Security Analysis,Portfolio Management,

and Financial Derivatives

Cheng Few LeeRutgers University, USA

Joseph FinnertyUniversity of Illinois, Urbana-Champaign, USA

John LeeCenter for PBBEF Research, USA

Alice C LeeState Street Corp., USA

Donald WortCalifornia State University East Bay, USA

Vjb World ScientificNEW JERSEY • LONDON • SINGAPORE • BEIJING • SHANGHAI • HONG KONG • TAIPEI • CHENNAI

Contents

Preface v

Preface for Security Analysis and Portfolio Management vii

1. Introduction 1

1.1. Objective of Security Analysis 41.2. Objective of Portfolio Management 51.3. Basic Approaches to Security Analysis and Portfolio

Management 71.4. Source of Information 91.5. Structure of the Book 101.6. Summary 16Questions and Problems 16Bibliography for Chapter 1 16

Part I Information and Security Valuation 19

2. Accounting Information and Regression Analysis 21

2.1. Introduction 212.2. Financial Statements: A Brief Review 22

2.2.1. Balance Sheet 222.2.2. Statement of Earnings 252.2.3. Statement of Equity 262.2.4. Statement of Cash Flows 26

Security Analysis, Portfolio Management, and Financial Derivatives

2.2.5. Interrelationship among Four FinancialStatements 36

2.2.6. Annual Versus Quarterly FinancialData 37

2.3. Critique of Accounting Information 372.3.1. Criticism ....'- 372.3.2. Methods for Improvement 39

2.3.2.1. Use of Alternative Information . . . 392.3.2.2. Statistical Adjustments 392.3.2.3. . Application of Finance and

Economic Theories 402.4. Static Ratio Analysis and Its Extension 40

2.4.1. Static Determination of FinancialRatios 412.4.1.1. Liquidity Ratios 432.4.1.2. Leverage Ratios 432.4.1.3. Activity Ratios 432.4.1.4. Profitability Ratios 442.4.1.5. Estimation of the Target

of a Ratio 452.4.2. Dynamic Analysis of Financial Ratios 46

2.4.2.1. Single-Equation DynamicAdjustment Process 46

2.4.2.2. Simultaneous Determinationof Financial Ratios 50

2.4.3. Statistical Distributionof Financial Ratios 51

2.5. Cost-Volume-Profit Analysis and itsApplications 532.5.1. Deterministic Analysis 532.5.2. Stochastic Analysis 56

2.6. Accounting Income Versus Economic Income 572.7. Summary 58Questions and Problems 59Appendix 2A: Simple Regression and Multiple

Regression 642A.1 Introduction 642A.2 Simple Regression 65

Contents xv

Appendix 2B: Instrumental Variables and Two-StagesLeast Squares 742B.1 Errors-in-Variable Problem 742B.2 Instrumental Variables 762B.3 Two-Stage, Least-Square 78

Bibliography to Appendix 2 79Bibliography for Chapter 2 . : . . . . , - 79

3. Common Stock: Return, Growth, and- Risk 81

3.1. Holding-Period Return 813.2. Holding-Period Yield 83

3.2.1. Arithmetic Mean 853.2.2. Geometric Mean 863.2.3. Weighted Unbiased Mean 89

3.3. Common-Stock Valuation Approaches 903.4. Growth-Rate Estimation and its Application 91

3.4.1. Compound-Sum Method 913.4.2. Regression Method 933.4.3. One-Period Growth Model \ 943.4.4. Two-Period Growth Model 983.4.5. Three-Period Growth Model 99

3.5. Risk 1043.5.1. Definitions of Risk 1043.5.2. Sources of Risk 105

3.5.2.1. Firm-Specific Factors 1063.5.2.2. Market and Economic Factors . . . 106

3.6. Covariance and Correlation 1073.7. Systematic Risk, Unsystematic Risk,

and the Market Model 1083.8. Summary 113Questions and Problems 114Appendix 3A: Logarithms and their Properties 115Bibliography for Chapter 3 117

4. Introduction to Valuation Theories 119

4.1. Discounted Cash-Flow Valuation Theory 1204.2. Bond Valuation 122

xvi Security Analysis, Portfolio Management, and Financial Derivatives

4.2.1. Perpetuity 1224.2.2. Term Bonds 123

4.3. Common-Stock Valuation 1254.4. M&M Valuation Theory 128

4.4.1. Review and Extension of M&MProposition I 132

4.4.2. Miller's Proposition on Debt and Taxes . . . . 1344.5. The Tax Reform Act of 1986 and Its Impact

on Firm Value 1384.6. Corporate Response to the Tax Reform Act

of 1986 1394.7. Capital Asset Pricing Model 1424.8. Option Valuation 146

• 4.9. Summary 150Questions and Problems 151Bibliography for Chapter 4 152

5. Bond Valuation and Analysis 155

5.1. Bond Fundamentals 155-5.1.1. Type of Issuer 156

5.1.1.1. U.S. Treasury 1565.1.1.2. Federal Agencies 1595.1.1.3. Municipalities 1595.1.1.4. Corporations 161

5.1.2. Bond Provisions 1615.1.2.1. Maturity Classes 1615.1.2.2. Mortgage Bond 1625.1.2.3. Debentures 1625.1.2.4. Coupons 1625.1.'2.5. Maturity 1635.1.2.6. Callability 1635.1.2.7. Sinking Funds 164

5.2. Bond Valuation, Bond Index, and Bond Beta 1655.2.1. Bond Valuation 1655.2.2. Bond Indices 1685.2.3. Bond Beta 169

5.3. Bond-Rating Procedures 172

Contents xvii

5.4. Term Structure of Interest 177

5.4.1. Theory 177

5.4.2. Estimation : 182

5.5. Convertible Bonds and their Valuation 186

5.6. Summary 192

Questions and Problems . ." 193

Appendix 5A: Worksheets for YieM Curves 195

Bibliography for Chapter 5 196

6. The Uses and Calculation of Market Indexes 199

6.1. Alternative Methods for Compilation of Stockand Price Indexes 200

6.1.1. Price-Weighted and Quantity-WeightedIndexes 200

6.1.2. Value-Weighted Indexes 203

6.2. Alternative Market Indexes 205

6.2.1. Dow Jones Industrial Average 205

6.2.2. Standard & Poor's Composite 500 Index . . . 206

6.2.3. New York Stock Exchange

Composite Index 207

6.2.4. Wilshire 5000 Equity Index 208

6.2.5. Standard & Poor's Composite 100 Index . . . 208

6.3. The User and Uses of Market Indexes 2096.4. Historical Behavior of Market Indexes and the

Implications of their Use for Forecasting 2106.4.1. Historical Behavior 210

6.4.2. Implications 211

6.5. Market-Index Proxy Errors and their Impact on BetaEstimates and Efficient-Market-Hypothesis Tests . . . . 212

6.6. Index-Proxy Error, Performance Measure,and the EMH Test 214

6.7. Summary 216

Questions and Problems . 216

Appendix 6A: Monthly Returns for the Wilshire 5000Equity Indexes 217

Bibliography for Chapter 6 223

xviii Security Analysis, Portfolio Management, and Financial Derivatives

Project I Financial Statement Analysis andSecurity Valuation

Part II Portfolio Theory and Asset Pricing 225

7. Sources of Risks and Their Determination 227

7.1. Risk Classification and Measurement 2277.1.1. Call Risk 2307.1.2. Convertible Risk 2317.1.3. Default Risk 2317.1.4. Interest-Rate Risk 2327.1.5. Management Risk 2327.1.6. Marketability (Liquidity) Risk 2337.1.7. Political Risk 2347.1.8. Purchasing-Power Risk 2347.1.9. Systematic and Unsystematic Risk 234

7.2. Portfolio Analysis and Application 2357.2.1. Expected Return on a Portfolio 2357.2.2. Variance and Standard Deviation

of a Portfolio 236.7.2.3. The Two-Asset Case 2397.2.4. Asset Allocation among Risk-Free Asset,

Corporate Bond, and Equity 2427.3. The Efficient Portfolio and Risk Diversification 244

7.3.1. The Efficient Portfolio 2447.3.2. Corporate Application of Diversification . . . 2467.3.3. The Dominance Principle • 2477.3.4. Three Performance Measures 2487.3.5. Interrelationship among Three Performance

Measures 2537.4. Determination of Commercial Lending Rate 2557.5. The Market Rate of Return and Market

Risk Premium 2577.6. Summary 260Questions and Problems 260Bibliography for Chapter 7 261

Contents xix

8. Risk-Aversion, Capital Asset Allocation, and MarkowitzPortfolio-Selection Model 265

8.1. Utility Theory, Utility Functions, and IndifferenceCurves 2668.1.1. Utility Theory 2668.1.2. Utility Functions 266

8.1.2.1. Linear "Utility Functionand Risk 270

8.1.2.2. Concave-Utility Functionand Risk 271

8.1.3. Risk Aversion and Asset Allocation 2748.1.4. Indifference Curves 276

8.2. Efficient Portfolios . . •.••.•.-.-. . . . . . -; • •. •.-•. . • . - . . . 2788.2.1. Portfolio Combinations 2788.2.2. Short Selling 280

8.3. Techniques for Calculating the Efficient Frontierwith Short Selling 2838.3.1. The Normal Distribution 2848.3.2. The Log-Normal Distribution .2868.3.3. Mathematical Method to Calculate Efficient

Frontier 2878.3.4. Portfolio Determination with Specific

Adjustment for Short Selling 2908.3.5. Portfolio Determination without Short

Selling 2938.4. Summary 294Questions and Problems 295Appendix 8A. Graphical Analysis in Markowitz

Portfolio-Selection Model: Three-SecurityEmpirical Solution 297

Bibliography for Chapter 8 . 309

9. Capital Asset Pricing Model and Beta Forecasting 313

9.1. A Graphical Approach to the DerivationoftheCAPM ' 313

xx Security Analysis, Portfolio Management, and Financial Derivatives

9.1.1. The Lending, Borrowing, and MarketPortfolios 314

9.1.2. The Capital Market Line 3169.1.3. The Security Market Line — The Capital

Asset Pricing Model 3189.2. Mathematical Approach tb the Derivation

of theCAPM :. 3219.3. The Market Model and Risk Decomposition 322

9.3.1. The Market Model . . ., 3239.3.2. Risk Decomposition 3239.3.3. Why Beta is Important

for Security Analysis 3249.3.4. Determination of Systematic Risk 326

. 9.4. Growth Rates, Accounting Betas, and Variance- - in EBIT 328

9.4.1. Sustainable Growth Rates 3289.4.2. ^ Accounting Beta 3319.4.3. Variance in EBIT 3319.4.4. Capital-Labor Ratio 3319.4.5. Fixed Costs and Variable Costs 332'9.4.6. Beta Forecasting 3339.4.7. Market-Based Versus Accounting-Based Beta

Forecasting 3349.5. Some Applications and Implications of the CAPM . . . 3389.6. Summary 340Questions and Problems 340Appendix 9A: Empirical Evidence for the Risk-Return

Relationship 3429A.I Anomalies in the Semi-Strong

Efficient-Market Hypothesis 348Bibliography for Chapter 9 350

10. Index Models for Portfolio Selection 353

10.1. The Single-Index Model 35310.1.1. Deriving the Single-Index Model 356

10.1.1.1. Expected Return of a Portfolio . . . 35610.1.1.2. Variance of a Portfolio 357

10.1.2. Portfolio Analysis and the Single-IndexModel 361

Contents xxi

10.1.3. The Market Model and Beta 36710.2. Multiple Indexes and the MIM 37010.3. Summary 374Questions and Problems 374Appendix 10A: A Linear-Programming Approach

to Portfolio-Analysis Models 375Appendix 10B: Expected Return, Variance, and Covariance

for an MIM 378Appendix 10C: Using Microsoft Excel to Calculate Optimal

Weights of a Portfolio 381Bibliography for Chapter 10 395

11. Performance-Measure Approaches for SelectingOptimum Portfolios 399

11.1. Sharpe Performance-Measure Approach With ShortSales Allowed 399

11.2. s Treynor-Measure Approach With ShortSales Allowed 407

11.3. Treynor-Measure Approach With Short SalesNot Allowed 411

11.4. Impact of Short Sales on Optimal-WeightDetermination 415

11.5. Economic Rationale of the TreynorPerformance-Measure Method 416

11.6. Summary 417Questions and Problems 417Appendix 11A: Derivation of Equation (11.6a) 418Appendix 1 IB: Derivation of Equation (11.10) 420Appendix 11C: Derivation of Equation (11.15) 421Appendix 11D: Quardratic Programming and Kuhn-Tucker

Conditions 422Appendix HE: Portfolio Optimization with Short-Selling

Constraints 426Bibliography for Chapter 11 432

12. The Efficient-Market Hypothesisand Security Valuation 435

12.1. Market Value Versus Book Value 43512.1.1. Assets 436

xxii Security Analysis, Portfolio Management, and Financial Derivatives

12.1.2. Liabilities and Owner's Equity 43712.1.3. Ratios and Market Information 43812.1.4. Market-to-Book Ratio 438

12.2. Market Efficiency in a Market-Model and CAPMContext 44212.2.1. Market Model . : . . . . 44512.2.2. Sharpe-Lintner CAPM Model 445

12.3. Tests for Market Efficiency 44612.3.1. Weak Form Efficiency . .•: 44612.3.2. Semi-Strong Form Efficiency 44712.3.3. Strong-Form Efficiency 451

12.4. Other Methods of Testing the EMH 45212.4.1. Random Walk with Reflecting Barriers . . . . 452

: 12.4.2. Variance-Bound Approach Test ; 45612.4.3. Hillmer and Yu's Relative EMH Test 456

12.5. Random Walk Hypothesis Versus EMH Test 45712.6. Market Anomalies 458

12.6.1. The P / E Effect 45812.6.2. The Size Effect 45812.6.3. The January Effect 459

12.7. Summary 460Questions and Problems 461Bibliography for Chapter 12 462

13. Arbitrage Pricing Theory and Intertemporal CapitalAsset Pricing Model 469

13.1. Multi-Index Models 47013.2. Model Specification of APT 475

13.2.1. Ross's Arbitrage Model Specification 47713.2.2. Empirical Test Methodology 486

13.3. APT: Empirical Results and Implications 48813.4. Identifying the Model Factors 49013.5. APT Versus MPT and the CAPM 49213.6. Intertemporal CAPM 49413.7. Applications of APT 49513.8. Summary 500Questions and Problems 500

Contents xxiii

Appendix 13A: Alternative Specifications of APT 502Appendix 13B: Lee and Wei's Empirical Results 505Bibliography for Chapter 13 508

Project II Market Model, CAPM;and Portfolio Analysis

Part III Futures and Option 513

14. Futures Valuation and Hedging 515

14.1. Futures Versus Forward Markets 51614.2. Futures Markets: Overview 51714.3. Components and Mechanics of Futures Markets . . . . 522

14.3.1. The Exchanges 52214.3.2. The Clearinghouse 52314.3.3. Margin 52414.3.4. Order Execution 52514.3.5. A Sample T-bill Futures Transaction 526

14.4. The Valuation of Futures Contracts 528'14.4.1. The Arbitrage Argument 52914.4.2. Interest Costs 52914.4.3. Carrying Costs 53014.4.4. Supply and Demand Effects 53114.4.5. The Effect of Hedging Demand 533

14.5. Hedging Concepts and Strategies 53514.5.1. Hedging Risks and Costs 53514.5.2. The Classic Hedge Strategy 53814.5.3. The Working Hedge Strategy 54014.5.4. The Johnson Minimum-Variance Hedge

Strategy 54314.5.5. The Howard-D'Antonio Optimal Risk-Return

Hedge Strategy 54414.5.5.1. Other Hedge Ratios 549

14.6. Summary 549Questions and Problems 549Appendix 14A: Basic Futures Terminology 552Bibliography for Chapter 14 554

xxiv Security Analysis, Portfolio Management, and Financial Derivatives

15. Commodity Futures, Financial Futures,and Stock-Index Futures 557

15.1. Commodity Futures 55715.2. Futures Quotations 56015.3. Financial Futures 560

15.3.1. Currency Futures 56015.3.1.1. Evolution '....' 56315.3.1.2. Advantages 56415.3.1.3. Pricing Currency Futures 567

15.3.2. The Traditional Theory of InternationalParity 57015.3.2.1. Interest-Rate Parity 57115.3.2.2. Purchasing-Power Parity 571

: „ 15.3.2.3. Fisherian Relation 57115.3.2.4. Forward Parity 572

15.3.3. Interest-Rate Futures 57215.3.4. U.S. Treasury Debt Futures 573

15.3.4.1. Characteristics of T-BillFutures 575

15.3.4.2. Pricing T-Bill FuturesContracts 575

15.3.4.3. Characteristics of T-Note andT-Bond Futures 579

15.3.5. The Eurodollar Futures Market 58015.3.5.1. Evolution 58015.3.5.2. Eurodollar Futures 583

15.4. Stock-Index Futures 58615.4.1. Pricing Stock-Index Futures Contracts . . . . 59015.4.2. Stock-Index Futures: Does the Tail Wag

the Dog? 59515.5. Summary 598Questions and Problems 598Bibliography for Chapter 15 599

16. Options and Option Strategies 603

16.1 The Option Market and Related Definitions 60416.1.1 What is an Option? 604

Contents xxv

16.1.2 Types of Options and TheirCharacteristics 604

16.1.3 Relationships between the Option Priceand the Underlying Asset Price 606

16.1.4 Additional Definitions and DistinguishingFeatures .; 609

16.1.5 Types of Underlying Asset 61116.1.6 Institutional Characteristics 612

16.2 Put-Call Parity . . . X . .-.- 61316.2.1 European Options 61316.2.2 American Options 61616.2.3 Futures Options 61716.2.4 Market Application 619

16.3 Risk-Return Characteristics of Options 62016.3.1 Long Call 62016.3.2 Short Call 62116.3.3 Long Put 62416.3.4 Short Put 62616.3.5 Long Straddle .62716.3.6 Short Straddle ' 63016.3.7 Long Vertical (Bull) Spread 63216.3.8 Short Vertical (Bear) Spread 63516.3.9 Calendar (Time) Spreads . 636

16.4 Excel Approach to Analyze the Option Strategies . . . 63716.4.1 Long Straddle 63816.4.2 Short Straddle 63916.4.3 Long Vertical (Bull) Spread 64116.4.4 Short Vertical (Bear) Spread 64116.4.5 Protective Put '. 64316.4.6 Covered Call 64316.4.7 ' Collar. . . . ' 646

16.5 Summary 646Questions and Problems 647Bibliography for Chapter 16 652

17. Option Pricing Theory and Firm Valuation 655

17.1 Basic Concepts of Options 65517.1.1 Option Price Information 658

xxvi Security Analysis, Portfolio Management, and Financial Derivatives

17.2 Factors Affecting Option Value 66217.2.1 Determining the Value of a Call Option

Before the Expiration Date 66217.3 Determining The Value of Options 672

17.3.1 Expected Value Estimation 67217.3.2 The Black-Scholes Option Pricing

Model H 67317.3.3 Taxation of Options 67717.3.4 American Options . . . . _ . . 678

17.4 Option Pricing Theory and Capital Structure 67917.4.1 Proportion of Debt in Capital Structure . . . 68217.4.2 Riskiness of Business Operations 68317.4.3 Option Pricing Approach to Determine

the Optimal Capital Structure 685- 17.5 Warrants 685

17.6 Summary 688Questions and Problems 689Appendix 17A: Applications of the Binomial Distribution

To Evaluate Call Options 694Bibliography for Chapter 17 702 '

18. Decision Tree and Microsoft ExcelApproach for Option Pricing Model 705

18.1 Call and Put Options 70618.2 One-Period Option Pricing Model 70818.3 Two-Period Option Pricing Model 71318.4 Using Microsoft Excel to Create the Binomial

Option Trees 71618.5 Black-Scholes Option Pricing Model 71918.6 Relationship between the Binomial Option Pricing

Model and the Black-Scholes Option PricingModel 724

18.7 Decision Tree Black-Scholes Calculation 72418.8 Summary 725Questions and Problems 726Appendex 18A: Excel VBA Code — Binomial Option

Pricing Model 728Bibliography for Chapter 18 738

Contents xxvii

19. Normal, Log-Normal Distribution, and Option Pricing Model 739

19.1 The Normal Distribution 74019.2 The Log-Normal Distribution 74119.3 The Log-Normal Distribution and Its Relationship

to the Normal Distribution .̂ 74219.4 Multivariate Normal'and Log-Normal

Distributions i . . . ' 74419.5 The Normal Distribution as an Application

to the Binomial and Poisson "Distribution 74819.6 Applications of the Log-Normal Distribution in Option

Pricing 75219.7 The Bivariate Normal Density Function 75419.8 American Call Options 757

19.8.1 Price American Call Options by the BivariateNormal Distribution 757

19.8.2 Pricing an American Call Option:An Example 760

19.9 Price Bounds for Options 76319.9.1 Options Written on Nondividend-Paying

Stocks 76319.9.2 Options Written on Dividend-Paying

Stocks 76419.10 Summary 769Questions and Problems 770Appendix 19A: Microsoft Excel Program for Calculating

Cumulative Bivariate Normal DensityFunction 771

Appendix 19B: Microsoft Excel Program for Calculatingthe American Call Options 773

Bibliography for Chapter 19 ' . . . 776

20. Comparative Static Analysis of the Option Pricing Models 777

20.1 Delta (A) 77720.1.1 Derivation of Delta for Different Kinds

of Stock Options . 77820.1.2 Application of Delta (A) 782

20.2 Theta (9) 783

xxviii Security Analysis, Portfolio Management, and Financial Derivatives

20.2.1 Derivation of Theta for Different Kindsof Stock Options 784

20.2.2 Application of Theta (9) 78720.3 Gamma (F) 788

20.3.1 Derivation of Gamma for Different Kindsof Stock O p t i o n s ' . . . . ' . 788

20.3.2 Application of Gamma (r) 79020.4 Vega (v) 792

20.4.1 Derivation of Vega for Different Kindsof Stock Options 793

20.4.2 Application of Vega (v) 79620.5 RHO (p) 797

20.5.1 Derivation of Rho for Different Kindsof Stock Options 797

20.5.2 Application of Rho (p) 79920.6 Derivation of Stock Options with Respect

to Exercise Price 80020.7 Relationship between Delta, Theta, and Gamma . . . . 80220.8 Summary 803Questions and Problems 803Bibliography for Chapter 20 804

Project III Option Valuation and Strategies

Part IV Applied Portfolio Management 807

21. Security Analysis and Mutual Fund Performance c 809

21.1 Fundamental Versus Technical Analysis 80921.1.1 Fundamental Analysis 81021.1.2 Technical Analysis 81721.1.3 Dow Theory 81821.1.4 The Odd-Lot Theory 81921.1.5 The Confidence Index 81921.1.6 Trading Volume . . . 82021.1.7 Moving Average . . -. 820

21.2 Anomalies and Their Implications 82321.2.1 Basu's Findings 824

Contents xxix

21.2.2 Reinganum's Findings 82521.2.3 Banz's Findings 82621.2.4 Keim's Findings 82621.2.5 Additional Findings 827

21.3 Security Rate-of-Return Forecasting 82821.3.1 Regression Approach . * 829

21.3.1.1 Fixed-Coefficient,MarketModel . 829

21.3.1.2 Time-Varying-Coefficient MarketModel 830

21.3.2 Time-Series Approach 83021.3.2.1 Component Analysis 83121.3.2.2 ARIMA Models 832

21.3.3 Composite Forecasting 83521.4 Value Line Ranking 837

21.4.1 Criteria of Ranking 83821.4.2 Performance Evaluation 839

21.5 Mutual Funds 84021.5.1 Mutual-Fund Classification 84121.5.2 Mutual-Fund Manager's Timing

and Selectivity 84221.6 Summary 857Questions and Problems 857Appendix 21A: Composite Forecasting Method 858Bibliography for Chapter 21 861

22. International Diversification and Asset Pricing 867

22.1 Exchange-Rate Risk 86822.2 Theoretical Effects of International Diversification . . . 873

22.2.1 Segmented Versus IntegratedWorld Markets 873

22.2.2 The CAPM and the APT AppliedInternationally 877

22.2.3 Inflation and Exchange-Rate Risks 87922.2.4 Are World Markets Efficient? 88222.2.5 Empirical Evidence Supporting International

Diversification 88322.3 Applied International Diversification

xxx Security Analysis, Portfolio Management, and Financial Derivatives

22.3.1 Direct Foreign Investment 88422.3.1.1 Canada 88522.3.1.2 Germany 88522.3.1.3 Japan 88522.3.1.4 Other Pacific-Basin Countries . . . . 88522.3.1.5 United-Kingdom 886

22.3.2 Indirect Foreign Investment . - . . ••• 88622.3.2.1 American Depository Receipts . . . 88622.3.2.2 Foreign bonds and Eurobonds . . . 88722.3.2.3 International Mutual Funds 888

22.3.3 Return, Risk, and Sharpe PerformanceMeasure for International Indexes 892

' 22.4 Currency Option and Index Option 89522.4.1 Currency Option 895

: , 22.4.2 Index Option 89922.5 Summary 900Questions and Problems 901Appendix 22A: Objectives and Policies of an International

Mutual Fund 902Bibliography for Chapter 22 904

23. Bond Portfolios: Managementand Strategy 909

23.1 Bond Strategies 90923.1.1 Riding the Yield Curve 90923.1.2 Maturity-Structure Strategies 91023.1.3 Swapping 911

23.1.3.1 Substitution Swap 91223.1.3.2 Intermarket-Spread Swap 91423.1.3.3 Interest-Rate

Anticipation Swap 91623.1.3.4 Pure Yield-Pickup Swap 919

23.2 Duration 91923.2.1 Weighted-Average Term to Maturity 92123.2.2 WATM Versus Duration Measure 92223.2.3 Yield to Maturity 92423.2.4 The Macaulay Model 927

23.3 Convexity 933

Contents xxxi

23.4 Contingent Immunization 93623.5 Bond Portfolios: A Case Study 93723.6 Summary 942Questions and Problems 943Bibliography for Chapter 23 945

24. Portfolio Insurance and Synthetic Options 949

24.1 Basic Concepts of Portfolio" Insurance 94924.2 Strategies and Implementation

of Portfolio Insurance 95524.2.1 Stop-Loss Orders 95624.2.2 Portfolio Insurance with Listed

Put Options 95624.2.3 Portfolio Insurance with Synthetic

Options 95924.2.4 Portfolio Insurance with Dynamic

Hedging 96324.3 Comparison of Alternative Portfolio-Insurance

Strategies 96424.3.1 Synthetic Options 96424.3.2 Listed Put Options 96724.3.3 Dynamic Hedging and Listed

Put Options 96824.4 Impact of Portfolio Insurance on the Stock Market

and Pricing of Equities 96924.4.1 Regulation and the Brady Report 971

24.5 ' Empirical Studies of Portfolio Insurance 97324.5.1 Leland (1985) 97524.5.2 Asay and Edelsburg (1986) . 97724.5.3 Eizman (1986) 97824.5.4 .Rendleman and McEnally (1987) 97924.5.5 Garcia and Gould (1987) 98024.5.6 Zhu and Kavee (1988) 98124.5.7 Perold and Sharpe (1988) 98124.5.8 Rendleman and O'Brien (1990) 98224.5.9 Loria, Pham, and Sim (1991) 98324.5.10 Do and Faff (2004) 98324.5.11 Cesari and Cremonini (2003) 98424.5.12 Herold, Maurer, and Purschaker (2005) . . . . 985

xxxii Security Analysis, Portfolio Management, and Financial Derivatives

24.5.13 Hamidi, Jurczenko, and Maillet (2007) . . . . 986

24.5.14 Ho, Cadle, and Theobald (2008) 986

24.6 Summary 987

Questions and Problems 988

Bibliography for Chapter 24 989

Project IV Mutual Fund, International Portfolio,and Bond Portfolio

Part V Special Topics 993

25. Capturing Equity Risk Premia 995

• •' 25.1 Global Equity Risk Model 99725.1.1 Estimation Universe 997

: ^ 25.1.2 GEM2 Factor Structure 99725.2 Factor Portfolios 1007

25.2.1 Simple Factor Portfolios 100725.2.2 Pure Factor Portfolios 100825.2.3 Optimized Factor Portfolios 1010

25.3 Results 101025.3.1 Cumulative Factor Returns 101025.3.2 Summary Statistics 1017

25.4 Leading Economic Indicators and BarraFactor Returns 1020

25.5 Summary . . 1023Questions and Problems 1024Bibliography for Chapter 25 1024

26. Simultaneous Equation Models for Security Valuation 1027

26.1 Warren and Shelton Model 102726.2 Johnson & ^Johnson as a Case Study 1032

26.2.1 Data Sources and Parameter Estimations . . . 104326.2.2 Procedure for Calculating WS Model 1043

26.3 Francis and Rowell Model 104926.3.1 FR Model Specification 105526.3.2 A Brief Discussion of FR'S Empirical

Results 106226.4 Feltham-Ohlson Model for Determining

Equity Value 1062

Contents xxxiii

26.5 Combined Forecasting Method to DetermineEquity Value 1065

26.6 Summary 1065Questions and Problems 1066Appendix 26A: Procedure of Using Microsoft Excel

to Run Finplan Program 1067Appendix 26B: Program of Finplan with an Example 1069Bibliography for Chapter 26 . : 1078

27. Ito's Calculus: Derivation of the Black-Scholes OptionPricing Model 1081

27.1 The Ito Process and Financial Modeling 108127.2 Ito Lemma 108627.3 Stochastic Differential-Equation Approach to

Stock-Price Behavior 108827.4 The Pricing of an Option 109327.5 A Reexamination of Option Pricing 109727.6 Remarks on Option Pricing 110327.7 Summary 1105Questions and Problems 1105Appendix 27A: An Alternative Method to Derive

the Black-Scholes Option Pricing Model . . . 110627A.1 Assumptions and the Present Value

of the Expected Terminal OptionPrice 1107

27A.2 Present Value of the PartialExpectation of the TerminalStock Price 1109

27A.3 Present Value of the Exercisei Price under Uncertainty 1112

Bibliography for Chapter 27 1114

Appendix Tables 1117

Acknowledgments 1123

Author Index 1129

Subject Index 1139