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CHAPTER 1Investments: Background and Issues

Investments--commitment of funds to one or more assets inthe 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.

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CHAPTER 2Financial Markets and Instruments

The purpose of this chapter is to provide an overview of

the major types of financial assets available toinvestors. Most of these securities will be discussed

in much greater detail in later chapters.

Money market securitiesTreasury bills—sold at discounts; risk-free

Certificates of deposit

Commercial paper

Banker’s acceptance

Eurodollars

Repurchase agreements

Federal funds

LIBOR

Fixed income securitiesTreasury notes and bonds

Federal agency debt

Municipal bonds

Corporate bonds

Mortgages and mortgage-backed securities

Equity securitiesCommon 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 MarketsOptions—puts and calls

Futures

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CHAPTER 3How 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 isexplained. 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; seasonedissues/initial public offerings (IPOs).

Private placement: sold directly to financial institutionssuch 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 formregistration 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, andderivative 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

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Level 2 receive all bid/ask quotes

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

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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; haveone of five year holding periods.

Closed-end investment companies: has a fixed capitaliza-tion 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 sharesare 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 funds5- Asset allocation funds

6- Index funds

7- Specialized sector funds

Use quuotes from WSJ

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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 currentportfolio; management fees; turnover rate.

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CHAPTER 5Investors 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

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CHAPTER 6Risk and RETURNS: Past and Prologue

Purpose of this chapter is to present an analysis of riskand 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 + CashBP

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 aninvestment 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

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risk-free. The most important decision an investor makes.

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:

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Chapter 7Efficient Diversification

Chapter focuses on the construction of the best possible

risky portfolio.

Two sources of risk: market risk, systematic risk, non-

diversifiable 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 mostwhen 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) = w

BE(r

B) + w

SE(r

S)

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

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the optimal risky portfolio. The second task is the

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 marketA 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 theindividual security betas.

When forming highly diversified portfolios, firm-specific

risk becomes irrelevant. Only systematic risk remains.

This means that for diversified investors, the relevant

risk measure for a security will be the security’s beta, β.

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CHAPTER 8Capital Asset Pricing and Arbitrage Pricing Theory

The capital asset pricing model, CAPM, provides a precise

prediction of the relationship we should observe betweenrisk 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.

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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.

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Chapter 9The Efficient Market Hypothesis

Efficient market: a market in which prices of securities

fully reflect all known information quickly and, onaverage, 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; pastprice changes should be unrelated to future price changes.

Semistrong form : prices reflect all publicly availableinformation; including earnings reports, dividend

announcements, stock splits, product development, financing

difficulties.

Strong form : prices reflect all information, public andprivate.

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

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2- The selection bias issue

3- The lucky event issue

Tests of the efficient market

Weak form evidence: test statistically the independence ofstock 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.

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Chapter 10BOND 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

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Zero coupon bonds: tax treatment

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 forbonds 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 twoparts: price risk and reinvestment risk.

Reinvestment rate risk1-the longer the maturity of a bond, the greater the

reinvestment risk

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2-the higher the coupon, the greater the dependence

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 andnegatively: 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

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duration, i.e. bond portfolio are relatively easy to

rebalance.

Passive Bond ManagementPassive 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.

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CHAPTER 12 Macroeconomic and Industry Analysis

Chapter presents a broad overview of macroeconomic and

industry variables.

Global economy: considerable variance in the economicperformance of different countries.

Effect of changing exchange rates.

Domestic macroeconomy: P/E varies with changes in interestrates, 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 themost 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

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Economic indicators: where are we today?

Industry analysis

Chapter 13Equity 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 ApproachThe 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 return3- 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

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Pitfalls in P/E analysis

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 andresearch costs.

Index funds:

Active strategy: assumes that investors possess someadvantage 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 toforecast stock returns through forecasting EPS. Uses

management presentations, annual reports, industry data,

etc.

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CHAPTER 16OPTIONS MARKETS

Option is an equity derivative security: a security thatderives 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 intermediarybetween 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 oppositeexpectations 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 calls1- bullish about the price of underlying stock.

2- Provides maximum leverage for speculative purposes.

3- Protect a short sale

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Buying puts1- 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 18FUTURES MARKETS

Objectives: 1- to explain the basics of futures markets ingeneral, and 2- to explain financial futures in particular.

Cash market: for immediate delivery, includes both the spotand 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 aspecified 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

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Daily price movements/limitations

(Put quote from WSJ on board and explain terms)

Margin: good faith deposit to ensure completion of thecontract.

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 thecash 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 contractBasis risk

Speculators: buy or sell in an attempt to make a profitFloor 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-incomesecurities, 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 hedgesLong hedges

Limitations of hedging with stock index futures

Program trading

Triple witching

Use of currency futures: car dealer protects against fall in

dollar.

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CHAPTER 19PERFORMANCE 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 portfolioactually earned and what it was expected to earn given its

level of systematic risk.

αp = rp – [rf + βp[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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