CHAPTER 1Investments: Background and Issues

Investments--commitment of funds to one or more assets in the expectation of reaping future benefits.

Financial assets—claims on real assetsReal 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 tradeoff2- efficient markets

Financial intermediaries: bring lenders and borrowers together.

Markets:1- direct search markets2- brokered markets3- dealer markets4- auction markets

Recent trendsGlobalization--ADRsSecuritizationFinancial 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 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 securitiesTreasury notes and bondsFederal agency debtMunicipal bondsCorporate bondsMortgages and mortgage-backed securities

Equity securities

Common stockPreferred stock

Stock and bond market indexesDow Jones Industrial Average: price-weightedS&P 550 Index: value weightedNikkei 225, FTSE (100), DAXBond market indicators

Derivative Markets Options—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 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

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Level 2 receive all bid/ask quotesLevel 1 receives only highest bid and lowest ask prices

Third market: OTC trading of exchange-listed securitiesFourth 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 systemSettlement: 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 issuesSecurities Act of 1934 established the SECSecurities Investor Protection Act of 1970

Circuit breakers: trading halts and collars

Insider trading

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Chapter 4Mutual 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 administration2- diversification and divisibility3- professional management4- lower transaction cost

NAV = (market value of assets – liabilities)/shares outstanding

Types of Investment CompaniesUnit 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 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 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 funds1- Money market funds—taxable and tax-exempt funds.2- Equity funds3- Fixed income funds4- Balanced and income funds5- Asset allocation funds6- Index funds7- Specialized sector funds

Use quuotes from WSJ

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Costs of investing in mutual funds1- front end load2- back end load3- operating expenses4- 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.

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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 companiesEndowment funds

2- Specify constraints: Five common constraints:Liquidity: how quickly can an asset be turned into cashInvestment horizon: Regulations: prudent man Tax considerationsUnique 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 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.

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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 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

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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 the individual 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.

CHAPTER 8

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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 portfolio2- 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, 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 investors2- information is costless and widely available3- information is generated in a random fashion4- 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 investor4- 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 issue2- The selection bias issue

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3- The lucky event issue

Tests of the efficient marketWeak 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 effectSmall firm in January effectNeglected firm effect and liquidity effectsBook-to-market ratiosReversal effectInside informationPostearnings announcementsValue Line enigmaMarket 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 interestCorporate bonds: WSJ quotes. Discuss call provisions, convertible bonds, puttable bonds, and floating rate bonds.

Preferred stock: Tax characteristics

Municipal bondsGovernment agenciesInternational bonds: foreign bonds and Eurobonds

Innovations: reverse floaters & indexed bonds

Default risk: Ratings and rating agencies.Junk bondsDeterminants of bond safety

Bond indentures:Sinking fundsSubordination clausesDividend restrictionsCollateral

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 dateDefault premium

Zero coupon bonds: tax treatment

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Original issue discount bondsSTRIPS

Yield curve: term structure of interest rateTerm 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 11Managing 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 investorSpeculative

Interest rate risk. Interest rate risk is made up of two parts: price risk and reinvestment risk.

Reinvestment rate risk1-the longer the maturity of a bond, the greater the reinvestment risk2-the higher the coupon, the greater the dependence

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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 portfolios3- 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.

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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 12Macroeconomic 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 economyUnemployment rate:

Capacity utilization rateInflation: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 savers2- demand for funds from business3- government’s net supply and/or demand for funds4- 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 actionsMonetary policy: changes in money supply; open market

operations; changes in discount rate.

Business cycles: cyclical and defensive industriesEconomic indicators: where are we today?Industry analysis

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Chapter 13Equity Valuation

Balance sheet valuation methods:Book valueLiquidation valueReplacement costsTobin’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 bWhere: 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 ratio2- required rate of return3- expected growth rate

Following relationship should hold:1- the higher the payout, the higher the PE2- the higher the expected growth rate, the higher the PE3- the higher the required rate of return, the lower the PE

Pitfalls in P/E analysis

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1- earnings based on accounting2- P/Es change over the business cycle3- 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.

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CHAPTER 16OPTIONS 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 buyPut option—right to sell

In the moneyOut of the moneyAt 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 optionsFutures optionsForeign currency optionsInterest rate options

How options work: buyer and seller have opposite expectations about the likely performance of the underlying stock.1- option may expire worthless2- option may be exercised3- 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 potential4- Used to protect an investor’s profit

Covered callProtective putsPortfolio insuranceStraddleSpreadsCollars

Option like SecuritiesCallable bondsConvertible securitiesWarrants

CHAPTER 18FUTURES 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 HouseZero-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 deliverLong: commit to purchaseOffset: typical method of settling a contractDaily price movements/limitations

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(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 marginMarket 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 futuresLong (buy) hedge: purchase a futures positionBasis = cash price – futures priceBasis must be zero on the maturity date of the contract Basis risk

Speculators: buy or sell in an attempt to make a profitFloor traders (locals) speculate because:1- leverage2- ease of transactions3- 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 hedgeSpeculating with interest rate futuresExplain basis risks

Stock index futures(Go over WSJ quote)Hedging with stock index futuresShort hedgesLong hedgesLimitations of hedging with stock index futuresProgram tradingTriple 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 policies2- strategies are developed and implemented3- market conditions, relative asset mix, and the

investor’s circumstances4- 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 better2- 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

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.

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Objectives of active portfolio management:

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