factor Model 329
Limits to Arbitrage
Estimating and Implementing a Three-Factor SML /
Extensions of the Three-Factor Model: A First Look /
Smart Betas and Multifactor Models
End of Chapter Material
Fundamental Risk / Implementation Costs / Model Risk
Limits to Arbitrage and the Law of One Price
“Siamese Twin” Companies / Equity Carve-Outs /
Closed-End Funds
334–340
Bubbles and Behavioral Economics / Evaluating the
Behavioral Critique
Chapter 11
The Efficient Market Hypothesis 341
12.2 Technical Analysis and Behavioral Finance 394
11.1 Random Walks and Efficient Markets 342
Trends and Corrections
Competition as the Source of Efficiency / Versions of the
Efficient Market Hypothesis
11.2 Implications of the EMH
Momentum and Moving Averages / Relative Strength /
Breadth
346
Machine Leaning and Technical Analysis / Sentiment
Indicators
Technical Analysis / Fundamental Analysis / Active versus
Passive Portfolio Management / The Role of Portfolio
Management in an Efficient Market / Resource Allocation
11.3 Event Studies
Trin Statistic / Confidence Index / Short Interest / Put/
Call Ratio
351
11.4 Are Markets Efficient?
A Warning
354
End of Chapter Material
The Issues
401–408
Chapter 13
The Magnitude Issue / The Selection Bias Issue / The
Lucky Event Issue
Empirical Evidence on Security Returns 409
Weak-Form Tests: Patterns in Stock Returns
13.1 Two-Pass Tests of Asset Pricing
Returns over Short Horizons / Returns over Long Horizons
410
Testing the Single-Factor SML
Predictors of Broad Market Returns / Semistrong Tests:
Market Anomalies
Setting Up the Sample Data / Estimating the SCL /
Estimating the SML
The Small-Firm Effect / The Neglected-Firm and
Liquidity Effects / Book-to-Market Ratios / Post–
Earnings-Announcement Price Drift / Other Predictors
of Stock Returns
13.2 Tests of the Multifactor Models
Strong-Form Tests: Inside Information / Interpreting the
Anomalies
13.3 Fama-French-Type Factor Models
The Market Index / Measurement Error in Beta
13.4 Liquidity and Asset Pricing 427
Bubbles and Market Efficiency
13.5 The Equity Premium Puzzle
11.5 Mutual Fund and Analyst Performance 368
429
Expected versus Realized Returns / Survivorship Bias /
Extensions to the CAPM May Mitigate the Equity Premium
Puzzle / Liquidity and the Equity Premium Puzzle /
Behavioral Explanations of the Equity Premium Puzzle
Stock Market Analysts / Mutual Fund Managers / So, Are
Markets Efficient?
374–380
Chapter 12
End of Chapter Material
Behavioral Finance and Technical
Analysis 381
12.1 The Behavioral Critique
419
Size and B/M as Risk Factors / Behavioral Explanations /
Momentum: A Fourth Factor / The Factor Zoo
Risk Premiums or Inefficiencies? / Anomalies or Data
Mining? / Anomalies over Time
End of Chapter Material
415
Labor Income / Private (Nontraded) Business /
Macroeconomic Risk Factors
435–438
PART IV
Fixed-Income Securities 439
382
Information Processing
Chapter 14
Limited Attention, Underreaction, and Overreaction /
Overconfidence / Conservatism / Confirmation Bias /
Extrapolation and Pattern Recognition
Bond Prices and Yields
14.1 Bond Characteristics
Behavioral Biases
439
440
Treasury Bonds and Notes
Framing / Mental Accounting / Regret Avoidance /
Affect and Feelings / Prospect Theory
Accrued Interest and Quoted Bond Prices
xi
Contents
16.2 Convexity
Corporate Bonds
Call Provisions on Corporate Bonds / Convertible
Bonds / Puttable Bonds / Floating-Rate Bonds
Preferred Stock / Other Domestic Issuers / International
Bonds / Innovation in the Bond Market
16.3 Passive Bond Management 527
Maturity / Inverse Floaters / Asset-Backed Bonds /
Catastrophe Bonds / Indexed Bonds
14.2 Bond Pricing
Bond-Index Funds / Immunization / Cash Flow Matching
and Dedication / Other Problems with Conventional
Immunization
446
16.4 Active Bond Management
Bond Pricing between Coupon Dates
14.3 Bond Yields
536
Sources of Potential Profit / Horizon Analysis
451
End of Chapter Material
Yield to Maturity / Yield to Call / Realized Compound
Return versus Yield to Maturity
14.4 Bond Prices over Time
14.5 Default Risk and Bond Pricing
Security Analysis 551
463
Chapter 17
Junk Bonds / Determinants of Bond Safety / Bond
Indentures
Macroeconomic and Industry Analysis
Sinking Funds / Subordination of Further Debt /
­Dividend Restrictions / Collateral
17.1 The Global Economy
551
551
17.2 The Domestic Macroeconomy
Yield to Maturity and Default Risk / Credit Default
Swaps / Credit Risk and Collateralized Debt
Obligations
End of Chapter Material
539–550
PART V
458
Yield to Maturity versus Holding-Period Return / ZeroCoupon Bonds and Treasury Strips / After-Tax Returns
554
Key Economic Indicators
Gross Domestic Product / Employment / Inflation /
Interest Rates / Budget Deficit / Sentiment
474–480
Chapter 15
17.3 Demand and Supply Shocks
556
17.4 Federal Government Policy
557
Fiscal Policy / Monetary Policy / Supply-Side Policies
The Term Structure of Interest Rates 481
15.1 The Yield Curve
519
Why Do Investors Like Convexity? / Duration and
Convexity of Callable Bonds / Duration and Convexity of
Mortgage-Backed Securities
17.5 Business Cycles 560
481
The Business Cycle / Economic Indicators
Bond Pricing
15.2 The Yield Curve and Future Interest Rates
17.6 Industry Analysis 564
484
Defining an Industry / Sensitivity to the Business Cycle /
Sector Rotation / Industry Life Cycles
The Yield Curve under Certainty / Holding-Period
Returns / Forward Rates
15.3 Interest Rate Uncertainty and Forward Rates 489
Start-Up Stage / Consolidation Stage / Maturity Stage /
Relative Decline
15.4 Theories of the Term Structure
Industry Structure and Performance
491
The Expectations Hypothesis / Liquidity Preference
Theory / Market Segmentation
15.5 Interpreting the Term Structure 495
Threat of Entry / Rivalry between Existing Competitors /
Pressure from Substitute Products / Bargaining Power
of Buyers / Bargaining Power of Suppliers
15.6 Forward Rates as Forward Contracts 498
End of Chapter Material
End of Chapter Material
500–508
Chapter 18
Equity Valuation Models
Chapter 16
Managing Bond Portfolios 509
16.1 Interest Rate Risk
574–582
18.1 Valuation by Comparables
583
583
Limitations of Book Value
510
18.2 Intrinsic Value versus Market Price 585
Interest Rate Sensitivity / Duration / What Determines
Duration?
18.3 Dividend Discount Models
Rule 1 for Duration / Rule 2 for Duration / Rule 3 for
Duration / Rule 4 for Duration / Rule 5 for Duration
587
The Constant-Growth DDM / Convergence of Price
to Intrinsic Value / Stock Prices and Investment
xii
Contents
Opportunities / Life Cycles and Multistage Growth
Models / Multistage Growth Models
18.4 The Price–Earnings Ratio 601
The Price–Earnings Ratio and Growth Opportunities /
P/E Ratios and Stock Risk / Pitfalls in P/E Analysis / The
Cyclically Adjusted P/E Ratio / Combining P/E Analysis
and the DDM / Other Comparative Valuation Ratios
Price-to-Book Ratio / Price-to-Cash-Flow Ratio /
Price-to-Sales Ratio / Be Creative
18.5 Free Cash Flow Valuation Approaches 611
Comparing the Valuation Models / The Problem with
DCF Models
18.6 The Aggregate Stock Market 615
End of Chapter Material 617–628
The Options Clearing Corporation / Other
Listed Options
Index Options / Futures Options / Foreign Currency
Options / Interest Rate Options
20.2 Values of Options at Expiration
20.3 Option Strategies
20.4 The Put-Call Parity Relationship
20.5 Option-like Securities
691
694
Callable Bonds / Convertible Securities /
Warrants / Collateralized Loans / Levered Equity
and Risky Debt
20.6 Financial Engineering 700
Financial Statement Analysis 629
20.7 Exotic Options
19.1 The Major Financial Statements 629
The Income Statement / The Balance Sheet /
The Statement of Cash Flows
19.2 Measuring Firm Performance 634
19.3 Profitability Measures 635
Return on Assets, ROA / Return on Capital, ROC /
Return on Equity, ROE / Financial Leverage and ROE /
Economic Value Added
19.4 Ratio Analysis 639
Decomposition of ROE / Turnover and Other Asset
Utilization Ratios / Liquidity Ratios / Market Price
Ratios: Growth versus Value / Choosing a Benchmark
19.5 An Illustration of Financial Statement Analysis 650
19.6 Comparability Problems 652
Inventor y Valuation / Depreciation / Inflation and
Interest Expense / Fair Value Accounting / Quality of
Earnings and Accounting Practices / International
Accounting Conventions
19.7 Value Investing: The Graham Technique 658
702
Asian Options / Barrier Options / Lookback
Options / Currency-Translated Options / Digital
Options
End of Chapter Material
703–714
Chapter 21
Option Valuation
21.1 Option Valuation: Introduction
715
715
Intrinsic and Time Values / Determinants of Option
Values
21.2 Restrictions on Option Values
719
Restrictions on the Value of a Call Option /
Early Exercise and Dividends / Early Exercise of
American Puts
21.3 Binomial Option Pricing
722
Two-State Option Pricing / Generalizing the
Two-State Approach / Making the Valuation Model
Practical
659–672
21.4 Black-Scholes Option Valuation
730
The Black-Scholes Formula / Implied Volatility /
Dividends and Call Option Valuation / Put
Option Valuation / Dividends and Put Option
Valuation
PART VI
Options, Futures, and Other
Derivatives 673
21.5 Using the Black-Scholes Formula 738
Hedge Ratios and the Black-Scholes Formula /
Portfolio Insurance / Option Pricing and the
Financial Crisis / Option Pricing and Portfolio
Theory / Hedging Bets on Mispriced
Options
Chapter 20
Options Markets: Introduction 673
20.1 The Option Contract
683
Protective Put / Covered Calls / Straddle / Spreads /
Collars
Chapter 19
End of Chapter Material
679
Call Options / Put Options / Option versus Stock
Investments
673
21.6 Empirical Evidence on Option Pricing 750
Options Trading / American versus European
Options / Adjustments in Option Contract Terms /
End of Chapter Material
xiii
751–762
Contents
Chapter 22
Risk-Adjusted Performance Measures / The Sharpe Ratio
for Overall Portfolios
Futures Markets 763
The M2 Measure and the Sharpe Ratio
22.1 The Futures Contract 763
The Basics of Futures Contracts / Existing Contracts
22.2 Trading Mechanics 769
The Clearinghouse and Open Interest / The Margin Account
and Marking to Market / The Convergence Property / Cash
versus Actual Delivery / Regulations / Taxation
22.3 Futures Markets Strategies 773
Hedging and Speculation / Basis Risk and Hedging
22.4 Futures Prices 777
The Spot-Futures Parity Theorem / Spreads / Forward
versus Futures Pricing
22.5 Futures Prices versus Expected Spot Prices 784
Expectations Hypothesis / Normal Backwardation /
Contango / Modern Portfolio Theory
End of Chapter Material 786–790
The Treynor Ratio / The Information Ratio / The Role
of Alpha in Performance Measures / Implementing
Performance Measurement: An Example / Realized
Returns versus Expected Returns / Selection Bias and
Portfolio Evaluation
24.2 Style Analysis
839
24.3Performance Measurement with Changing Portfolio
Composition 841
Performance Manipulation and the Morningstar RiskAdjusted Rating
24.4 Market Timing
845
The Potential Value of Market Timing / Valuing Market
Timing as a Call Option / The Value of Imperfect
Forecasting
24.5 Performance Attribution Procedures
Chapter 23
850
Asset Allocation Decisions / Sector and Security Selection
Decisions / Summing Up Component Contributions
Futures, Swaps, and Risk Management 791
End of Chapter Material
23.1 Foreign Exchange Futures 791
The Markets / Interest Rate Parity / Direct versus Indirect
Quotes / Using Futures to Manage Exchange Rate Risk
23.2 Stock-Index Futures 799
The Contracts / Creating Synthetic Stock Positions: An
Asset Allocation Tool / Index Arbitrage / Using Index
Futures to Hedge Market Risk
23.3 Interest Rate Futures 804
Hedging Interest Rate Risk
23.4 Swaps 806
Swaps and Balance Sheet Restructuring / The Swap
Dealer / Other Interest Rate Contracts / Swap Pricing /
Credit Risk in the Swap Market / Credit Default Swaps
23.5 Commodity Futures Pricing 813
Pricing with Storage Costs / Discounted Cash Flow
Analysis for Commodity Futures
End of Chapter Material 817–826
855–866
Chapter 25
International Diversification 867
25.1 Global Markets for Equities
867
Developed Countries / Emerging Markets / Market
Capitalization and GDP / Home-Country Bias
25.2Exchange Rate Risk and International
Diversification 871
Exchange Rate Risk / Investment Risk in International
Markets / International Diversification / Are Benefits
from International Diversification Preserved in
Bear Markets?
25.3 Political Risk
882
25.4International Investing and Performance
Attribution 885
Constructing a Benchmark Portfolio of Foreign Assets /
Performance Attribution
PART VII
End of Chapter Material
Applied Portfolio
Management 827
889–894
Chapter 26
Alternative Assets 895
26.1 Alternative Assets 896
Chapter 24
The Alternative Asset Universe
Portfolio Performance Evaluation 827
Hedge Funds / Private Equity / Real Assets / Structured
Products
24.1The Conventional Theory of Performance
Evaluation 827
Alternative Assets versus Traditional Assets
Average Rates of Return / Time-Weighted Returns versus
Dollar-Weighted Returns / Adjusting Returns for Risk /
Transparency / Investors / Investment Strategies /
Liquidity / Investment Horizon / Fee Structure
xiv
Contents
27.4Treynor-Black versus Black-Litterman: Complements,
Not Substitutes 951
Role of Alternative Assets in Diversified Portfolios /
Growth of Alternative Assets
26.2 Hedge Funds
900
The BL Model as Icing on the TB Cake / Why Not
Replace the Entire TB Cake with the BL Icing?
Hedge Fund Strategies / Statistical Arbitrage / HighFrequency Strategies /
27.5 The Value of Active Management
Electronic News Feeds / Cross-Market Arbitrage /
Electronic Market Making / Electronic “Front Running”
Portable Alpha
26.3 Venture Capital and Angel Investors
27.6 Concluding Remarks on Active Management
905
End of Chapter Material
Angel Investors / Venture Capital / Venture Capital and
Investment Stages / Fund Life Cycle / Private Equity
Valuation / Venture Syndication / Venture Capital and
Innovation
26.4 Leveraged Buyout Funds
Appendix B: The General Black-Litterman Model 957
Chapter 28
913
Investment Policy and the Framework of the
CFA Institute 959
26.5Performance Measurement for Alternative
Investment Funds 916
28.1 The Investment Management Process 960
28.2 Investor Objectives 962
Liquidity and Performance
Individual Investors
Liquidity and Hedge Fund Performance / Liquidity and
Private Equity
Personal Trusts / Mutual Funds / Pension Funds /
Endowment Funds / Life Insurance Companies /
Non–Life Insurance Companies / Banks
Survivorship Bias and Backfill Bias / Tail Events /
Historical Hedge Fund Performance / Style Analysis /
Historical Performance of Private Equity
28.3 Investor Constraints 966
Liquidity / Investment Horizon / Regulations / Tax
Considerations / Unique Needs
Grandstanding / Industry Specialization
Efficient Frontier
26.6 Fee Structure in Alternative Investments
28.4 Policy Statements
926
28.5 Asset Allocation
973
Top-Down Asset Allocation for Institutional Investors /
Monitoring and Revising the Portfolio
928–934
28.6 Managing Portfolios of Individual Investors 975
Chapter 27
Investment in Residence / Saving for Retirement and
the Assumption of Risk / Retirement Planning Models /
Target Date Funds / Tax Sheltering and Asset Allocation
The Theory of Active Portfolio
Management 935
The Tax-Deferral Option / Tax-Protected Retirement
Plans / Deferred Annuities / Variable and Universal
Life Insurance
935
Forecasts of Alpha Values and Extreme Portfolio Weights /
Restriction of Tracking Risk
28.7 Pension Funds 981
27.2The Treynor-Black Model and Forecast
Precision 942
Defined Contribution Plans / Defined Benefit Plans /
Pension Investment Strategies
Adjusting Forecasts for the Precision of Alpha /
Distribution of Alpha Values / Organizational Structure
and Performance
27.3 The Black-Litterman Model
969
Sample Policy Statements for Individual Investors
Incentive Fees / Private Equity Chasing Waterfalls /
Funds of Funds
27.1 Optimal Portfolios and Alpha Values
955
955–956
Appendix A: Forecasts and Realizations of Alpha 956
Leveraged Buyout Firm Structure / The Deal / Exits /
Leveraged Buyouts and Innovation
End of Chapter Material
953
A Model for the Estimation of Potential Fees /
Results from the Distribution of Actual Information
Ratios / Results from Distribution of Actual Forecasts
Investing in Equities
End of Chapter Material
984–994
946
Black-Litterman Asset Allocation Decision / Step 1: The
Covariance Matrix from Historical Data / Step 2:
Determination of a Baseline Forecast / Step 3:
Integrating the Manager’s Private Views / Step 4:
Revised (Posterior) Expectations / Step 5: Portfolio
Optimization
REFERENCES TO CFA PROBLEMS 995
GLOSSARY
G-1
NAME INDEX I
SUBJECT INDEX I-4
NOTATION, FORMULAS F-1
xv
Preface
T
he past three decades witnessed rapid and profound change in the investments industry as well
as a financial crisis of historic magnitude. The vast
expansion of financial markets during this period was due
in part to innovations in securitization and credit enhancement that gave birth to new trading strategies. These
strategies were in turn made feasible by developments in
communication and information technology, as well as by
advances in the theory of investments.
Yet the financial crisis of 2008–2009 also was rooted in
the cracks of these developments. Many of the innovations
in security design facilitated high leverage and an exaggerated notion of the efficacy of risk transfer strategies. This
engendered complacency about risk that was coupled with
relaxation of regulation as well as reduced transparency,
masking the precarious condition of many big players in
the system. Of necessity, our text has evolved along with
financial markets and their influence on world events.
Investments, Thirteenth Edition, is intended primarily as a textbook for courses in investment analysis. Our
guiding principle has been to present the material in a
framework that is organized by a central core of consistent
fundamental principles. We attempt to strip away unnecessary mathematical and technical detail, and we have
concentrated on providing the intuition that may guide
students and practitioners as they confront new ideas and
challenges in their professional lives.
This text will introduce you to major issues currently of
concern to all investors. It can give you the skills to assess
watershed current issues and debates covered by both the popular media and more-specialized finance journals. Whether
you plan to become an investment professional, or simply a
sophisticated individual investor, you will find these skills
essential, especially in today’s rapidly evolving environment.
Our primary goal is to present material of p­ ractical value,
but all three of us have spent our careers as researchers in
financial economics and find virtually all of the material
in this book to be of great intellectual interest. The capital
asset pricing model, the arbitrage pricing model, the efficient markets hypothesis, the option-­pricing model, and the
other centerpieces of modern financial theory are as much
intellectually engaging subjects as they are of immense
practical importance for the sophisticated investor.
In our effort to link theory to practice, we also have
attempted to make our approach consistent with that of
the CFA Institute. In addition to fostering research in
finance, the CFA Institute administers an education and
certification program to candidates seeking designation
as a Chartered Financial Analyst (CFA). The CFA curriculum represents the consensus of a committee of distinguished scholars and practitioners regarding the core of
knowledge required by the investment professional.
Many features of this text make it consistent with and
relevant to the CFA curriculum. Questions adapted from
past CFA exams appear at the end of nearly every chapter,
and references are listed at the end of the book. Chapter 3
includes excerpts from the “Code of Ethics and Standards
of Professional Conduct” of the CFA Institute. Chapter 28,
which discusses investors and the investment process,
presents the CFA Institute’s framework for systematically
relating investor objectives and constraints to ultimate
investment policy. End-of-chapter problems also include
questions from test-prep leader Kaplan Schweser.
In the Thirteenth Edition, we have continued our systematic presentation of Excel spreadsheets that will allow
you to explore concepts more deeply. These spreadsheets,
available in Connect and on the student resources site
(www.mhhe.com/Bodie13e), provide a taste of the sophisticated analytic tools available to professional investors.
UNDERLYING PHILOSOPHY
While the financial environment is constantly evolving,
many basic principles remain important. We believe that
xvi
Preface
fundamental principles should organize and motivate all
study and that attention to these few central ideas can simplify the study of otherwise difficult material. These principles are crucial to understanding the securities traded in
financial markets and in understanding new securities that
will be introduced in the future, as well as their effects on
global markets. For this reason, we have made this book thematic, meaning we never offer rules of thumb without reference to the central tenets of the modern approach to finance.
The common theme unifying this book is that security
markets are nearly efficient, meaning most securities are
usually priced appropriately given their risk and return
attributes. Free lunches are rarely found in markets as
competitive as the financial market. This simple observation is, nevertheless, remarkably powerful in its implications for the design of investment strategies; as a result, our
discussions of strategy are always guided by the implications of the efficient markets hypothesis. While the degree
of market efficiency is, and always will be, a matter of
debate (in fact we devote a full chapter to the behavioral
challenge to the efficient market hypothesis), we hope our
discussions throughout the book convey a good dose of
healthy skepticism concerning much conventional wisdom.
a bank account, only then considering how much to invest
in something riskier that might offer a higher expected
return. The logical step at this point is to consider risky
asset classes, such as stocks, bonds, or real estate. This
is an asset allocation decision. S
­ econd, asset allocation
is the primary determinant of the risk–return profile
of the investment portfolio, and so it deserves primary
attention in a study of investment policy.
3. This text offers a broad and deep treatment of
futures, options, and other derivative security
­markets. These markets are both crucial and integral to the financial universe. Your only choice is to
become conversant in these markets—whether you are
to be a finance professional or simply a sophisticated
individual investor.
NEW IN THE THIRTEENTH EDITION
The following is a guide to changes in the Thirteenth Edition. This is not an exhaustive road map, but instead is
meant to provide an overview of substantial additions and
changes to coverage from the last edition of the text.
Chapter 1 The Investment Environment
The chapter addresses recent controversies about stakeholder capitalism and ESG investing. It also further
expands its treatment of Fintech, cryptocurrencies, and
other digital assets.
Distinctive Themes
Investments is organized around several important themes:
1. The central theme is the near-informational-efficiency
of well-developed security markets, such as those in the
United States, and the general awareness that competitive markets do not offer “free lunches” to participants.
A second theme is the risk–return trade-off. This
too is a no-free-lunch notion, holding that in competitive security markets, higher expected returns come
only at a price: the need to bear greater investment
risk. However, this notion leaves several questions unanswered. How should one measure the risk of an asset? What should be the quantitative trade-off between
risk (properly measured) and expected return? The approach we present to these issues is known as modern
portfolio theory, which is another organizing principle
of this book. Modern portfolio theory focuses on the
techniques and implications of efficient diversification,
and we devote considerable attention to the effect of
diversification on portfolio risk as well as the implications of efficient diversification for the proper measurement of risk and the risk–return relationship.
2. This text places great emphasis on asset ­allocation.
We prefer this emphasis for two important r­ easons. First,
it corresponds to the procedure that most i­ ndividuals actually follow. Typically, you start with all of your money in
Chapter 2 Asset Classes and Financial
Instruments
The chapter addresses changes in markets, most notably
the replacement of LIBOR with new rates such as SOFR.
Chapter 3 How Securities Are Traded
New sections on SPACs, order internalization, and the
GameStop squeeze have been added to the chapter.
Chapter 5 Risk, Return, and the Historical Record
In addition to thorough updating, this chapter has been
extensively reorganized to improve flow and understanding.
Chapter 10 Arbitrage Pricing Theory and Multifactor Models of Risk and Return
The discussion of multifactor models has been updated
and expanded, with a focus on the adoption of new variants such as the Fama-French five-factor model.
Chapter 11 The Efficient Market Hypothesis
The debate on efficient markets has been further developed. The chapter now includes a discussion of Shiller’s
fads hypothesis, as well as new material on extra-market
risk factors, and a discussion of the challenges posed by
xvii
Preface
data snooping for the interpretation of empirical evidence
on risk and return.
an overview of the types of securities traded in those markets, and explain how and where securities are traded. We
also discuss in depth mutual funds and other investment
companies, which have become an increasingly important
means of investing for individual investors. Perhaps most
important, we address how financial markets can influence
all aspects of the global economy, as in 2008.
The material presented in Part One should make it possible for instructors to assign term projects early in the course.
These projects might require the student to analyze in detail
a particular group of securities. Many instructors like to
involve their students in some sort of investment game, and
the material in these chapters will facilitate this process.
Parts Two and Three contain the core of modern
portfolio theory. Chapter 5 is a general discussion of risk
and return, making the general point that historical returns
on broad asset classes are consistent with a risk–return
trade-off and examining the distribution of stock returns.
We focus more closely in Chapter 6 on how to describe
investors’ risk preferences and how they bear on asset
allocation. In the next two chapters, we turn to portfolio
optimization (Chapter 7) and its implementation using
index models (Chapter 8).
After our treatment of modern portfolio theory in Part
Two, we investigate in Part Three the implications of that
theory for the equilibrium structure of expected rates of
return on risky assets. Chapter 9 treats the capital asset
pricing model and Chapter 10 covers multifactor descriptions of risk and the arbitrage pricing theory. Chapter 11
covers the efficient market hypothesis, including its rationale as well as evidence that supports the hypothesis and
challenges it. Chapter 12 is devoted to the behavioral critique of market rationality. Finally, we conclude Part Three
with Chapter 13 on empirical evidence on security pricing.
This chapter contains evidence concerning the risk–return
relationship, as well as liquidity effects on asset pricing.
Part Four is the first of three parts on security valuation. This part treats fixed-income securities—bond
pricing (Chapter 14), term structure relationships (Chapter 15), and interest-rate risk management (Chapter 16).
Parts Five and Six deal with equity securities and derivative securities. For a course emphasizing security analysis
and excluding portfolio theory, one may proceed directly
from Part One to Part Four with no loss in continuity.
Finally, Part Seven considers several topics important
for portfolio managers, including performance evaluation,
international diversification, active management, and
practical issues in the process of portfolio management.
This part also contains a chapter on alternative assets,
with an emphasis on hedge funds and private equity.
Chapter 12 Behavioral Finance and Technical
Analysis
The material on behavioral finance now includes confirmation bias. The section on technical analysis includes a
new discussion of machine learning.
Chapter 13 Empirical Evidence on Security
Returns
This chapter has been extensively rewritten. Older material has been replaced with treatments of issues such as
the so-called factor zoo, appropriate criteria for accepting
a new risk factor, and the implications of disaster risk for
the equity risk premium.
Chapter 15 The Term Structure of Interest Rates
Market segmentation is now included as another potential
explanation of the term structure.
Chapter 17 Macroeconomic and Industry Analysis
The discussion of the macroeconomy has been updated to
include lessons learned during the COVID-19 pandemic,
particularly the implications of supply side and supply
chain issues for inflation.
Chapter 23 Futures, Swaps, and Risk
Management
The treatment of interest rate swaps has been updated to
account for the transition away from the LIBOR rate.
Chapter 26 Alternative Assets
This chapter, originally entitled Hedge Funds now has a
wider focus on Alternative Assets. It includes substantial
coverage of private equity, including angel investing, venture capital, and leveraged buyouts.
Chapter 28 Investment Policy and the Framework of the CFA Institute
This chapter has been substantially reorganized, in particular, its treatment of tax sheltering and top-down asset
allocation.
ORGANIZATION AND CONTENT
The text is composed of seven sections that are fairly
independent and may be studied in a variety of sequences.
Because there is enough material in the book for a
­two-semester course, clearly a one-semester course will
require the instructor to decide which parts to include.
Part One is introductory and contains important institutional material focusing on the financial environment. We
discuss the major players in the financial markets, provide
xviii
Distinctive Features
This book contains several features designed to
make it easy for students to understand, ­absorb, and
apply the concepts and techniques presented.
Confirming Pages
288
CONCEPT CHECKS
PART V
Data from the last 95 years for the broad U.S. equity market yield the following statistics: average excess return,
8.9%; standard deviation, 20.3%.
a. To the extent that these averages approximated investor expectations for the period, what must have been
the average coefficient of risk aversion?
Confirming Pages
b. If the coefficient of risk aversion were actually 3.5, what risk premium would have been consistent with the
market’s historical standard deviation?
Expected Returns on Individual Securities
The CAPM is built on the insight that the appropriate risk premium on an asset will be
determined by its contribution to the risk of investors’ overall portfolios. Portfolio risk is
what matters to investors and is what governs the risk premiums they demand.
Remember that in the CAPM, all investors use the same input list, that is, the same estimates of expected returns, variances, and covariances, and, therefore, all end up using the
market as their optimal risky portfolio. To calculate the variance of the market portfolio,
we use the bordered covariance matrix with the market portfolio weights, as discussed in
Chapter 7. We highlight GE in this depiction of the n stocks in the market portfolio so that
we can measure the contribution of GE to the risk of the market portfolio.
Recall that we calculate the variance of the portfolio by summing over all the elements
of the covariance matrix, first multiplying each element by the portfolio weights from the
row and the column. The contribution of one stock to portfolio variance therefore can be
expressed as the sum of all the covariance terms in the column corresponding to the stock,
where each covariance is first multiplied by both the stock’s weight from its row and the
weight from its column.5
Security Analysis
Example 18.3
Equilibrium in Capital Markets
Concept Check 9.2
A unique feature of this book! These selftest questions and problems found in the
body of the text enable the students to
determine whether they’ve understood
the preceding material. Detailed solutions
are provided at the end of each chapter.
590
PART III
The Constant-Growth DDM
NUMBERED EXAMPLES
High Flyer Industries has just paid its annual dividend of $3 per share. The dividend is
expected to grow at a constant rate of 8% indefinitely. The beta of High Flyer stock is 1.0,
the risk-free rate is 6%, and the market risk premium is 8%. What is the intrinsic value of the
stock? What would be your estimate of intrinsic value if you believed that the stock was
riskier, with a beta of 1.25?
Because a $3 dividend has just been paid and the growth rate of dividends is 8%, the
forecast for the year-end dividend is $3 × 1.08 = $3.24. The market capitalization rate (using
the CAPM) is 6% + 1.0 × 8% = 14%. Therefore, the value of the stock is
are integrated throughout chapters.
Using the worked-out solutions to these
Portfolio
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w
w
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w
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to answer
concrete
questions.
1
$3.24
D1
V0 = _____
= _______ = $54
k − g .14 − .08
If the stock is perceived to be riskier, its value must be lower. At the higher beta, the
market capitalization rate is 6% + 1.25 × 8% = 16%, and the stock is worth only
$3.24
_______
= $40.50
2
GE
n
1
1
1
1
2
1
GE
1
n
2
2
1
2
2
2
GE
2
n
GE
GE
n
n
1
1
GE
n
2
2
GE
n
GE
GE
GE
n
n
n
Thus, the contribution of GE’s stock to the variance of the market portfolio is
.16 − .08
w GE[w 1Cov(R 1, R GE) + w 2Cov(R 2, R GE) + · · · + w GE Cov(R GE, R GE) + · · ·
+ w nCov(R n , R GE)]
(9.3)
5
WORDS FROM THE
STREET BOXES
What Level of Risk Is Right for You?
No risk, no reward. Most people intuitively understand that they
have to bear some risk to achieve an acceptable return on their
investment portfolios.
But how much risk is right for you? If your investments turn
sour, you may put at jeopardy your ability to retire, to pay for
bod12665_ch09_283-314.indd 288
your kid’s college education, or to weather an unexpected
need for cash. These worst-case scenarios focus our attention
on how to manage our exposure to uncertainty.
Assessing—and quantifying—risk aversion is, to put it mildly,
difficult. It requires confronting at least these two big questions.
First, how much investment risk can you afford to take?
If you have a steady high-paying job, for example, you have
greater ability to withstand investment losses. Conversely, if
you are close to retirement, you have less ability to adjust your
lifestyle in response to bad investment outcomes.
Second, you need to think about your personality and
decide how much risk you can tolerate. At what point will you
be unable to sleep at night?
To help clients quantify their risk aversion, many financial
firms have designed quizzes to help people determine whether
they are conservative, moderate, or aggressive investors.
These quizzes try to get at clients’ attitudes toward risk and
their capacity to absorb investment losses.
Here is a sample of the sort of questions that can shed light
on an investor’s risk tolerance.
Short
articles and financial coverage
1. The larger its expected dividend per share.
adapted
from
business
periodicals,
such
2. The lower
the market
capitalization
rate, k.
3. The Wall
higher the
expectedJournal,
growth rate ofare
dividends.
as The
Street
included
Another implication
of the constant-growth
model is
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ingrow
boxes
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articles
at the same rate as dividends. To see this, suppose Steady State stock is selling at its
intrinsic
value of for
$57.14,
so that V0 = P0.relevance
Then
are
chosen
real-world
and
D1
clarity of presentation. P0 = _____
k−g
An alternative approach would be to measure GE’s contribution to market variance as the sum of the elements
in the row and the column corresponding to GE. In this case, GE’s contribution would be twice the sum in
Equation 9.3. The approach that we take allocates contributions to portfolio risk among securities in a conConfirming Pages
venient manner in that the sum of the contributions of each stock equals the total portfolio variance, whereas
the alternative measure of contribution would sum to twice the portfolio variance. This results from a type of
double-counting because adding both the rows and the columns for each stock would result in each entry in the
matrix being added twice. Using either approach, GE’s contribution to the variance of the market return would
be directly proportional to the covariance of its returns with the market.
WORDS FROM THE STREET
The constant-growth DDM is valid only when g is less than k. If dividends were
expected to grow forever at a rate faster than k, the value of the stock would be infinite. If
an analyst derives an estimate of g greater than k, that growth rate must be unsustainable
in the long run. The appropriate valuation model to use in this case is a multistage DDM
such as those discussed below.
The constant-growth DDM is so widely used by stock market analysts that it is worth
exploring some of its implications and limitations. The constant-growth rate DDM implies
that a stock’s value will be greater:
Notice that price is proportional to dividends. Therefore, next year, when the dividends
paid to Steady State stockholders are expected to be higher by g = 5%, price also should
increase by 5%. To confirm this, we can write
D2 = $4(1.05) = $4.20
D2
$4.20
P1 = _____
= ________ = $60.00
k − g .12 − .05
MEASURING YOUR RISK TOLERANCE
Circle the letter that corresponds to your answer.
1. The stock market fell by more than 30% in 2008. If you had
been holding a substantial stock investment in that year,
which of the following would you have done?
which is 5% higher than the current price of $57.14. To generalize,
a. Sold off the remainder of your investment before it had
the chance to fall further.
D2
D1(1 + g) _____
D1
= _________
=
(1 + g) = P0(1 + g)
P1 = _____
k−g
k−g
k−g
b. Stayed the course with neither redemptions nor
purchases.
c. Bought more stock, reasoning that the market is now
cheaper and therefore offers better deals.
2. The value of one of the funds in your 401(k) plan (your primary source of retirement savings) increased 30% last year.
What will you do?
a. Move your funds into a money market account in case
the price gains reverse.
4. At the end of the month, you find yourself:
a. Short of cash and impatiently waiting for your next
paycheck.
b. Not overspending your salary, but not saving very much.
06/07/22
01:25 PM
c. With a comfortable surplus of funds to put into
your savings account.
5. You are 30 years old and enrolling in your company’s
retirement plan, and you need to allocate your contributions across 3 funds: a money market account, a bond
fund, and a stock fund. Which of these allocations sounds
best to you?
a. Invest everything in a safe money-market fund.
b. Split your money evenly between the bond fund and
stock fund.
c. Put everything into the stock fund, reasoning that by the
time you retire, the year-to-year fluctuations in stock,
returns will have evened out.
6. You are a contestant on Let’s Make a Deal, and have just
won $1,000. But you can exchange the winnings for two
random payoffs. One is a coin flip with a payoff of $2,500
if the coin comes up heads. The other is a flip of two coins
with a payoff of $6,000 if both coins come up heads. What
will you do?
a. Keep the $1,000 in cash.
b. Choose the single coin toss.
c. Choose the double coin toss.
7. Suppose you have the opportunity to invest in a start-up
firm. If the firm is successful, you will multiply your investment by a factor of ten. But if it fails, you will lose everything.
You think the odds of success are around 20%. How much
would you be willing to invest in the start-up?
a. Nothing
b. 2 months’ salary
c. 6 months’ salary
8. Now imagine that to buy into the start-up you will need to
borrow money. Would you be willing to take out a $10,000
loan to make the investment?
a. No
b. Maybe
c. Yes
b. Sit tight and do nothing.
bod12665_ch18_583-628.indd
590
06/30/22 10:27 AM
xix
c. Put more of your assets into that fund, reasoning that its
value is clearly trending upward.
3. How would you describe your non-investment sources of
income (e.g., your salary)?
a. Highly uncertain
b. Moderately stable
c. Highly stable
SCORING YOUR RISK TOLERANCE
For each question, give yourself one point if you answered (a),
two points if you answered (b), and three points for a (c). The
higher your total score, the greater is your risk tolerance, or,
equivalently, the lower is your risk aversion.
Confirming Pages
Confirming Pages
EXCEL APPLICATIONS
The Thirteenth Edition features Excel
Spreadsheet
Applications with Excel513
C H A P T E R 1 6 Managing Bond Portfolios
questions. A sample spreadsheet is
Duration
presented in the text with an interactive
To measure the effective maturity of a bond making many payments, we average over
the maturity of each of the bond’s cash flows.
Frederickavailable
Macaulay called in
this Connect
average the
version
and on the
duration of the bond. Macaulay’s duration equals the weighted average of the times to
each coupon or principal payment, with student
weights relatedresources
to the “importance”site
of thatat
pay-www.mhhe
ment to the value of the bond. Specifically, the weight applied to each payment time is the
.com/Bodie13e.
proportion of the total value of the bond accounted
for by that payment, that is, the present
eXcel APPLICATIONS: Two–Security Model
T
Table 7.1. This spreadsheet is available in Connect or through
your course instructor.
he accompanying spreadsheet can be used to analyze
the return and risk of a portfolio of two risky assets. The
model calculates expected return and volatility for varying
weights of each security as well as the optimal risky and minimum-variance portfolios. Graphs are automatically generated
for various model inputs. The model allows you to specify a
target rate of return and solves for optimal complete portfolios
composed of the risk-free asset and the optimal risky portfolio. The spreadsheet is constructed using the two-security
return data (expressed as decimals, not percentages) from
A
B
C
D
E
3
1. Suppose your target expected rate of return is 11%.
a. What is the lowest-volatility portfolio that provides that
expected return?
b. What is the standard deviation of that portfolio?
c. What is the composition of that portfolio?
value of the payment divided by the bond price.
We define the weight, wt , associated with the cash flow made at time t (denoted CFt) as
F
CF t / (1 + y)t
w t = __________
Bond price
Asset Allocation Analysis: Risk and Return
2
Expected
Standard
Correlation
Return
Deviation
Coefficient
Covariance
0.08
0.12
0.3
0.0072
Expected
Standard
Reward to
3
4
Security 1
5
Security 2
0.13
0.2
T-Bill
0.05
0
8
Weight
Weight
9
Security 1
6
7
Security 2
Return
Deviation
Volatility
10
1
0
0.08000
0.12000
0.25000
11
0.9
0.1
0.08500
0.11559
0.30281
12
0.8
0.2
0.09000
0.11454
0.34922
13
0.7
0.3
0.09500
0.11696
0.38474
14
0.6
0.4
0.10000
0.12264
0.40771
Expected Return (%)
1
Excel Question
11
5
0
0
5
10
where y is the bond’s yield to maturity. The numerator on the right-hand side of this equation is the present value of the cash flow occurring at time t while the denominator is the
value of all the bond’s payments. These weights sum to 1.0 because the sum of the cash
flows discounted at the yield to maturity equals the bond price.
Using these values to calculate the weighted average of the times until the receipt of
each
of25the 30
bond’s
payments, we obtain Macaulay’s duration formula:
15
20
35
Standard Deviation (%)
T
D = ∑ t × wt
(16.1)
t=1
Confirming Pages
Spreadsheet 16.1 uses Equation 16.1 to find the durations of an 8% coupon and zeroor 5% per
1. Specify the return characteristics of all securities (expected returns, variances,
coupon bond, each with two years to maturity and yield to maturity of 10%,
covariances).
2. Establish the risky portfolio (asset allocation):
a. Calculate the optimal risky portfolio, P (Equation 7.13).
A
B
C
D
E
H A P T EPRusing
5 the
Risk,
Return,determined
and the Historical
161
b. Calculate the properties ofCportfolio
weights
in step Record
(a)
1
Time until
PV of CF
and Equations 7.2 and 7.3.
(Discount rate
2
Payment
3. Allocate funds between the risky portfolio and the risk-free asset (capital
Period
Cash Flow
3
(Years)
5% per period)
allocation):risk-free rate
expected shortfall (ES)
effective annual rate (EAR)
1
40
0.5
38.095
4 A. 8% coupon bond
KEY TERMS
conditional
tail expectation
annual percentage ratea.
(APR)
2
Calculaterisk
thepremium
fraction of the complete portfolio
allocated
to portfolio P (the risky
40
1.0
36.281
5
(CTE) 7.14).
nominal interest rate
portfolio)excess
and toreturn
T-bills (the risk-free asset) (Equation
3
40
1.5
34.554
6
lower partial
standard
risk
aversion
real interest rate
4
2.0
855.611
1040
b. Calculate
the
share of the complete portfolio
invested
in each asset and in
7
deviation (LPSD)
dividend yield
T-bills. normal distribution
Sum:
964.540
8
Sortino ratio
skew
scenario analysis
9
lognormal
distribution
mean rate of return Recall that ourkurtosis
two risky assets, the bond and stock
mutual
funds, are already diversi1
0.5
0.000
0
10 B. Zero-coupon
taildiversification
risk
variance
fied portfolios. The
within each of these portfolios must be credited for a
2
1.0
0.000
0
11
valuereduction
at risk (VaR)
standard deviation
good deal of the risk
compared to undiversified single securities. For example,
3
1.5
0.000
0
12
the standard deviation of the rate of return on an average stock in the last 10 years has
4
2.0
822.702
1000
13
been about 28% (see Figure 7.2). In contrast, the standard deviation of the S&P 500 in this
Sum:
822.702
14
period was considerably lower, around 17%. This is evidence of the importance of diversiArithmetic average of n returns: (r1 + r2 + · · · + rn ) / n
KEY EQUATIONS
15
fication within each asset class.
16 Semiannual int rate: 0.05
Geometric average of n returns: [(1 + r1) (1 + r2) · · · (1 + rn)]1/n − 1
17
Continuously compounded rate of return, rcc = ln(1 + Effective annual rate)
215
18 *Weight = Present value of each payment (column E) divided by the bond price.
Expected return: ∑ [prob(Scenario) × Return in scenario]
F
EXCEL EXHIBITS
Selected exhibits are set as Excel
spreadsheets, and the accompanying
files are available in Connect and on the
student resources site at www.mhhe
.com/Bodie13e.
________
bod12665_ch07_201-250.indd
1 + Nominal return
Real rate of return: ________________ − 1
1 + Inflation rate
Column sums
06/07/22subject
01:17 PM to rounding error.
3
Frederick Macaulay, Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields,
and Stock Prices in the United States Since 1856 (New York: National Bureau of Economic Research, 1938).
Real rate of return (continuous compounding): rnominal − Inflation rate
1. The Fisher equation tells us that the real interest rate approximately equals the nominal rate minus
the inflation rate. Suppose the inflation rate increases from 3% to 5%. Does the Fisher equation
imply that this increase will result in a fall in the real rate of interest? Explain.
2. You’ve just stumbled on a new dataset that enables you to compute historical rates of return on
U.S. stocks all the way back to 1880. What are the advantages and disadvantages in using these
data to help estimate the expected rate of return on U.S. stocks over the coming year?
3. The Narnian stock market had a rate of return of 45% last year, but the inflation rate was 30%.
What was the real rate of return to Narnian investors?
PROBLEM SETS
PROBLEM SETS
bod12665_ch16_509-550.indd
308
513
PART III
4. You have $5,000 to invest for the next year and are considering three alternatives:
a. A money market fund with an average maturity of 30 days offering a current yield of 3% per year.
b. A 1-year savings deposit at a bank offering an interest rate of 4%.
c. A 20-year U.S. Treasury bond offering a yield to maturity of 5% per year.
What role does your forecast of future interest rates play in your decisions?
5. Use Figure 5.1 in the text to analyze the effect of the following on the level of real interest rates:
161
06/25/22 08:50 AM
1.5
1.0
What would be the fair return for each company according to the capital asset pricing model (CAPM)?
EXAM PREP QUESTIONS
bod12665_ch05_125-166.indd
Confirming Pages
We strongly believe that practice in solving
problems is critical to understanding investments, so each chapter provides a good
Equilibrium in Capital Markets
variety of problems. Select problems and
4. Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%.
algorithmic
versions $1are
assignable
within
Company
Discount
Store
Everything $5
Forecasted return
12%
11%
Connect.
Standard deviation of returns
8%
10%
Beta
a. Businesses become more pessimistic about future demand for their products and decide to
reduce their capital spending.
b. Households are induced to save more because of increased uncertainty about their future
Social Security benefits.
c. The Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in
order to increase the supply of money.
®
Practice questions for the CFA exams provided by Kaplan Schweser, A Global Leader
in CFA® Education, are available in selected
chapters for additional test practice. Look
for the Kaplan Schweser logo. Learn more at
www.schweser.com.
0.0000
0.0000
0.0000
2.0000
2.0000
Calculating the duration of two bonds
215
E(rP) − rf
Portfolio risk premium
Sharpe ratio: _____________________________ = _________
Standard deviation of excess return
σP
0.0000
0.0000
0.0000
1.0000
1.0000
Spreadsheet 16.1
Variance: ∑[prob(Scenario) × (Deviation from mean in scenario)2]
Standard deviation: √Variance
Weight*
0.0395
0.0376
0.0358
0.8871
1.0000
G
Column (C)
times
Column (F)
0.0197
0.0376
0.0537
1.7741
1.8852
5. Characterize each company in the previous problem as underpriced, overpriced, or properly priced.
6. What is the expected rate of return for a stock that has a beta of 1.0 if the expected return on the
market is 15%?
a. 15%.
b. More than 15%.
c. Cannot be determined without the risk-free rate.
7. Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of .6. Which of the following statements is most accurate?
06/07/22 01:40 PM
eXcel
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xx
a. The expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn,
Inc.
b. The stock of Kaskin, Inc., has more total risk than the stock of Quinn, Inc.
c. The stock of Quinn, Inc., has more systematic risk than that of Kaskin, Inc.
8. You are a consultant to a large manufacturing corporation that is considering a project with the
following net after-tax cash flows (in millions of dollars):
Years from Now
After-Tax Cash Flow
0
−40
1–10
15
The project’s beta is 1.8.
a. Assuming that rf = 8% and E(rM) = 16%, what is the net present value of the project?
b. What is the highest possible beta estimate for the project before its NPV becomes negative?
9. Consider the following table, which gives a security analyst’s expected return on two stocks in
two particular scenarios for the rate of return on the market:
expected rate of return?
c. In what sense does the discount bond offer “implicit call protection”?
31. A newly issued bond pays its coupons once annually. Its coupon rate is 5%, its maturity is
20 years, and its yield to maturity is 8%.
a. Find the holding-period return for a 1-year investment period if the bond is selling at a yield
to maturity of 7% by the end of the year.
b. If you sell the bond after one year, what taxes will you owe if the tax rate on interest income
is 40% and the tax rate on capital gains income is 30%? The bond is subject to original-issuediscount tax treatment.
c. What is the after-tax holding-period return on the bond?
d. Find the realized compound yield before taxes for a 2-year holding period, assuming that
(i) you sell the bond after two years, (ii) the bond yield is 7% at the end of the second year,
and (iii) the coupon can be reinvested for one year at a 3% interest rate.
e. Use the tax rates in part (b) to compute the after-tax 2-year realized compound yield. Remember to take account of OID tax rules.
CFA PROBLEMS
1. Leaf Products may issue a 10-year maturity fixed-income security, which might include a sinking
fund provision and either refunding or call protection.
a. Describe a sinking fund provision.
b. Explain the impact of a sinking fund provision on:
We provide several questions adapted
for this text from past CFA examinations
in applicable chapters. These questions
represent the kinds of questions that
professionals in the field believe are
relevant to the “real world.” Located at
the back of the book is a listing of each
CFA question and the level and year
of the CFA exam it was included in for
easy reference.
i. The expected average life of the proposed security.
ii. Total principal and interest payments over the life of the proposed security.
c. From the investor’s point of view, explain the rationale for demanding a sinking fund provision.
2. Bonds of Zello Corporation with a par value of $1,000 sell for $960, mature in five years, and
have a 7% annual coupon rate paid semiannually.
a. Calculate the:
i. Current yield.
ii. Yield to maturity to the nearest whole percent (i.e., 3%, 4%, 5%, etc.).
iii. Realized compound yield for an investor with a 3-year holding period and a reinvestment
rate of 6% over the period. At the end of three years, the 7% coupon bonds with two years
remaining will sell to yield 7%.
b. Cite one major shortcoming for each of the following fixed-income yield measures:
i. Current yield.
ii. Yield to maturity.
iii. Realized compound yield.
3. On May 30, 2023, Janice Kerr is considering one of the newly issued 10-year AAA corporate
bonds shown in the following exhibit.
Description
bod12665_ch14_439-480.indd
Coupon
Price
Callable
Call Price
Sentinal, due May 30, 2033
4.00%
100
Noncallable
Colina, due May 30, 2033
4.20%
100
Currently callable
CHAPTER 3
478
NA
102 Pages
Confirming
How Securities Are Traded
95
06/20/22 10:49 AM
8. Consider the following limit-order book for FinTrade stock. The last trade in the stock occurred
at a price of $50.
Limit Buy Orders
EXCEL PROBLEMS
Selected chapters contain problems,
denoted by an icon, specifically linked to
Excel templates that are available in Connect and on the student resource site at
www.mhhe.com/Bodie13e.
Limit Sell Orders
Price
Shares
Price
$49.75
500
$50.25
Shares
100
49.50
800
51.50
100
49.25
500
54.75
300
49.00
200
58.25
100
48.50
600
a. If a market buy order for 100 shares comes in, at what price will it be filled?
b. At what price would the next market buy order be filled?
c. If you were a security dealer, would you want to increase or decrease your inventory of this
stock?
9. You are bullish on Telecom stock. The current market price is $50 per share, and you have
$5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest
rate of 8% per year and invest $10,000 in the stock.
eXcel
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a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next
year? The stock currently pays no dividends.
b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately.
10. You are bearish on Telecom and decide to sell short 100 shares at the current market price of
$50 per share.
a. How much in cash or securities must you put into your brokerage account if the broker’s
initial margin requirement is 50% of the value of the short position?
b. How high can the price of the stock go before you get a margin call if the maintenance
margin is 30% of the value of the short position?
11. Suppose that Xtel currently is selling at $20 per share. You buy 1,000 shares using $15,000 of
your
own money, borrowing the remainder of the purchase price from your broker. The rate on
Confirming
Pages
the margin loan is 8%.
CHAPTER 5
Risk, Return, and the Historical Record
1. The OECD regularly publishes its economic outlook for the G20 countries as well as the
world as a whole. You can find a recent report at www.oecd.org/economic-outlook. What is
the forecast for U.S. inflation for the next year?
Please visit us at
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a. What is the percentage increase in the net worth of your brokerage account if the price of
Xtel immediately changes to: (i) $22; (ii) $20; (iii) $18? What is the relationship between
your percentage return and the percentage change in the price of Xtel?
b. If the maintenance margin is 25%, how low can Xtel’s price fall before you get a
margin
165 call?
c. How would your answer to (b) change if you had financed the initial purchase with only
$10,000 of your own money?
d. What is the rate of return on your margined position (assuming again that you invest $15,000
of your own money) if Xtel is selling after 1 year at: (i) $22; (ii) $20; (iii) $18? What is the
relationship between your percentage return and the percentage change in the price of Xtel?
Assume that Xtel pays no dividends.
e. Continue to assume that a year has passed. How low can Xtel’s price fall before you get a
margin call?
3. What is the expected real rate based on your answers to (1) and (2)?
4. What is the real rate of interest on one-year inflation-protected T-bonds (TIPS)? You can also
find this at the St. Louis Fed site, or from the online version of The Wall Street Journal, online.
wsj.com. Look for the tab for Markets, then Market Data.
5. Is the value for the expected real rate that you found in (3) consistent with the value you found
in (4)?
6. How does the current real rate compare to its historical average?
bod12665_ch03_061-098.indd
1. a. EAR = (1 + .01)12 − 1 = .1268 = 12.68%
b. EAR = e.12 − 1 = .1275 = 12.75%
Choose the continuously compounded rate for its higher EAR.
2. a. 1 + rnom = (1 + rreal )(1 + i ) = (1.03)(1.08) = 1.1124
rnom = 11.24%
b. 1 + rnom = (1.03)(1.10) = 1.133
rnom = 13.3%
3. Number of bonds bought is 27,000/900 = 30
Higher
Unchanged
Lower
Expected rate of return
eXcel
These exercises provide students with
simple activities to enhance their experience using the Internet. Easy-to-follow
instructions and questions are presented so
students can utilize what they have learned
in class and apply it to today’s data-driven
world.
2. What is the one-year nominal interest rate on 1-year Treasury securities? You can find this at
the St. Louis Fed data site fred.stlouisfed.org.
Interest Rates
Please visit us at
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E-INVESTMENTS BOXES
E-INVESTMENTS EXERCISES
SOLUTIONS TO CONCEPT CHECKS
eXcel
Probability
Year-End Bond Price
HPR
End-of-Year Value
0.2
0.5
0.3
$850
915
985
(75 + 850)/900 − 1 = 0.0278
0.1000
0.1778
0.1089
(75 + 850)30 = $27,750
$29,700
$31,800
xxi
95
06/06/22 08:58 AM
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Acknowledgments
Throughout the development of this text,
experienced instructors have provided critical feedback and suggestions for improvement. These individuals deserve a special
thanks for their valuable insights and
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Acknowledgments
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xxvii
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Acknowledgments
For granting us permission to include
many of its examination questions in the
text, we are grateful to the CFA Institute.
In addition, we would like to thank
Nicholas Racculia, whose authoring
efforts on Chapter 26 as well as our Connect online content will greatly assist both
students and instructors.
Much credit is due to the development and production team at
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Manager.
xxviii
Finally, we thank Judy, Hava, and
Sheryl, who contribute to the book with
their support and understanding.
Zvi Bodie
Alex Kane
Alan J. Marcus
1
CHAPTER
AN INVESTMENT IS the current commitment
of money or other resources in the expectation of reaping future benefits. For example,
you might purchase shares of stock anticipating that the future proceeds will justify both the
time your money is tied up as well as the risk of
the investment. The time you will spend studying this text (not to mention its cost) also is an
investment. You are forgoing either current leisure or the income you could be earning at a job
in the expectation that your future career will be
sufficiently enhanced to justify this commitment
of time and effort. While these two investments
differ in many ways, they share one key attribute
that is central to all investments: You sacrifice
something of value now, expecting to reap the
benefits later.
This text can help you become an informed
practitioner of investments. We will focus on
investments in securities such as stocks, bonds,
or derivatives contracts, but much of what we
discuss will be useful in the analysis of any type
of investment. The text will provide you with
background in the organization of various securities markets; will survey the valuation and
risk management principles useful in particular
markets, such as those for bonds or stocks; and
will introduce you to the principles of portfolio
construction.
PART I
The Investment
Environment
Broadly speaking, this chapter addresses several topics that will provide perspective for the
material that is to come later. First, before delving
into the topic of “investments,” we consider the
role of financial assets in the economy. We discuss the relationship between securities and the
“real” assets that actually produce goods and services for consumers, and we consider why financial assets are important to the functioning of a
developed economy.
Given this background, we then take a first
look at the types of decisions that confront investors as they assemble a portfolio of assets. These
investment decisions are made in an environment
where higher returns usually can be obtained only
at the price of greater risk and in which it is rare to
find assets that are so mispriced as to be obvious
­bargains. These themes—the risk–return trade-off
and the efficient pricing of financial assets—are
central to the investment process, so it is worth
pausing for a brief discussion of their implications
as we begin the text. These implications will be
fleshed out in much greater detail in later chapters.
We provide an overview of the organization of
security markets as well as its key participants.
Finally, we discuss the financial crisis that began
playing out in 2007 and peaked in 2008. The
crisis dramatically illustrated the c­onnections
between the financial system and the “real”
(continued)
1
(concluded)
side of the economy. We look at the origins of
the crisis and the lessons that may be drawn
1.1
about systemic risk. We close the chapter with an
­overview of the remainder of the text.
Real Assets versus Financial Assets
The material wealth of a society is ultimately determined by the productive capacity of its
economy, that is, the goods and services its members can create. This capacity is a function
of the real assets of the economy: the land, buildings, machines, and knowledge that can
be used to produce goods and services.
In contrast to real assets are financial assets such as stocks and bonds. Such ­securities
historically were no more than sheets of paper (and today, are far more likely to be,
­computer entries), and they do not contribute directly to the productive capacity of the
economy. Instead, these assets are the means by which individuals in well-developed economies hold their claims on real assets. Financial assets are claims to the income generated
by real assets (or claims on income from the government). If we cannot own our own auto
plant (a real asset), we can still buy shares in Ford or Toyota (financial assets) and thereby
share in the income derived from the production of automobiles.
While real assets generate net income to the economy, financial assets simply define the
allocation of income or wealth among investors. When investors buy securities issued by
companies, the firms use the money so raised to pay for real assets, such as plant, equipment, technology, or inventory. So investors’ returns ultimately come from the income
produced by the real assets that were financed by the issuance of those securities.
The distinction between real and financial assets is apparConcept Check 1.1
ent when we compare the balance sheet of U.S. households,
shown in Table 1.1, with the composition of national wealth
Are the following assets real or financial?
in the United States, shown in Table 1.2. Household wealth
includes financial assets such as bank accounts, corporate
a. Patents
stock, or bonds. However, these securities, which are finanb. Lease obligations
cial assets of households, are ­liabilities of the issuers of the
c. Customer goodwill
securities. For example, a bond that you treat as an asset
d. A college education
because it gives you a claim on interest income and repaye. A $5 bill
ment of principal from Toyota is a liability of Toyota, which
is obligated to make these p­ ayments. Your asset is Toyota’s
liability. Therefore, when we aggregate over all balance sheets, these claims cancel out,
leaving only real assets as the net wealth of the economy. National wealth consists of structures, equipment, inventories of goods, and land.1
1
You might wonder why real assets held by households in Table 1.1 amount to $44,599 billion, while total real
assets in the domestic economy (Table 1.2) are far larger, at $86,282 billion. A big part of the difference reflects
the fact that real assets held by firms, for example, property, plant, and equipment, are included as financial
assets of the household sector, specifically through the value of corporate equity and other stock market investments. Also, Table 1.2 includes assets of noncorporate businesses. Finally, there are some differences in valuation
­methods. For example, equity and stock investments in Table 1.1 are measured by market value, whereas plant
and equipment in Table 1.2 are valued at replacement cost.
2
CHAPTER 1
Assets
$ Billion
% Total
Liabilities and Net Worth
Real assets
Real estate
Consumer durables
Other
Total real assets
$37,558
6362
679
$44,599
24.4%
4.1%
0.4%
28.9%
Liabilities
Mortgages
Consumer credit
Bank and other loans
Other
Total liabilities
Financial assets
Deposits and money market shares
Life insurance reserves
Pension reserves
Corporate equity
Equity in noncorp. business
Mutual fund shares
Debt securities
Other
Total financial assets
TOTAL
$17,374
1,854
29,876
28,285
13,114
11,661
5,772
1,626
$109,562
$154,161
11.3%
1.2%
19.4%
18.3%
8.5%
7.6%
3.7%
1.1%
71.1%
100.0%
Net worth
$ Billion
% Total
$11,331
4,163
1,125
624
$17,244
7.4%
2.7%
0.7%
0.4%
11.2%
136,917
$154,161
88.8%
100.0%
Table 1.1
Balance sheet of U.S. households
Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2021.
Assets
$ Billion
Commercial real estate
Residential real estate
Equipment & intellectual property
Inventories
Consumer durables
TOTAL
$20,842.9
45,816.3
10,316.2
2,944.5
6,361.9
$86,282
Table 1.2
Domestic net worth
Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the
Federal Reserve System, June 2021.
We will focus almost exclusively on financial assets. But keep in mind that the ­successes
or failures of these financial assets ultimately depend on the performance of the underlying
real assets.
1.2
3
The Investment Environment
Financial Assets
It is common to distinguish among three broad types of financial assets: fixed income,
equity, and derivatives. Fixed-income or debt securities promise either a fixed stream of
income or a stream of income determined by a specified formula. For example, a corporate
4
PART I
Introduction
bond typically promises the bondholder a fixed amount of interest each year. Other socalled floating-rate bonds promise payments that depend on current i­nterest rates. For
example, a bond may pay an interest rate fixed at 2 percentage points above the rate paid
on U.S. ­Treasury bills. Unless the borrower is declared bankrupt, the payments on these
securities are either fixed or determined by formula. For this reason, the investment
performance of debt securities typically is least closely tied to the financial condition of
the issuer.
Fixed-income securities come in a tremendous variety of maturities and payment
­provisions. At one extreme, money market securities are short term, highly marketable, and
generally of very low risk, for example, U.S. Treasury bills or bank certificates of deposit
(CDs). In contrast, the fixed-income capital market includes long-term securities such as
Treasury bonds, as well as bonds issued by federal agencies, state and local municipalities,
and corporations. These bonds range from very safe in terms of default risk (e.g., Treasury
securities) to relatively risky (e.g., high-yield or “junk” bonds). They also are designed
with extremely diverse provisions regarding payments provided to the investor and protection against the bankruptcy of the issuer. We will take a first look at these securities in
Chapter 2 and undertake a more detailed analysis of the debt market in Part Four.
Unlike debt securities, common stock, or equity, represents an ownership share in the
corporation. Equityholders are not promised any particular payment. They receive any
dividends the firm may pay and have prorated ownership in the real assets of the firm. If
the firm is successful, the value of equity will increase; if not, it will decrease. The performance of equity investments, therefore, is tied directly to the success of the firm and its
real assets. For this reason, equity investments tend to be riskier than investments in debt
securities. Equity markets and equity valuation are the topics of Part Five.
Finally, derivative securities such as options and futures contracts provide payoffs that
are determined by the prices of other assets such as bond or stock prices. For example, a
call option on a share of Intel stock might turn out to be worthless if Intel’s share price
remains below a threshold or “exercise” price such as $50 a share, but it can be quite
valuable if the stock price rises above that level.2 Derivative securities are so named
because their values derive from the prices of other assets. For example, the value of the
call option will depend on the price of Intel stock. Other important derivative securities are
futures and swap contracts. We will treat these in Part Six.
Derivatives have become an integral part of the investment environment. One use of
derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties.
This is done successfully every day, and the use of these securities for risk management is
so commonplace that the multitrillion-dollar market in derivative assets is routinely taken
for granted. Derivatives also can be used to take highly speculative positions, however.
Every so often, one of these positions blows up, resulting in well-publicized losses of
hundreds of millions of dollars. While these losses attract considerable attention, they are
in fact the exception to the more common use of such securities as risk management tools.
Derivatives will continue to play an important role in portfolio construction and the
financial system. We will return to this topic later in the text.
Investors and corporations regularly encounter other financial markets as well. Firms
engaged in international trade regularly transfer money back and forth between dollars
and other currencies. In London alone, over $2 trillion of currency is traded each day and
worldwide trading volume exceeds $6 trillion.
2
A call option is the right to buy a share of stock at a given exercise price on or before the option’s expiration
date. If the market price of Intel remains below $50 a share, the right to buy for $50 will turn out to be valueless.
If the share price rises above $50 before the option expires, however, the option can be exercised to obtain the
share for only $50.
CHAPTER 1
The Investment Environment
Investors also might invest directly in some real assets. For example, dozens of
commodities are traded on exchanges such as the New York Mercantile Exchange or the
Chicago Board of Trade. You can buy or sell corn, wheat, natural gas, gold, silver, and so on.
Commodity and derivative markets allow firms to adjust their exposure to various
business risks. For example, a construction firm may lock in the price of copper by buying
copper futures contracts, thus eliminating the risk of a jump in the price of its raw materials. Wherever there is uncertainty, investors may be interested in trading, either to speculate or to lay off their risks, and a market may arise to meet that demand.
1.3
Financial Markets and the Economy
We stated earlier that real assets determine the wealth of an economy, while financial
assets merely represent claims on real assets. Nevertheless, financial assets and the markets in which they trade play several crucial roles in developed economies. Financial assets
allow us to make the most of the economy’s real assets.
The Informational Role of Financial Markets
Stock prices reflect investors’ collective assessment of a firm’s current performance and
future prospects. When the market is more optimistic about the firm, its share price will
rise. That higher price makes it easier for the firm to raise capital and therefore encourages investment. In this manner, stock prices play a major role in the allocation of capital
in market economies, directing it to the firms and applications with the greatest perceived
potential. For example, in 2021, big investors poured huge investments into startup firms
focusing on new battery technologies that could store energy created by renewables such
as wind or solar power.3 The prospect of big profits if this technology pans out prompted
investors to allocate their funds toward these ventures. This dynamic was a good example
of market incentives directing capital to applications where there is the prospect of a large
payoff.
Do capital markets actually channel resources to the most efficient use? At times,
they appear to fail miserably. Companies or whole industries can be “hot” for a period of
time (think about the dot-com bubble that peaked and then collapsed in 2000), attract a
large flow of investor capital, and then fail after only a few years.
The process seems highly wasteful. But we need to be careful about our standard of
efficiency. No one knows with certainty which ventures will succeed and which will fail.
It is therefore unreasonable to expect that markets will never make mistakes. The stock
market encourages allocation of capital to those firms that appear at the time to have the
best prospects. Many smart, well-trained, and well-paid professionals analyze the prospects of firms whose shares trade on the stock market. Stock prices reflect their collective
judgment.
You may well be skeptical about resource allocation through markets. But if you are,
take a moment to think about the alternatives. Would a central planner make fewer mistakes? Would you prefer that Congress make these decisions? To paraphrase Winston
Churchill’s comment about democracy, markets may be the worst way to allocate capital
except for all the others that have been tried.
3
Scott Patterson, “Investors Hunt for Battery Advances,” The Wall Street Journal, September 10, 2021, p. B1.
5
6
PART I
Introduction
Consumption Timing
Some individuals are earning more than they currently wish to spend. Others, for example,
retirees, spend more than they currently earn. How can you shift your purchasing power
from high-earnings to low-earnings periods of life? One way is to “store” your wealth in
financial assets. In high-earnings periods, you can invest your savings in financial assets
such as stocks and bonds. In low-earnings periods, you can sell these assets to provide
funds for your consumption needs. By so doing, you can “shift” your consumption over
the course of your lifetime, thereby allocating your consumption to periods that provide
the greatest satisfaction. Thus, financial markets allow individuals to separate decisions
concerning current consumption from constraints that otherwise would be imposed by
current earnings.
Allocation of Risk
Virtually all real assets involve some risk. When Toyota builds its auto plants, for example,
it cannot know for sure what cash flows those plants will generate. Financial markets and
the diverse financial instruments traded in those markets allow investors with the greatest
taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater
extent, stay on the sidelines. For example, if Toyota raises the funds to build its auto plant
by selling both stocks and bonds to the public, the more optimistic or risk-tolerant investors
can buy shares of its stock, while the more conservative ones can buy its bonds. Because
the bonds promise to provide a fixed payment, the stockholders bear most of the business
risk but reap potentially higher rewards. Thus, capital markets allow the risk that is
inherent to all investments to be borne by the investors most willing to bear it.
This allocation of risk also benefits the firms that need to raise capital to finance
their investments. When investors are able to select security types with the risk-return
characteristics that best suit their preferences, each security can be sold for the best
possible price. This facilitates the process of building the economy’s stock of real assets.
Separation of Ownership and Management
Many businesses are owned and managed by the same individual. This simple organization is well suited to small businesses and, in fact, was the most common form of business
organization before the Industrial Revolution. Today, however, with global markets and
large-scale production, the size and capital requirements of firms have skyrocketed. For
example, at the end in 2021, Chevron listed on its balance sheet about $156 billion of
property, plant, and equipment and total assets of $240 billion. Corporations of such size
simply cannot exist as owner-operated firms. Chevron actually has tens of thousands of
stockholders with an ownership stake in the firm proportional to their holdings of shares.
Such a large group of individuals obviously cannot actively participate in the day-today management of the firm. Instead, they elect a board of directors that in turn hires and
supervises the management of the firm. This structure means that the owners and managers of the firm are different parties. This gives the firm a stability that the owner-managed
firm cannot achieve. For example, if some stockholders decide they no longer wish to
hold shares in the firm, they can sell their shares to other investors, with no impact on the
management of the firm. Thus, financial assets and the ability to buy and sell those assets
in the financial markets allow for easy separation of ownership and management.
How can all of the disparate owners of the firm, ranging from large pension funds
holding hundreds of thousands of shares to small investors who may hold only a single
share, agree on the objectives of the firm? Financial markets can provide some guidance.
The overwhelming orthodoxy in the business community since
the 1970s was that the goal of the firm should be to maximize
value and that corporate governance, for example, incentive
packages for top management, should be designed to encourage that goal. The idea is that when value is maximized, we will
all be in a better position to pursue our personal goals including,
if we wish, support for “good causes.” But in 2019, America’s
Business Roundtable, a group of CEOs of the country’s largest corporations, advocated for broader corporate goals that
address the interests of other stakeholders, including employees, customers, and the communities in which firms operate.
Their argument is that firms need to recognize and respond to
ethical and societal considerations beyond their private pursuit
of profit, in other words, that there is a built-in tension between
shareholder capitalism and stakeholder capitalism.
The critics of value maximization argue that it does not
provide incentives to firms to respond to important societal
and economic challenges and that if firms concern themselves only with their own interests, they will ignore potential
value-reducing impacts of their actions on other players. For
example, should a firm increase its value by a trivial amount
if it thereby increases unemployment for a large number of
workers? Should it increase its value by gutting pension plans
established for its former employees? Should it increase profits
by evading the costs of clean production even if that would pollute the environment? These critics argue that firms should be
encouraged and perhaps forced to take a broader view of their
obligations to their many stakeholders.
They argue further that enlightened strategies can actually
be financially beneficial, and that long-term value maximization
requires sustainable investment strategies compatible with a
healthier and more resilient economy in the future. These sustainability criteria are commonly grouped under the umbrella
of environmental, social, and governance, or ESG, investing. In
fact, the ESG sector has exploded in the last few years, with
ESG-oriented mutual and exchange-traded funds in the United
States capturing about one-fourth of new investments in 2020.
On the other hand, traditionalists are wary of an unfocused
commitment to many competing and unspecified interests that
could impede accountability. Should the firm, for example, offer
a better service to its customers if doing so makes the company a less attractive place to work? Given these sorts of conflicting objectives, how should one judge whether managers
have performed well? Who will set these goals, and how much
power is it appropriate to give to nonshareholders with little
skin in the game? What incentives will remain for innovation
and risk taking if corporate goals are set in the political arena?
Is it right to downplay the importance of monetary success?
After all, many institutions devoted to the public good and the
economic security of individuals rely on the success of the
endowment funds and pension funds that help pay for their
activities. Finally, regardless of their preferences, competition
may force firms to pursue value-maximizing strategies—if they
don’t, they run the risk that competitors who do will put them
out of business.
How might one thread this needle? One middle-ground
approach focuses on encouraging enlightened self-interest. It
can be value maximizing to establish a reputation as a good
place to work if that helps the firm attract and retain good
employees. It can be value maximizing to avoid scandal, disruption, and fines. It can also be value maximizing to provide
products and treat customers in a manner that encourages
repeat business. And if customers want goods produced by
well-treated workers using environmentally responsible practices, it will be in the firm’s interest to design production processes with those goals in mind. Consumers also vote with
their feet, and firms that wish to do well may face pressure to
do good.
Of course, it would be naïve to believe that there will never
be conflicts between value maximization, even maximization of
long-term value, and other social considerations. Potential conflicts may call for government intervention to nudge incentives
in one direction or the other. For example, governments may
tax polluting activities to make it value maximizing to reduce
emissions. They may set and enforce antitrust rules to foster
competition and prevent any one firm from becoming powerful
enough to ride roughshod over the interests of customers and
employees. They can demand transparency to allow outsiders
to make informed judgments of how the company is behaving.
The world is full of slippery slopes and competing goals,
and no economic system will at all times and in all places
arrive at the best compromise between narrow self-interest
and broader social impact. Enlightened capitalism that recognizes that long-term success is compatible with, and in fact may
demand, consideration of the wider implications of corporate
actions may strike as good a balance as one can hope for.
While the particular goals of each corporation’s many investors may vary widely, all shareholders will be better able to achieve those personal goals when the firm acts to enhance
the value of their shares. For this reason, value maximization has for decades been widely
accepted as a useful organizing principle for the firm. More recently, some observers have
questioned this goal, arguing that the firm should attempt to balance the interests of its
many stakeholders, for example, employees, customers, suppliers, and communities. The
nearby box examines this debate.
7
WORDS FROM THE STREET
Stakeholder Capitalism
8
PART I
Introduction
Do managers really attempt to maximize firm value? It is easy to see how they might be
tempted to engage in activities not in the best interest of shareholders. For example, they
might engage in empire building or avoid risky projects to protect their own jobs or overconsume luxuries such as corporate jets, reasoning that the cost of such perquisites is largely
borne by the shareholders. These potential conflicts of interest are called agency problems
because managers, who are hired as agents of the shareholders, may pursue their own interests instead.
Several mechanisms have evolved to mitigate potential agency problems. First, compensation plans tie the income of managers to the success of the firm. A major part of
the total compensation of top executives is often in the form of shares or stock options,
which means that the managers will not do well unless the stock price increases, benefiting
shareholders. (Of course, we’ve learned that overuse of options can create its own agency
problem. Options can create an incentive for managers to manipulate information to prop
up a stock price temporarily, giving them a chance to cash out before the price returns to a
level reflective of the firm’s true prospects. More on this shortly.) Second, while boards of
directors have sometimes been portrayed as defenders of top management, they can, and in
recent years, increasingly have, forced out management teams that are underperforming.
Third, outsiders such as security analysts and large institutional investors such as mutual
funds or pension funds monitor the firm closely and make the life of poor performers at
the least uncomfortable. Such large investors today hold about half of the stock in publicly
listed firms in the United States.
Finally, bad performers are subject to the threat of takeover. If the board of directors
is lax in monitoring management, unhappy shareholders in principle can elect a different
board. They can do this by launching a proxy contest in which they seek to obtain enough
proxies (i.e., rights to vote the shares of other shareholders) to take control of the firm
and vote in another board. Historically, this threat was usually minimal. Shareholders who
attempt such a fight have to use their own funds, while management can defend itself using
corporate coffers.
However, in recent years, the odds of a successful proxy contest have increased along
with the rise of so-called activist investors. These are large and deep-pocketed investors,
often hedge funds, that identify firms they believe to be mismanaged in some respect.
They buy large positions in shares of those firms and then campaign for slots on the board
of directors and/or for specific reforms.
Example 1.1
Activist Investors and Corporate Control
Here are a few of the better-known activist investors, along with a sample of their more
notable initiatives:
• Nelson Peltz, Trian. Trian gained a seat on General Electric’s board of directors and pressured the company to cut costs, to return capital to shareholders, for example, through
stock buybacks, and to downsize the firm.
• William Ackman, Pershing Square. Took 8.3% stake in software company ADP, where he
pushed for management changes.
• Dan Loeb, Third Point. Took large position in Royal Dutch Shell and pressed the company
to split into two independent firms, one focusing on its legacy business lines, such as oil
exploration and refining, and the other on low-carbon and renewable energy sources.
CHAPTER 1
The Investment Environment
• Carl Icahn. One of the earliest and most combative of activist investors. Pushed HP to
accept a takeover bid made by Xerox.
• Christer Gardell, Cevian Capital. Cevian is the largest activist firm in Europe. In 2021,
it built up a 5% stake in the insurer Avian and then pressured the company to
­commit to deeper cost reductions and to pay out £5 billion in dividends or stock
repurchases.
• Paul Singer, Elliott Management. Built up a large stake in the U.K. drug manufacturer
Glaxo­
SmithKline after GSK’s disappointing performance in the development of a
Covid vaccination. Elliott is now expected to demand a large say in the firm’s future
management.
• Engine No. 1. A newcomer to the field, this formerly little-known fund gained the backing
of large institutional investors like BlackRock and Vanguard and won three seats on the
board of ExxonMobil, filling them with candidates with backgrounds in green energy and
operational expertise.
Aside from proxy contests, the real takeover threat is from other firms. If one firm
observes another underperforming, it can acquire the underperforming business and
replace management with its own team. The stock price should rise to reflect the prospects of improved performance, which provides an incentive for firms to engage in such
takeover activity.
Corporate Governance and Corporate Ethics
We’ve argued that securities markets can play an important role in facilitating the deployment of capital to the most productive uses. But market signals will help to allocate capital
efficiently only if investors are acting on accurate information. We say that markets need
to be transparent for investors to make informed decisions. If firms can mislead the public
about their prospects, then much can go wrong.
Despite the many mechanisms to align incentives of shareholders and managers, the
three years from 2000 through 2002 were filled with a seemingly unending series of
scandals that collectively signaled a crisis in corporate governance and ethics. For
­example, the telecom firm WorldCom overstated its profits by at least $3.8 billion
by improperly classifying expenses as investments. When the true picture emerged,
it resulted in the largest bankruptcy in U.S. history, at least until Lehman Brothers
smashed that record in 2008. The next-largest U.S. bankruptcy was Enron, which used
its now-­notorious “­special-purpose entities” to move debt off its own books and similarly ­present a misleading picture of its financial status. Unfortunately, these firms had
plenty of company. Other firms such as Rite Aid, HealthSouth, Global Crossing, and
Qwest Communications also manipulated and misstated their accounts to the tune of
billions of dollars. And the scandals were hardly limited to the United States. Parmalat,
the Italian dairy firm, claimed to have a $4.8 billion bank account that turned out not to
exist. These episodes suggest that agency and incentive problems are far from solved,
and that transparency is far from complete.
Other scandals of that period included systematically misleading and overly optimistic
research reports put out by stock market analysts. (Their favorable analysis was traded
for the promise of future investment banking business, and analysts were commonly
9
10
PART I
Introduction
compensated not for their accuracy or insight, but for their role in garnering investment
banking business for their firms.) Additionally, initial public offerings were allocated to
corporate executives as a quid pro quo for personal favors or the promise to direct future
business back to the manager of the IPO.
What about the auditors who were supposed to be the watchdogs of the firms?
Here too, incentives were skewed. Recent changes in business practice had made
the consulting businesses of these firms more lucrative than the auditing function.
For example, Enron’s (now-defunct) auditor Arthur Andersen earned more money
­consulting for Enron than by auditing it. Given Arthur Andersen’s incentive to protect its consulting profits, we should not be surprised that it was overly lenient in its
auditing work.
In 2002, in response to the spate of ethics scandals, Congress passed the S
­ arbanes–
Oxley Act, commonly referred to as SOX, to tighten the rules of corporate governance and disclosure. For example, the act requires corporations to have more
independent directors, that is, more directors who are not themselves managers (or
affiliated with managers). The act also requires each CFO to personally vouch for the
corporation’s accounting statements, provides for an ­
­
oversight board to oversee
the auditing of public companies, and prohibits auditors from providing various other
services to clients.
1.4
The Investment Process
Investors’ portfolios are simply their collections of investment assets. Once a portfolio
is established, it is updated or “rebalanced” by selling existing securities and using the
proceeds to buy new securities, by investing additional funds to increase the overall size of
the portfolio, or by selling securities to decrease the size of the portfolio.
Investment assets can be categorized into broad asset classes, such as stocks, bonds, real
estate, commodities, and so on. Investors make two types of decisions in constructing their
portfolios. The asset allocation decision is the choice among these broad asset classes,
while the security selection decision is the choice of which particular securities to hold
within each asset class.
“Top-down” portfolio construction starts with asset allocation. For example, an individual who currently holds all of his money in a bank account would first decide what
proportion of the overall portfolio ought to be moved into stocks, bonds, and so on. In
this way, the broad features of the portfolio are established. For example, while the average annual return on the common stock of large firms since 1926 has been about 12%
per year, the average return on U.S. Treasury bills has been less than 4%. On the other
hand, stocks are far riskier, with annual returns (as measured by the Standard & Poor’s
500 index) that have ranged as low as –46% and as high as 55%. In contrast, T-bills
are effectively risk-free: You know what interest rate you will earn when you buy them.
Therefore, the decision to allocate your investments to the stock market or to the money
market where Treasury bills are traded will have great ramifications for both the risk and
the return of your portfolio. A top-down investor first makes this and other crucial asset
allocation decisions before turning to the decision of the particular securities to be held
in each asset class.
CHAPTER 1
The Investment Environment
Security analysis involves the valuation of particular securities that might be included
in the portfolio. For example, an investor might ask whether Merck or Pfizer is more
­attractively priced. Both bonds and stocks must be evaluated for investment attractiveness,
but valuation is far more difficult for stocks because a stock’s performance usually is far
more sensitive to the prospects of the issuing firm.
In contrast to top-down portfolio management is a “bottom-up” strategy in which the
portfolio is constructed from securities that seem attractively priced without as much
concern for the resultant asset allocation. Such a technique can result in unintended bets
on one or another sector of the economy. For example, it might turn out that the portfolio
ends up with a very heavy representation of firms in one industry, from one part of the
country, or with exposure to one source of uncertainty. However, a bottom-up strategy
does focus the portfolio on the assets that seem to offer the most attractive investment
opportunities.
1.5
Markets Are Competitive
Financial markets are highly competitive. Thousands of intelligent and well-backed
analysts constantly scour securities markets searching for the best buys. This competition
means that we should expect to find few, if any, “free lunches,” securities that are so underpriced that they represent obvious bargains. This no-free-lunch proposition has several
implications. Let’s examine two.
The Risk–Return Trade-Off
Investors invest for anticipated future returns, but those returns rarely can be predicted
precisely. There will almost always be risk associated with investments. Actual or
realized returns will almost always deviate from the expected return anticipated at the start
of the investment period. For example, in 1931 (the worst calendar year for the market
since 1926), the S&P 500 index fell by 46%. In 1933 (the best year), the index gained 55%.
You can be sure that investors did not anticipate such extreme performance at the start of
either of these years.
Naturally, if all else could be held equal, investors would prefer investments with
the highest expected return.4 However, the no-free-lunch rule tells us that all else
cannot be equal. If you want higher expected returns, you will have to pay a price
in terms of accepting higher investment risk. If any particular asset offered a higher
expected return imposing without extra risk, investors would rush to buy it, with the
result that its price would be driven up. Individuals considering investing in the asset
at the now-higher price will find the investment less attractive. The price will rise
until expected return is no more than commensurate with risk. At this point, investors can anticipate a “fair” return relative to the asset’s risk, but no more. Similarly,
4
The “expected” return is not the return investors believe they necessarily will earn, or even their most likely
return. It is instead the result of averaging across all possible outcomes, recognizing that some outcomes are more
likely than others. It is the average rate of return across possible economic scenarios.
11
12
PART I
Introduction
if returns were independent of risk, there would be a rush to sell high-risk assets and
their prices would fall. The assets would get cheaper (improving their expected future
rates of return) until they eventually were attractive enough to be included again in
investor portfolios. We conclude that there should be a risk–return trade-off in the
securities markets, with higher-risk assets priced to offer higher expected returns than
lower-risk assets.
Of course, this discussion leaves several important questions unanswered. How should
one measure the risk of an asset? What should be the quantitative trade-off between risk
(properly measured) and expected return? One would think that risk would have something to do with the volatility of an asset’s returns, but this guess turns out to be only
partly correct. When we mix assets into diversified portfolios, we need to consider the
interplay among assets and the effect of diversification on the risk of the entire portfolio.
­Diversification means that many assets are held in the portfolio so that the exposure to
any particular asset is limited. The effect of diversification on portfolio risk, the implications for the proper measurement of risk, and the risk–return relationship are the topics of
Part Two. These topics are the subject of what has come to be known as modern portfolio
theory. The development of this theory brought two of its pioneers, Harry Markowitz and
William Sharpe, Nobel Prizes.
Efficient Markets
Another implication of the no-free-lunch proposition is that we should rarely expect
to find bargains in the security markets. We will spend all of Chapter 11 examining
the theory and evidence concerning the hypothesis that financial markets process all
available information about securities quickly and efficiently, that is, that the security
price usually reflects all the information available to investors concerning its value.
According to this hypothesis, as new information about a security becomes available, its
price quickly adjusts so that at any time, the security price equals the market consensus
estimate of the value of the security. If this were so, there would be neither underpriced
nor overpriced securities.
One interesting implication of this “efficient market hypothesis” concerns the choice
between active and passive investment-management strategies. Passive management
calls for holding highly diversified portfolios without spending effort or other resources
attempting to improve investment performance through security analysis. Active
­management is the attempt to improve performance either by identifying mispriced
securities or by timing the performance of broad asset classes—for example, increasing one’s commitment to stocks when one is bullish on the stock market. If markets are
efficient and prices reflect all relevant information, perhaps it is better to follow passive
strategies instead of spending resources in a futile attempt to outguess your competitors
in the financial markets.
If the efficient market hypothesis were taken to the extreme, there would be no point in
active security analysis; only fools would commit resources to actively analyze securities.
Without ongoing security analysis, however, prices eventually would depart from “correct”
values, creating new incentives for experts to move in. Therefore, even in ­environments
as competitive as the financial markets, we may observe only near-­efficiency, and profit
opportunities may exist for especially diligent and creative investors. In Chapter 12, we
examine such challenges to the efficient market hypothesis, and this motivates our discussion of active portfolio management in Part Seven. Nevertheless, our discussions of security analysis and portfolio construction generally must account for the likelihood of nearly
efficient markets.
CHAPTER 1
1.6
The Investment Environment
The Players
From a bird’s-eye view, there would appear to be three major players in the financial markets:
1. Firms are net demanders of capital. They raise capital now to pay for investments
in plant and equipment. The income generated by those real assets provides the
returns to investors who purchase the securities issued by the firm.
2. Households typically are net suppliers of capital. They purchase the securities
issued by firms that need to raise funds.
3. Governments can be borrowers or lenders, depending on the relationship between tax
revenue and government expenditures. Since World War II, the U.S. government typically has run budget deficits, meaning that its tax receipts have been less than its expenditures. The government, therefore, has had to borrow funds to cover its budget deficit.
Issuance of Treasury bills, notes, and bonds is the major way that the government borrows funds from the public. In contrast, in the latter part of the 1990s, the government
enjoyed a short-lived budget surplus and was able to retire some ­outstanding debt.
Corporations and governments do not sell all or even most of their securities directly
to individuals. For example, about half of all stock is held by large financial institutions
such as pension funds, mutual funds, insurance companies, and banks. These financial
institutions stand between the security issuer (the firm) and the ultimate owner of the
security (the individual investor). For this reason, they are called financial intermediaries.
Similarly, corporations do not market their own securities to the public. Instead, they hire
agents, called investment bankers, to represent them to the investing public. Let’s examine
the roles of these intermediaries.
Financial Intermediaries
Households want desirable investments for their savings, yet the small (financial) size
of most households makes direct investment difficult. A small investor seeking to lend
money to businesses that need to finance investments doesn’t advertise in the local newspaper to find a willing and desirable borrower. Moreover, an individual lender would not
be able to diversify across borrowers to reduce risk. Finally, an individual lender is not
equipped to assess and monitor the credit risk of borrowers.
For these reasons, financial intermediaries have evolved to bring the suppliers of
capital (investors) together with the demanders of capital (primarily corporations and the
­federal government). These financial intermediaries include banks, investment companies,
insurance companies, and credit unions. Financial intermediaries issue their own securities
to raise funds to purchase the securities of other corporations.
For example, a bank raises funds by borrowing (taking deposits) and lending that money
to other borrowers. The spread between the interest rates paid to depositors and the rates
charged to borrowers is the source of the bank’s profit. In this way, lenders and borrowers
do not need to contact each other directly. Instead, each goes to the bank, which acts as an
intermediary between the two. The problem of matching lenders with borrowers is solved
when each comes independently to the common intermediary.
Financial intermediaries are distinguished from other businesses in that both their assets
and their liabilities are overwhelmingly financial. Table 1.3 presents the aggregated balance
sheet of commercial banks, one of the largest sectors of financial intermediaries. Notice
that the balance sheet includes only very small amounts of real assets. Compare Table 1.3
to the aggregated balance sheet of the nonfinancial corporate sector in Table 1.4, for which
13
14
PART I
Introduction
Assets
Real assets
Equipment and premises
Other real estate
Total real assets
Financial assets
Cash
Investment securities
Loans and leases
Other financial assets
Total financial assets
Other assets
Intangible assets
Other
Total other assets
TOTAL
$ Billion
$
% Total
187.5
4.4
191.9
0.8%
0.0%
0.9%
$ 3,628.6
5,479.3
10,610.7
1,371.4
$21,090.1
16.1%
24.3%
47.0%
6.1%
93.5%
$
$
392.0
890.2
$ 1,282.2
$22,564.2
1.7%
3.9%
5.7%
100.0%
Liabilities and Net Worth
$ Billion
% Total
$18,458.8
595.6
297.8
959.1
$20,311.2
81.8%
2.6%
1.3%
4.3%
90.0%
$ 2,253.0
$22,564.2
10.0%
100.0%
Liabilities and Net Worth
$ Billion
% Total
Liabilities
Debt securities
Bank loans & mortgages
Other loans
Trade debt
Other
Total liabilities
$ 7,387
1,772
2,077
3,121
10,319
$24,676
14.5%
3.5%
4.1%
6.1%
20.3%
48.5%
$26,181
$50,856
51.5%
100.0%
Liabilities
Deposits
Debt and other borrowed funds
Federal funds and repurchase agreements
Other
Total liabilities
Net worth
Table 1.3
Balance sheet of FDIC-insured commercial banks and savings institutions
Note: Column sums may differ from total because of rounding error.
Source: Federal Deposit Insurance Corporation, www.fdic.gov, June 2021.
Assets
$ Billion
% Total
Real assets
Equipment & intellectual property
Real estate
Inventories
Total real assets
$ 8,428
14,859
2,687
$25,974
16.6%
29.2%
5.3%
51.1%
Financial assets
Deposits and cash
Marketable securities
Trade and consumer credit
Other
Total financial assets
TOTAL
$ 2,326
4,032
4,296
14,229
$24,883
$50,856
4.6%
7.9%
8.4%
28.0%
48.9%
100.0%
Net worth
Table 1.4
Balance sheet of U.S. nonfinancial corporations
Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2021.
CHAPTER 1
The Investment Environment
real assets are about half of all assets. The contrast arises because intermediaries simply
move funds from one sector to another. In fact, the primary social function of such
intermediaries is to channel household savings to the business sector.
Other examples of financial intermediaries are investment companies, insurance
companies, and credit unions. All these firms offer similar advantages in their intermediary role. First, by pooling the resources of many small investors, they are able to lend
considerable sums to large borrowers. Second, by lending to many borrowers, intermediaries achieve significant diversification, so they can accept loans that individually might be
too risky. Third, intermediaries build expertise through the volume of business they do and
can use economies of scale and scope to assess and monitor risk.
Investment companies, which pool and manage the money of many investors, also
arise out of economies of scale. Here, the problem is that most household portfolios are not
large enough to be spread across a wide variety of securities. In terms of brokerage fees
and research costs, purchasing one or two shares of many different firms is very expensive.
Mutual funds have the advantage of large-scale trading and portfolio management, while
participating investors are assigned a prorated share of the total funds according to the size
of their investment. This system gives small investors advantages they are willing to pay
for via a management fee to the mutual fund operator.
Investment companies also can design portfolios specifically for large investors with
particular goals. In contrast, mutual funds are sold in the retail market, and their investment
philosophies are differentiated mainly by strategies that are likely to attract a large number
of clients.
Like mutual funds, hedge funds also pool and invest the money of many clients.
But they are open only to institutional investors such as pension funds or endowment funds,
or to wealthy individuals. They are more likely to pursue complex and higher-risk strategies. They typically keep a portion of trading profits as part of their fees, whereas mutual
funds charge a fixed percentage of assets under management.
Economies of scale also explain the proliferation of analytic services available to
investors. Newsletters, databases, and brokerage house research services all engage in
research to be sold to a large client base. This setup arises naturally. Investors clearly
want information, but with small portfolios to manage, they do not find it economical to
personally gather all of it. Hence, a profit opportunity emerges: A firm can perform this
service for many clients and charge for it.
Investment Bankers
Just as economies of scale and specialization create profit opportunities for financial
­intermediaries, these economies also create niches for firms that perform specialized
­services for businesses. Firms raise much of their capital by selling securities such as
stocks and bonds to the public. Because these firms do not do so frequently, however,
investment bankers that specialize in such activities can offer their services at a cost
below that of maintaining an in-house security issuance division. In this role, they are
called underwriters.
Investment bankers advise the issuing corporation on the prices it can charge for
the securities issued, appropriate interest rates, and so forth. Ultimately, the investment
banking firm handles the marketing of the security in the primary market, where new
issues of securities are offered to the public. Later, investors can trade previously issued
securities among themselves in the so-called secondary market.
For most of the last century, investment banks and commercial banks in the U.S. were
separated by law. While those regulations were effectively eliminated in 1999, the industry
15
WORDS FROM THE STREET
Separating Commercial Banking from Investment Banking
Until 1999, the Glass-Steagall Act had prohibited banks in the
United States from both accepting deposits and underwriting
securities. In other words, it forced a separation of the investment and commercial banking industries. But when GlassSteagall was repealed, many large commercial banks began
to transform themselves into “universal banks” that could offer
a full range of commercial and investment banking services.
In some cases, commercial banks started their own investment banking divisions from scratch, but more frequently they
expanded through merger. For example, Chase Manhattan
acquired J.P. Morgan to form JPMorgan Chase. Similarly, Citigroup acquired Salomon Smith Barney to offer wealth management, brokerage, investment banking, and asset management
services to its clients. Most of Europe had never forced the separation of commercial and investment banking, so their giant
banks such as Credit Suisse, Deutsche Bank, HSBC, and UBS
had long been universal banks. Until 2008, however, the standalone investment banking sector in the U.S. remained large and
apparently vibrant, including such storied names as Goldman
Sachs, Morgan-Stanley, Merrill Lynch, and Lehman Brothers.
But the industry was shaken to its core in 2008, when several investment banks were beset by enormous losses on
their holdings of mortgage-backed securities. In March, on the
verge of insolvency, Bear Stearns was merged into JPMorgan
Chase. On September 14, 2008, Merrill Lynch, also suffering
steep ­mortgage-related losses, negotiated an agreement to be
acquired by Bank of America. The next day, Lehman Brothers
entered into the largest bankruptcy in U.S. history, having failed to
find an acquirer able and willing to rescue it from its steep losses.
The next week, the only two remaining major independent
investment banks, Goldman Sachs and Morgan Stanley, decided
to convert from investment banks to traditional bank holding
companies. In doing so, they became subject to the supervision of
national bank regulators such as the Federal Reserve and the far
tighter rules for capital adequacy that govern commercial banks.
The firms decided that the greater stability they would enjoy as
traditional banks, particularly the ability to fund their operations
through bank deposits and access to emergency borrowing from
the Fed, justified the conversion. These mergers and conversions
marked the effective end of the independent investment banking
industry—but not of investment banking. Those services are now
supplied by the large universal banks.
The debate about the separation between commercial and
investment banking that seemed to have ended with the repeal
of Glass-Steagall has come back to life. The Dodd-Frank Wall
Street Reform and Consumer Protection Act places new restrictions on bank activities.
For example, the Volcker Rule, named after former chair of
the Federal Reserve Paul Volcker, prohibits banks from “proprietary trading,” that is, trading securities for their own accounts,
and restricts their investments in hedge funds or private equity
funds. The rule is meant to limit the risk that banks can take
on. While the Volcker Rule is less restrictive than Glass-Steagall
had been, they both are motivated by the belief that banks
enjoying federal guarantees should be subject to limits on the
sorts of activities in which they can engage.
Proprietary trading is a core activity for investment banks,
so limitations on this activity for commercial banks reintroduces
a separation between these business models. However, these
restrictions elicited pushback from the industry, which argued
that it resulted in a brain drain of top traders from banks to
hedge funds. In 2018, the Dodd-Frank bill was in effect partially repealed when new legislation granted all but the largest
banks exemptions from some of its regulations.
known as “Wall Street” until 2008 was still composed of large, independent investment
banks such as Goldman Sachs, Merrill Lynch, and Lehman Brothers. But that stand-alone
model came to an abrupt end in September 2008, when all the remaining major U.S. investment banks were absorbed into commercial banks, declared bankruptcy, or ­reorganized as
commercial banks. The nearby box presents a brief introduction to these events.
Venture Capital and Private Equity
While large firms can raise funds directly from the stock and bond markets with help from
their investment bankers, smaller and younger firms that have not yet issued securities
to the public do not have that option. Start-up companies rely instead on bank loans and
investors who are willing to invest in them in return for an ownership stake in the firm.
The equity investment in these young companies is called venture capital (VC). Sources
of venture capital are dedicated venture capital funds, wealthy individuals known as angel
investors, and institutions such as pension funds.
Most venture capital funds are set up as limited partnerships. A management company
starts with its own money and raises additional capital from limited partners such as
pension funds. That capital may then be invested in a variety of start-up companies.
16
CHAPTER 1
The Investment Environment
The management company usually sits on the start-up company’s board of directors, helps
recruit senior managers, and provides business advice. It charges a fee to the VC fund for
overseeing the investments. After some period of time, for example, 10 years, the fund is
liquidated and proceeds are distributed to the investors.
Venture capital investors commonly take an active role in the management of a start-up
firm. Other active investors may engage in similar hands-on management but focus instead
on firms that are in distress or firms that may be bought up, “improved,” and sold for a
profit. Collectively, these investments in firms that do not trade on public stock exchanges
are known as private equity investments.
Fintech, Financial Innovation, and Decentralized Finance
Surveying the major actors on the financial scene highlighted in this section, it is clear
that when the needs of market participants create profit opportunities, markets tend to
evolve to provide those desired services. Sometimes, those innovations are spurred by
technological advances that make possible previously infeasible products. Fintech is the
application of technology to financial markets, and it has changed many aspects of the
financial landscape.
While we have focused on financial intermediaries, technology allowing individuals to
interact directly has led to some financial disintermediation. This trend toward the elimination of the intermediary has been dubbed decentralized finance or DeFi.
Peer-to-peer lending is a good example of a technology that can be used to link l­ enders
and borrowers directly, without need of an intermediary like a commercial bank. One
of the major players in this market is LendingClub, whose Web site allows borrowers to
apply for personal loans up to $40,000 or business loans up to $300,000. The potential
borrower is given a credit score, and then lenders (which the company calls investors)
can decide whether to participate in the loan. LendingClub does not itself lend funds;
instead, its platform provides information about borrowers and lenders and allows them
to interact directly.
Robo Advice While the very wealthy can afford to hire financial advisors, most investors do not have enough assets to justify that inevitably expensive guidance. Robo advisors
seek to bring affordable advice to a wide swath of investors. You begin by filling out an
online questionnaire about your financial situation and risk tolerance. A computer algorithm then recommends an investment portfolio, which usually will consist of low cost
mutual or exchange-traded funds. It may also periodically rebalance your account as the
value of each fund fluctuates.
Blockchains We are all accustomed to financial transactions that are recorded in a centralized ledger. For example, your credit card company maintains a record, or database, of
all of the purchases and payments you make through its network. Your bank maintains a
ledger of deposits and withdrawals. Stock exchanges maintain a ledger of who has bought
and sold stocks. These ledgers are centralized in the sense that they are administered by
a particular trusted party running and hosting the database. By their nature, they do not
allow for anonymity, and they can be targets of hackers. This is why the administrator must
be trusted—in terms of both honesty and efficiency.
In contrast, blockchains provide a record of transactions that is distributed over a network of connected computers. No single administrator controls it, so there is no single
target for potential hackers to attack. Instead, the network sets up a protocol by which
new transactions can be securely added to a public distributed ledger. The identities of
17
18
PART I
Introduction
each party to the transaction can be masked, allowing for anonymity. The ledger is essentially a list of transactions recorded in a “blockchain,” and each transaction results in a
time-stamped update to the block. Distributing the blockchain across a dispersed network
makes it harder for any hacker to attack its integrity. When the ledger is public, it is difficult to either bypass or manipulate the historical record of agreed-to transactions, and
crucially, there is no need for the trusted administrator that lies at the heart of a centralized ledger.
Blockchain technology is most associated with cryptocurrency such as Bitcoin (see following discussion), but it is ideally suited for a wider range of secure digital transactions.
For example, they might include secure sharing of medical data or supply chain monitoring. Blockchains are probably best thought of more generally as databases that allow verification of information by a decentralized network of participants. As such, they can play
a potentially large role in facilitating decentralized finance, providing data and enabling
“smart contracts” in which software can authorize transactions in response to a particular
triggering event without human intervention.
Another recent blockchain innovation is the NFT, or non-fungible token, which is proof
of ownership of a digital asset such as a digital work of art or even an original video of a
sports event.
Cryptocurrencies Cryptocurrencies, for example, Bitcoin or Ethereum, use blockchain technology to create payment systems that bypass traditional channels such as
credit cards, debit cards, or checks. This alternative system offers greater security and
anonymity for financial transactions. Bitcoin was introduced in 2009, but it has since
been joined by many other digital currencies; in 2021, there were approximately 4,000
different cryptocurrencies. But many of these have essentially no or negligible trading
volume and almost all are far smaller (in terms of total outstanding value) than Bitcoin
or Ethereum.
Cryptocurrency’s promise as an alternative to traditional currencies and payment systems still remains unclear. One challenge is price volatility, making it a problematic store
of value. In 2021, for example, the dollar value of one bitcoin ranged from below $30,000
to more than $63,000. Another challenge is that transactions require enormous amounts
of costly energy for the computers that validate those transactions. Moreover, the rate at
which transactions can be validated remains miniscule compared to that offered by the
traditional credit card network. These problems limit the efficacy of cryptocurrency as a
means of exchange.
A more recent innovation in this regard is the stablecoin. This is a cryptocurrency that
the issuer pledges to redeem for a conventional currency (e.g., the U.S. dollar) on demand.
The largest stablecoin today is Tether. Stable-dollar cryptocurrencies typically are backed
by holdings of dollars, often held by a third-party custodian, which ensures the ability to
convert into dollars. In other cases, the collateral might be other assets or cryptocurrencies,
but that generally requires overcollaterization to compensate for the risk of fluctuations in
the value of the collateral. Without adequate collateralization, stable coins are vulnerable
to “runs” in which a wave of investors attempt to withdraw their money at once. The Fed
and other regulators have expressed concern with the potential for runs and are considering
new regulatory approaches to limit that risk.
Governments are also concerned about the use of anonymous transactions to avoid
taxes, enable trade in illegal items, or facilitate ransomware and have begun to step up their
regulation of these markets. Notwithstanding these challenges, the technology is still new,
and enthusiasts predict it will upend today’s financial landscape, allowing participants to
avoid the fees and costs of dealing with more traditional centralized exchanges.
CHAPTER 1
The Investment Environment
Digital tokens A variation on cryptocurrency is the digital token issued in an initial
coin offering, or ICO. The ICO is a source of crowdfunding in which start-up firms raise
cash by selling digital tokens. The token is a form of cryptocurrency that can eventually be used to purchase products or services from the start-up. However, once issued, the
coins can be bought or sold among investors like other digital currencies, thus allowing
for speculation on their value. Given this potential, some have argued that these coins are
in fact securities issued by the firm, and thus should be subject to SEC regulation. Some
countries, for example China and South Korea, have banned ICOs altogether. It seems safe
to predict that the legal status of these coins will evolve considerably in coming years.
Digital currency As cryptocurrencies have become more familiar, sovereign governments have begun to contemplate developing digital currencies issued by their own central
banks. For example, a government might pay tax refunds directly into its citizen’s digital wallets (rather than mailing checks or arranging for direct deposit into a conventional
bank account). Similarly, citizens could pay bills by transferring funds from their wallets directly into those of their creditors. Like cryptocurrencies, this system would bypass
the traditional financial system, as well as its associated fees and relatively slow clearing
mechanisms. But unlike them, it would not be subject to the problem of fluctuating value.
China is already running trials of a digital yuan, and the Fed announced in 2021 that it
would study the feasibility of a digital currency for the United States. Some of the major
unanswered questions for digital currency surround security, privacy, and government
access to financial activity. Nevertheless, it seems possible that digital currencies will soon
become part of the financial landscape.
1.7
The Financial Crisis of 2008–2009
This chapter has laid out the broad outlines of the financial system, as well as some of the
links between the financial side of the economy and the “real” side in which goods and
services are produced. The financial crisis of 2008 illustrated in a painful way the intimate
ties between these two sectors. We present in this section a capsule summary of the crisis,
attempting to draw some lessons about the role of the financial system as well as the causes
and consequences of what has become known as systemic risk. Some of these issues are
complicated; we consider them briefly here but will return to them in greater detail later in
the text once we have more context for analysis.
Antecedents of the Crisis
In early 2007, most observers thought it inconceivable that within two years, the world
financial system would be facing its worst crisis since the Great Depression. At the
time, the economy seemed to be marching from strength to strength. The last significant
macroeconomic threat had been from the implosion of the high-tech bubble in 2000–2002.
But the Federal Reserve responded to an emerging recession by aggressively reducing
interest rates. Figure 1.1 shows that Treasury bill rates dropped drastically between 2001
and 2004, and the LIBOR rate, which was the interest rate at which major money-center
banks at the time loaned to each other, fell in tandem.5 These actions appeared to have been
successful, and the recession was short-lived and mild.
5
LIBOR stands for London Interbank Offer Rate. It was until 2021 the major rate charged in an interbank lending
market outside of the U.S. See Chapter 2 for a discussion of the phase-out of the LIBOR market.
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PART I
Introduction
8
3-month LIBOR
3-month T-Bill
TED Spread
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Figure 1.1 Short-term LIBOR and Treasury-bill rates and the TED spread
By mid-decade the economy was apparently healthy once again. Although the stock
market had declined substantially between 2001 and 2002, Figure 1.2 shows that it
reversed direction just as dramatically beginning in 2003, fully recovering all of its
­post-tech-meltdown losses within a few years. Of equal importance, the banking sector
seemed healthy. The spread between the LIBOR rate (at which banks borrow from each
other) and the Treasury-bill rate (at which the U.S. government borrows), a common measure of credit risk in the banking sector (often referred to as the TED spread 6), was only
around .25% in early 2007 (see the bottom curve in Figure 1.1), suggesting that fears of
default or “counterparty” risk in the banking sector were extremely low.
Indeed, the apparent success of monetary policy in this recession, as well as in the last
30 years more generally, had engendered a new term, the “Great Moderation,” to describe
the fact that recent business cycles—and recessions in particular—seemed so mild
compared to past experience. Some observers wondered whether we had entered a golden
age for macroeconomic policy in which the business cycle had been tamed.
The combination of dramatically reduced interest rates and an apparently stable
economy fed a historic boom in the housing market. Figure 1.3 shows that U.S. housing
prices began rising noticeably in the late 1990s and accelerated dramatically after 2001
as interest rates plummeted. In the 10 years beginning in 1997, average prices in the
U.S. approximately tripled.
But the newfound confidence in the power of macroeconomic policy to reduce risk, the
impressive recovery of the economy from the high-tech implosion, and particularly the
housing price boom following the aggressive reduction in interest rates may have sown
the seeds for the debacle that played out in 2008. On the one hand, the Fed’s policy of
reducing interest rates had resulted in low yields on a wide variety of investments, and
investors were hungry for higher-yielding alternatives. On the other hand, low volatility
and optimism about macroeconomic prospects encouraged greater tolerance for risk in the
6
TED stands for Treasury–Eurodollar spread. The Eurodollar rate in this spread is in fact LIBOR.
CHAPTER 1
The Investment Environment
Cumulative value of a $1 investment
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Figure 1.2 Cumulative returns on the S&P 500 index
Index (January 2000 = 100)
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Figure 1.3 The Case-Shiller index of U.S. housing prices
Source: Case Shiller Composite Housing Price Index, www.us.spindices.com.
search for these higher-yielding investments. Nowhere was this more evident than in the
exploding market for securitized mortgages.
Changes in Housing Finance
Prior to 1970, most mortgage loans would come from a local lender such as a neighborhood savings bank or credit union. A homeowner would borrow funds for a home purchase
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