CHAPTER 1
Investments: Background and Issues
Investments--commitment of funds to one or more assets in
the expectation of reaping future benefits.
Financial assets—claims on real assets
Real assets—assets used to produce goods and services.
Types of financial assets: fixed income securities,
equities, and derivative securities.
Investment process: 1-asset allocation-choice among broad
asset classes.
2-security selection-choice of specific securities
within each asset class.
Financial markets are highly competitive:
1- risk-return tradeoff
2- efficient markets
Financial intermediaries: bring lenders and borrowers
together.
Markets:
1- direct search markets
2- brokered markets
3- dealer markets
4- auction markets
Recent trends
Globalization--ADRs
Securitization
Financial engineering
Perspective on investing: each individual must develop an
overall financial plan…includes purchase of house,
insurance, and emergency reserve
Professional designations: 1) Chartered Financial Analyst
(CFA), 2) Certified Financial Planner (CFP), and 3)
Chartered Financial Consultant (ChFC)
Good investors must come to gripes with is uncertainty.
All market participants, including professionals, make
errors. No one can consistently forecast what will happen
in the financial markets.
1
CHAPTER 2
Financial Markets and Instruments
The purpose of this chapter is to provide an overview of
the major types of financial assets available to investors.
Most of these securities will be discussed in much greater
detail in later chapters.
Money market securities
Treasury bills—sold at discounts; risk-free
Certificates of deposit
Commercial paper
Banker’s acceptance
Eurodollars
Repurchase agreements
Federal funds
LIBOR
Fixed income securities
Treasury notes and bonds
Federal agency debt
Municipal bonds
Corporate bonds
Mortgages and mortgage-backed securities
Equity securities
Common stock
Preferred stock
Stock and bond market indexes
Dow Jones Industrial Average: price-weighted
S&P 550 Index: value weighted
Nikkei 225, FTSE (100), DAX
Bond market indicators
Derivative Markets
Options—puts and calls
Futures
2
CHAPTER 3
How Securities Are Traded
Chapter provides an analysis of the structure of security
markets, with securities organized by where they are
traded. Terminology and functioning of the market is
explained. NYSE and OTC markets discussed in detail.
The importance of financial markets is the allocation
function it serves to channel funds from savers to
borrowers; operationally efficient with the lowest possible
prices for transaction services. Primary markets would not
function well without secondary markets.
Primary markets: market for new issues; seasoned
issues/initial public offerings (IPOs).
Private placement: sold directly to financial institutions
such as life insurance companies and pension funds. Does
not have to be registered with the SEC.
Investment banker: firm specializing in the sale of new
securities. Underwriting: the purchase of an issue from a
firm and resell to the public…compensated by a spread; may
form a syndicate. Issuer files a registration statement
with the SEC; issues a prospectus.
Shelf registration: (Rule 415) File a short form
registration and place the issue on the shelf to be sold
over time.
Initial Public Offerings (IPOs): Road show; bookbuilding;
underpricing; poor long-term performance
Secondary Markets: auction vs. negotiated markets.
NYSE has 1366 seats, commission brokers, role of the
specialist, over 3,000 firms listed.
Amex—about 770 firms listed, large volume in options, and
derivative securities.
Regional exchanges
Over-the-counter (OTC) markets: 35,000 issues traded;
Bid/ask price;
Nasdaq National Market System: about 4,000 firms listed;
Level 3 may enter bid/ask prices
Level 2 receive all bid/ask quotes
3
Level 1 receives only highest bid and lowest ask prices
Third market: OTC trading of exchange-listed securities
Fourth market: direct trading in exchange-listed
securities.
Electronic Communications networks (ECNs)
Types of orders: market order, limit order, stop order
Role of specialist: maintain a fair and orderly market and
provide price continuity to the market.
Block sales:
Super-Dot system
Settlement: within three business days
Full service vs. discount brokers
Buying on the margin: initial margin and maintenance margin
Short selling:
Regulation of securities markets:
Securities Act of 1933: new issues
Securities Act of 1934 established the SEC
Securities Investor Protection Act of 1970
Circuit breakers: trading halts and collars
Insider trading
4
Chapter 4
Mutual Funds and Other Investment Companies
Investment company: Financial intermediaries that invest
the funds of individual investors in securities or other
assets. They provide:
1- record keeping and administration
2- diversification and divisibility
3- professional management
4- lower transaction cost
NAV = (market value of assets – liabilities)/shares
outstanding
Types of Investment Companies
Unit investment trust: typically an unmanaged portfolio of
fixed-income securities that are almost never changed; have
one of five year holding periods.
Closed-end investment companies: has a fixed capitalization whose shares trade OTC. The shares may sell at
premium to NAV or at a discount.
Commingled funds: trusts or retirement accounts managed by
a bank, or insurance company.
Real estate investment trusts (REITs): invest in real
estate and is similar to a closed end fund.
Mutual funds: new shares are sold and outstanding shares
are redeemed…formed by an investment advisory firm that
selects the board of trustees, who hire a separate
management company. Shares are sold and redeemed at NAV.
Types of mutual funds
1- Money market funds—taxable and tax-exempt funds.
2- Equity funds
3- Fixed income funds
4- Balanced and income funds
5- Asset allocation funds
6- Index funds
7- Specialized sector funds
Use quuotes from WSJ
5
Costs of investing in mutual funds
1- front end load
2- back end load
3- operating expenses
4- 12b-1 expenses
Mutual funds are not taxed but investors are taxed on
dividends and gains.
Mutual fund performance: Index funds outperformed 81% of
managed funds in last decade…Salomon Broad Index
outperformed 80% of managed bond funds.
Information on mutual funds: use Morningstar.
One should match investment objectives with fund types.
Prospectus shows investment objectives; its current
portfolio; management fees; turnover rate.
6
CHAPTER 5
Investors and the Investment Process
The basic framework for investing may be divided into four
stages.
1- Investors and Objectives: Individual investors need to
understand their objectives in terms of expected return
and risk. Changes in age will affect risk/return
objectives.
Professional investors or do it yourself?
Pension funds: defined contribution plans-employee bears
the risk; defined benefit-risk is borne by the employer.
Life insurance companies
Endowment funds
2- Specify constraints: Five common constraints:
Liquidity: how quickly can an asset be turned into cash
Investment horizon:
Regulations: prudent man
Tax considerations
Unique needs
3- Formulate policy: After the determination of investor’s
objectives and constraints, then an investment policy
can be formed. The first, and the biggest decision, is
the asset allocation decision.
Major asset categories: money market assets, fixed
income securities, equities, non-US securities, real
estate, precious metals and other commodities.
Active vs. passive policies.
Taxes: Tax shelter options must be considered. The tax
deferral option from capital gains.
Tax deferred retirement plans should be optimized.
4- Monitor and rebalance
7
CHAPTER 6
Risk and RETURNS: Past and Prologue
Purpose of this chapter is to present an analysis of risk
and return early enough in the text for these concepts to
be used throughout the text. Risk/return are key elements
of investment decisions—in effect everything else revolves
around these two factors.
HPR = EP – BP + Cash
BP
Difference between arithmetic average and geometric average
Risk:
Probability distribution: Possible outcomes with their
probabilities.
Variance: expected value of the squared deviation from the
mean.
Standard deviation: square root of the variance.
Risk Premiums:
Risk free rate: return of T-bill.
Risk premium: return in excess of risk-free rate.
Risk aversion: reluctance to accept risk. Investors will
accept risk because they expect to earn a risk premium.
They are speculating on the returns.
Look at the historical record. It gives us our best
estimate of what we can expect over a long period of time.
Go over Ibbotson/Sinquefield studies.
What do we learn from standard deviations and normal
distributions that help investors understand risk?
Inflation and real rates of return:
Nominal interest rate indicates the growth rate of an
investment while the real interest rate indicates the
growth rate of the investor’s purchasing power.
Fisher argued that the nominal rate should increase one for
one with increases in the expected inflation.
Asset allocation: The choice of the proportion of the total
portfolio that will be in the two major assets: risky and
risk-free. The most important decision an investor makes.
8
This decision accounts for 94% of the differences in
returns on institutionally managed funds.
In investing, leave the proportion of each asset in the
risky portfolio unchanged but change portfolio risk by
changing the risky/risk-free asset mix.
Risky asset: The weight of the risky portfolio in an
investor’s portfolio.
Risk-free asset: The weight of T-bills and/or money market
securities in the portfolio.
Capital allocation line: Fig. 6.8
Risk tolerance and asset allocation
Passive strategies: A strategy built on the premise that
securities are fairly priced and the investor should select
a diversified portfolio that mirrors a broad group of
securities. Such strategies are called indexing.
Index funds: their record and why invest in them.
Costs and benefits of passive investing:
9
Chapter 7
Efficient Diversification
Chapter focuses on the construction of the best possible
risky portfolio.
Two sources of risk: market risk, systematic risk, nondiversifiable risk and unique risk, firm-specific risk,
nonsystematic risk, diversifiable risk.
Asset allocation between risky assets:
The key determination of portfolio risk is the extent to
which returns on the two assets tend to vary with each
other. The statistical term is the correlation between the
returns of the assets in the portfolio. Correlations can
range from –1 to + 1. Portfolio risk is reduced the most
when the returns of two assets most reliably offset each
other.
Correlation coefficient = ρ = covarianceij
σi x σj
Risk-Return trade-off with two risk assets portfolio
Rate of Return:
rp = wBrB + wSrS
Expected rate of return: E(rp) = wBE(rB) + wSE(rS)
Var.: σp2 = (wBσB)2 + (wSσS)2 + 2(wBσB)(wsσS)ρBS
Discuss Fig. 7.3
The mean-variance criterion: The selection of those
portfolios that are mean-variance efficient.
Discuss Fig. 7.4
The optimal portfolio with a risk-free asset:
Discuss Fig. 7.5 – 7.7.
Efficient Diversification: 1- identify the most efficient
risk-return combinations available, 2- determine the
optimal portfolio, & 3- choose an appropriate mix between
the optimal risky portfolio and the risk-free asset.
Separation property: The portfolio choice can be separated
into two independent tasks. First, is the determination of
the optimal risky portfolio. The second task is the
10
personal choice of the amount of the risky and risk-free
asset to have in the portfolio. (This process is sometimes
called the separation theorem.)
Single-factor asset market
A factor model is a statistical model used to measure the
firm specific versus systematic risk of a stock’s return.
The single index model of security returns uses a market
index, such as the S&P 500, to represent systematic risk.
The excess return on a security may be stated as:
Ri = αi + βM + ei
The model specifies the two sources of risk: market or
systematic risk attributable to the security’s sensitivity
to market movements and firm specific risk.
The above equation is a single-variable regression equation
of Ri on the market excess return RM. The regression line
is called the security characteristic line. The slope of
this line is beta. The average security has a beta of 1,
while aggressive securities will have a beta that is
greater than one. A security can have a negative beta,
which means that it provides a hedge against systematic
risk.
The beta of a portfolio is the simple average of the
individual security betas.
When
risk
This
risk
forming highly diversified portfolios, firm-specific
becomes irrelevant. Only systematic risk remains.
means that for diversified investors, the relevant
measure for a security will be the security’s beta, β.
11
CHAPTER 8
Capital Asset Pricing and Arbitrage Pricing Theory
The capital asset pricing model, CAPM, provides a precise
prediction of the relationship we should observe between
risk of an asset and its expected return. The model
provides a bench mark rate of return for evaluating
possible investments and it helps us make an educated guess
as to the expected return on assets that have not yet been
traded in the marketplace.
The exploitation of security mispricing to earn risk-free
economic profits is called arbitrage.
Demand for stock and equilibrium prices: market prices are
determined by supply and demand.
The capital asset pricing model: A model that relates the
required rate of return for a security to its risk as
measured by beta.
Assumptions of the CAPM: p. 233
Implications of the CAPM:
1- All investors will choose to hold the market portfolio
2- The market portfolio will be on the efficient frontier.
A passive strategy is efficient. The mutual fund
theorem implies that only one mutual fund of risky
assets is sufficient to satisfy investor’s demands.
3- The risk premium of the market portfolio is proportional
to both the risk of the market and to the degree of risk
aversion of the average investor.
4- The risk premium on individual assets will be
proportional to the risk premium on the market portfolio
and to the beta of the security on the market
E(rp) = rf + βp[E(rM) – rf]
The Security Market Line (SML): graphical representation of
the expected return-beta relationship of the CAPM. It is
valid booth for portfolios and individual assets.
Applications of CAPM:
1- Use of the SML as a benchmark to assess the fair
expected return on a risky asset. The difference
between fair and actual expected rate on a stock is
called the stock’s alpha, α.
2- May be used in capital budgeting to obtain the hurdle
rate for a project.
12
The CAPM and Index Models: The CAPM relies on a theoretical
market portfolio, however, the use of an index model,
utilizing the S&P 500, comes close to representing the
market portfolio.
ri – rj = αi + βi(rM - rf) ei
Estimating the index model: Regression of a security’s
return on the returns of an index.
Explain Table 8.5 and Fig. 8.6
CAPM and the Index model: Discuss Tables 8.7 – 8.9
And Figs.8.7 – 8.10
Predicting Betas: Betas are not consistent; there is a
regression toward the mean.
CAPM and the real world
Arbitrage Pricing Theory (APT): skim pp. 252 – 260.
13
Chapter 9
The Efficient Market Hypothesis
Efficient market: a market in which prices of securities
fully reflect all known information quickly and, on
average, accurately. Therefore, the current price of a
stock reflects all known information. The EM concept does
not require a perfect adjustment in prices resulting from
information, only unbiased adjustment.
Market can be expected to be efficient because:
1- large number of rational, profit maximizing investors
2- information is costless and widely available
3- information is generated in a random fashion
4- investors react quickly and fully to new information
Random walk: The notion that stock price changes are random
and unpredictable. If stock price changes are predictable
then the market is inefficient.
Forms of market efficiency:
Weak form: prices reflect all price and volume data; past
price changes should be unrelated to future price changes.
Semistrong form: prices reflect all publicly available
information; including earnings reports, dividend
announcements, stock splits, product development, financing
difficulties.
Strong form: prices reflect all information, public and
private.
Implications of the EMH: technical analysis and the EMH are
diametrically opposed.
Implications for fundamental analysis: investor must be a
superior analyst. Money managers could reduce the
resources devoted to assessing individual securities. Task
would become:
1- be certain that diversification is achieved.
2- Achieve the appropriate level of risk.
3- Remember the tax situation of the investor
4- Keep transaction costs to a minimum
Are markets efficient?
There are three factors that will keep us from determining
the answer to this question.
1- The magnitude issue
2- The selection bias issue
14
3- The lucky event issue
Tests of the efficient market
Weak form evidence: test statistically the independence of
stock prices changes (serial correlation and signs tests).
Little evidence exists that technical trading rules based
solely on past price and volume data can outperform a
simple buy and hold strategy.
Filter rules:
Predictors of broad market movements:
Market anomalies:
Semistrong form evidence: use of event studies.
Abnormal return = ARit = Rit – E(Rit)
Cumulative abnormal return = CARi = ARit
P/E effect
Small firm in January effect
Neglected firm effect and liquidity effects
Book-to-market ratios
Reversal effect
Inside information
Postearnings announcements
Value Line enigma
Market crash of October 1987. 20% in one day!
Mutual fund performance: these people are professionals
aren’t they?
So, are markets efficient?
The market is quite efficient but not totally efficient.
15
Chapter 10
BOND PRICES and YIELDS
Chapter focuses on two aspects of critical importance to
bond investors: prices and yields
Basis point- 1/100 of one percentage point.
Bond characteristics: A fixed income security that pays a
specified cash flow over a specified period.
Coupons—coupon rate---par/face value---zero coupon bonds
Treasury bonds: WSJ quotes. Asked yield and accrued
interest
Corporate bonds: WSJ quotes. Discuss call provisions,
convertible bonds, puttable bonds, and floating rate bonds.
Preferred stock: Tax characteristics
Municipal bonds
Government agencies
International bonds: foreign bonds and Eurobonds
Innovations: reverse floaters & indexed bonds
Default risk: Ratings and rating agencies.
Junk bonds
Determinants of bond safety
Bond indentures:
Sinking funds
Subordination clauses
Dividend restrictions
Collateral
Bond pricing: the present value of the expected cash flows.
(Go over the formula)
The inverse relationship between prices and yields.
Convexity
Bond Yields:
Yield to maturity = the promised compounded rate of
return of a bond held to maturity.
Yield to call = the promised return to the call date
Default premium
Zero coupon bonds: tax treatment
16
Original issue discount bonds
STRIPS
Yield curve: term structure of interest rate
Term structure of interest rates—the relationship between
time to maturity and yields for a particular category of
bonds at a particular point in time.
Yield curve: the relationship between yields and time for
bonds that are identical except for maturity. WSJ CURVE
Term structure theories: 1- expectations theory—long-term
rate is equal to an average of the short-term rates that
are expected over the long-term period.
2-Liquidity preference theory—investors receive a liquidity
premium to induce them to lend long-term.
3-market segmentation theory—market participants may
operate only within certain maturity ranges.
4-preferred habitat theory—investors have preferred
maturity sectors but are willing to shift to other
maturities if they are adequately compensated.
Chapter 11
Managing Fixed Income Investments
Objectives:
1- To explain two important concepts that influence changes
in interest rates, the term structure of interest rates
and yield spreads.
2- To examine bond strategies and management, thereby
emphasizing the analysis and management in a portfolio
sense of one of the major financial assets.
3- To introduce the two key alternatives available to
investors, passive management strategies and active
management strategies.
Why Buy Bonds?
Conservative investor
Speculative
Interest rate risk. Interest rate risk is made up of two
parts: price risk and reinvestment risk.
Reinvestment rate risk
1-the longer the maturity of a bond, the greater the
reinvestment risk
2-the higher the coupon, the greater the dependence
17
of the total $ return from the bond on reinvestment
of the coupons
Malkiel’s bond theorems:
1- Bond prices move inversely to interest rates.
2- A decrease in rates will raise bond prices more than a
corresponding increase in rates will lower prices.
3- For a given change in market yields, changes in bond
prices are directly related to time to maturity.
4- The % price change that occurs as a result of the direct
relationship between a bond’s maturity and its price
volatility increase at a diminishing rate as the time to
maturity increases.
5- Bond price fluctuations (volatility) and bond coupon
rates are inversely related.
Problem: interest rates affect returns both positively and
negatively: price change and reinvestment rate change.
Solution: Duration: weighted average time to recover all
interest payments plus principal...measured in years.
Present duration equation and how to calculate.
Duration will always be less than the time to maturity for
coupon bonds.
Use of duration.
1- measure of the effective maturity.
2- used to immunize portfolios
3- measure of the interest rate sensitivity of a bond
portfolio.
ΔP = -(D*Δy)P
Duration is related to the key bond variables:
1- Duration expands with time to maturity but at a
decreasing rate
2- YTM is inversely related to duration.
3- Coupon is inversely related to duration
Duration tells us the difference between the effective
lives of alternate bonds; used in immunizations and
measures of bond sensitivity to interest rate movements.
Duration is additive, which means that a bond portfolio’s
duration is a weighted average of each individual bond’s
duration, i.e. bond portfolio are relatively easy to
rebalance.
18
Passive Bond Management
Passive management strategies—investor does not actively
seek out trading possibilities in attempting to outperform
the market. Choose bonds that match their objectives, risk,
and return profiles.
1- buy and hold.
2- Bond index…match an index
Immunization—a hybrid strategy. Protect a bond portfolio
against interest rate risk. Portfolio is immunized if the
duration of the portfolio is equal to the investment
horizon.
Convexity: a term used to refer to the degree to which
duration changes as YTM changes.
Active Bond Management
The bond variables of major importance in assessing the
change in bond prices are coupon and maturity.
Implications:
1- to obtain maximum price change for a given expected
change in interest rates, purchase low-coupon long
maturity bonds.
2- To protect against an expected change in interest rates,
choose large coupon, short maturity bonds.
Types of bond swaps:
1- Substitution swap: the exchange of one bond for a bond
with similar attributes but more attractively priced.
2- Intermarket spread swap: switching from one segment of
the bond market to another.
3- Rate anticipation swap: a switch made in response to
forecasts of interest rate changes.
4- Pure yield pickup swap: moving to higher yield bond,
usually with longer maturities.
Spreads change over time—widen during recessions and narrow
during times of economic prosperity.
Interest rate swaps: derivative security.
19
CHAPTER 12
Macroeconomic and Industry Analysis
Chapter presents a broad overview of macroeconomic and
industry variables.
Global economy: considerable variance in the economic
performance of different countries.
Effect of changing exchange rates.
Domestic macroeconomy: P/E varies with changes in interest
rates, risk, inflation, etc.
Key economic statistics:
GDP: indication of expanding or contracting economy
Unemployment rate:
Capacity utilization rate
Inflation:
Interest rates:
Budget deficit:
Sentiment:
Interest rates: The level of interest rates is perhaps the
most important macroeconomic factor to consider in one’s
investment analysis.
Factors that determine the level of interest rates:
1- supply of funds from savers
2- demand for funds from business
3- government’s net supply and/or demand for funds
4- expected inflation
Demand and supply shocks:
Demand shocks: reduction in taxes, increases in money
supply, increases in government spending.
Supply shocks: changes in price of imported oil, freezes,
floods, droughts, changes in wage rates.
Federal government policy:
Fiscal policy—government spending and tax actions
Monetary policy: changes in money supply; open market
operations; changes in discount rate.
Business cycles: cyclical and defensive industries
Economic indicators: where are we today?
Industry analysis
20
Chapter 13
Equity Valuation
Balance sheet valuation methods:
Book value
Liquidation value
Replacement costs
Tobin’s q: ratio of market value to replacement costs
Intrinsic value: the relationship between intrinsic value
(PV analysis) of an asset and market value. Investors have
different opinions about k and g.
Dividend discount models: Same as from Bus 231.
Discuss variable and their impact on stock price.
P0 = D1/(k – g)
Small change in g &/or k can result in large price changes
Dividend payout ratio: percentage of earnings paid out as
dividends
G = ROE x b
Where: b = plowback ratio (fraction of earnings reinvested
in firm)
Life cycles and relationship to growth and earnings
retention.
Value Line
P/E Approach
The P/E approach is sometimes called the earnings
multiplier approach. P/E is important and is reported
every day in the WSJ. Basically an identity:
Po = E1 x Po/E1
Determinants of the P/E ratio: P/E = D/E/(k-g)
1- dividend payout ratio
2- required rate of return
3- expected growth rate
Following relationship should hold:
1- the higher the payout, the higher the PE
2- the higher the expected growth rate, the higher the PE
3- the higher the required rate of return, the lower the PE
Pitfalls in P/E analysis
21
1- earnings based on accounting
2- P/Es change over the business cycle
3- The denominator of the ratio responds more sensitively
to the business cylce than the numerator.
Understanding the PE model can help investors understand
the dividend discount model.
Price/Book value sometimes used to value companies
particularly financial services companies.
Price/Cash Flow ratio:
Price/Sales ratio:
Building portfolios:
Asset allocation: refers to the allocation of portfolio
assets, i.e., how much in stocks and bonds. Asset
allocation is the investor’s most important decision.
Passive strategy: Buy and Hold…reducing transactions and
research costs.
Index funds:
Active strategy: assumes that investors possess some
advantage relative to other market participants, i.e.,
superior analytical or judgement skills, superior
information, or ability to do what other investors are
unable to do.
Security selection: financial analyst role is to attempt to
forecast stock returns through forecasting EPS. Uses
management presentations, annual reports, industry data,
etc.
22
CHAPTER 16
OPTIONS MARKETS
Option is an equity derivative security: a security that
derives its value by having a claim on the underlying
common stock.
(Go over a current quote from the WSJ)
Call option—right to buy
Put option—right to sell
In the money
Out of the money
At the money
Option Clearing Corporation: functions as an intermediary
between the brokers representing the buyers and writers.
OCC randomly selects, called assignment, and once assigned,
the writer can not execute an offsetting transaction to
eliminate the obligation.
Index options
Futures options
Foreign currency options
Interest rate options
How options work: buyer and seller have opposite
expectations about the likely performance of the underlying
stock.
1- option may expire worthless
2- option may be exercised
3- option may be sold in secondary market
Payoffs and profits from basic option positions
(Go over payoff profiles from: 1-buying a call, 2-writing a
call, 3- buying a put, and 4- writing a put.)
Basic option strategies:
Buying calls
1- bullish about the price of underlying stock.
2- Provides maximum leverage for speculative purposes.
3- Protect a short sale
23
Buying puts
1- bearish on the underlying stock
2- maximize the leverage potential
4- Used to protect an investor’s profit
Covered call
Protective puts
Portfolio insurance
Straddle
Spreads
Collars
Option like Securities
Callable bonds
Convertible securities
Warrants
CHAPTER 18
FUTURES MARKETS
Objectives: 1- to explain the basics of futures markets in
general, and 2- to explain financial futures in particular.
Cash market: for immediate delivery, includes both the spot
and forward markets.
Futures markets serve a valuable economic purpose by allowing
hedgers to shift price risk to speculators.
Futures markets include commodities and financial futures.
Regulated by Commodity Futures Trading Commission
(CFTC)
Function of Clearing House
Zero-sum game
Future contract: a standardized, transferrable agreement to
buy or sell a designated amount of a commodity or asset at a
specified future price and date. An obligation to take or
make delivery.
Mechanics of trading:
Short: commit to deliver
Long: commit to purchase
Offset: typical method of settling a contract
Daily price movements/limitations
24
(Put quote from WSJ on board and explain terms)
Margin: good faith deposit to ensure completion of the
contract.
Initial margin: each clearing house sets its own but brokerage
firm can require a higher margin
Market to market daily: maintenance margin, margin calls.
Methods of delivery
Hedgers: futures position is opposite to their position in the
cash market.
Short (sell) hedge: sell the futures
Long (buy) hedge: purchase a futures position
Basis = cash price – futures price
Basis must be zero on the maturity date of the contract
Basis risk
Speculators: buy or sell in an attempt to make a profit
Floor traders (locals) speculate because:
1- leverage
2- ease of transactions
3- low transaction costs
Determination of futures prices: spot-futures parity
Financial futures: contracts on equity, fixed-income
securities, and currencies.
Interest rate futures
(Go over quote)
Hedging with interest rate futures: short hedge
Speculating with interest rate futures
Explain basis risks
Stock index futures
(Go over WSJ quote)
Hedging with stock index futures
Short hedges
Long hedges
Limitations of hedging with stock index futures
Program trading
Triple witching
Use of currency futures: car dealer protects against fall in
dollar.
25
CHAPTER 19
PERFORMANCE EVALUATION & PORTFOLIO MANAGEMENT
Portfolio management as a process:
1- development of investment policies
2- strategies are developed and implemented
3- market conditions, relative asset mix, and the
investor’s circumstances
4- portfolio adjustments
Framework for evaluating portfolio performance: performance
based on risk and return.
Risk-adjusted measures of performance:
Sharpe: Measures excess return per unit of total risk.
Sharpe measure = [rp – rf]/σp
1- higher the result the better
2- portfolios can be ranked by the Sharpe measure
Treynor: Measures excess return per unit of systematic
risk. Treynor assumes that portfolios are well
diversified.
Treynor measure = [rp – rf]/βp
Comparing the Sharpe and Treynor measures: choice depends
upon the definition of risk. If the portfolios are fully
diversified, the rankings will be identical. Differences
in rankings between the two measures can result from
substantial differences in diversification.
Jensen’s measure: difference between what the portfolio
actually earned and what it was expected to earn given its
level of systematic risk.
αp = rp – [rf + p[rM – rf]
If alpha is significantly positive, this is evidence of
superior performance, and if alpha is negative, then
evidence of inferior performance.
Choosing the right risk measure
Market timing: Example on pp. 623-624
Use of bogey benchmark
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Asset allocation: the % of funds to be placed in stocks,
bonds, and cash. The key is to know when and how to
rebalance asset allocation because trade-offs are involved.
Objectives of active portfolio management:
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