1 1he lnvesLmenL LnvlronmenL .....................................................................................

2
2 AsseL Classes and llnanclal lnsLrumenLs .................................................................... 3
3 Pow securlLles are Lraded ........................................................................................ 10
4 MuLual lunds and oLher lnvesLmenL companles ...................................................... 12
3 Learlng AbouL 8eLurn and 8lsk from Lhe PlsLorlcal 8ecord ...................................... 13
6 8lsk and rlsk averslon ............................................................................................... 18
7 CpLlmal 8lsky orLfollos ........................................................................................... 19
9 1he CaplLal AsseL rlclng Model ............................................................................... 22
10 ArblLrage rlclng 1heory and mulLlfacLor models of rlsk and reLurn .................... 23
12 8ehavloral llnance and 1echnlcal Analysls ........................................................... 28
13 Lmplrlcal evldence on securlLy reLurns ................................................................ 30
14 8ond rlces and ?lelds .......................................................................................... 31
13 1he 1erm SLrucLure of lnLeresL 8aLes ................................................................... 33
16 Managlng 8ond orLfollos .................................................................................... 37
24 orLfollo erformance LvaluaLlon ........................................................................ 40
23 orLfollo performance evaluaLlon ........................................................................ 43
1 1he |nvestment Lnv|ronment

1.1Investments and f|nanc|a| assets
sseotlol ootote of oo lovestmeot ls to.
1: 8educe currenL consumpLlon
2: lanned for laLer consumpLlon

!"#$ #&&"'& are asseLs Lo produce goods and servlces CeneraLe neL lncome Lo Lhe economy
()*#*+)#$ #&&"'& are clalms on real asseLs (such as sLock and bonds)
AllocaLe lncome or wealLh among lnvesLors.

Assets L|ab|||t|es
keol Assets

lloooclol Assets

Lxamp|es:
- aLenLs: 8eal
- Lease obllgaLlons: llnanclal
- CusLomers goodwlll: 8eal
- A college educaLlon: 8eal
- A $10 blll: llnanclal

I|nanc|a| assets
We dlsLlngulsh among a broad Lype of flnanclal asseLs common Lypes are:
1: llxed lncome
2: LqulLy
3: uerlvaLlves
I|xed |ncome promlse elLher a flxed sLream of lncome or a sLream of lncome LhaL ls deLermlned
accordlng Lo a speclfled formula. llxed lncome securlLles come ln a Lremendous varleLy of
maLurlLles and paymenL provlslons.
AL one exLreme Lhe mooey motket Lhls refers Lo flxed lncome securlLles LhaL are shorL, hlghly
markeLable, low rlsk.
ln conLrasL ls Lhe copltol motket lncludes long Lerm securlLles (Lreasury bonds), bonds lssued
federal agencles, sLaLe and local munlclpallLles.
Lqu|ty or common stock Lhls represenL Lhe ownershlp share ln Lhe corporaLlon. lnvesLmenLs ln
equlLy Lend Lo be rlskler Lhan flxed lncome, because success depends on Lhe success of Lhe flrm
Der|vat|ve secur|t|es. Such as opLlons and fuLures conLracLs provlde payoffs LhaL are deLermlned
by Lhe prlces of oLher asseLs such as bonds or sLock prlces (fuLure swap conLracLs)
I|nanc|a| markets
,*-./0#').*#$ /.$"1 lnvesLors ln Lhe sLock markeL ulLlmaLely declde whlch companles wlll llve
and dle. SLock prlces wlll reflecL Lhelr collecLlve [udgmenL.
2.*&304').* ')0)*51 flnanclal markeLs allow lndlvldual Lo separaLe declslons concernlng currenL
consumpLlon from consLralnLs LhaL oLherwlse would be lmposed by currenL earnlngs. ShlfL
consumpLlon by savlng earnlngs ln hlgh earnlngs perlod Lo low low earnlngs perlod -> work llfe
Lo reLlremenL.

A||ocat|on of r|sk: caplLal markeLs allow Lhe rlsk LhaL ls lnherenL Lo all lnvesLmenLs Lo be borne
by Lhe lnvesLors mosL wllllng Lo bear rlsk. L.C. lnvesLmenL ln lord planL: low rlsk (bond) hlgh rlsk
(shares), buL boLh have a dlfferenL reward sysLem.

6"4#/#').* .7*"/&8)4 #*9 0#*#5"0"*'1 Lhls sLrucLure means LhaL Lhe owners and managers
of Lhe flrm are dlfferenL parLles. Agency problem (managers who are hlres as agenLs of Lhe
shareholders, may pursue Lhelr own lnLeresL.)
Mecboolsm to solve oqeocy ptoblem ote.
1. CompensaLlon plan Lle Lhe lncome of managers Lo Lhe success of Lhe flrm.
2. 1he board of dlrecLors are noL defenders of Lop managemenL Lhey can force ouL managemenL
Leams LhaL are under performlng.
3 CuLslders (penslon funds, securlLy analysLs) monlLor Lhe flrm closely and make Lhe llfe of poor
performers aL Lhe leasL uncomforLable.
4. 8ad performers are sub[ecL Lo Lhe LhreaL of a Lakeover. Shareholders can elecL a dlfferenL
board by (proxy conLesL)

Cr|s|s |n corporate governance
lor markeLs Lo be efflclenL Lhere musL be enough Lransparency LhaL allows lnvesLors Lo make
well-lnformed declslons.
Account|ng scanda|s example Lnron and WorldCom
Ana|yst scanda|s (overopLlmlsLlc research rapporLs) example ClLy group Salamon SmlLh 8arney
In|t|a| pub||c offer|ng cred|t Swlss flrsL 8osLon

1he |nvestments process
Asset a||ocat|on chooslng among broad asseL classes such as sLocks and bonds
Secur|ty se|ect|on declslon ls Lo cholce of whlch parLlcular securlLles Lo hold wlLhln asseL classes
1op down porLfollo consLrucLlon Lechnlque sLarLs wlLh Lhe asseL allocaLlon declslon-Lhe
allocaLlon of funds across broad asseL classes-and Lhe progress Lo more speclflc securlLy
selecLlon declslon.
Secur|ty ana|ys|s lnvolves Lhe valuaLlon of parLlcular securlLles LhaL mlghL be lncluded ln Lhe
porLfollo

! 1op down porLfollo managemenL

ln conLrasL ls Lhe boLLom-up sLraLegy: Lhls sLraLegy does focus Lhe porLfollo on Lhe asseLs LhaL
seem Lo offer Lhe mosL aLLracLlve lnvesLmenL opporLunlLles.

I|nanc|a| markets are h|gh|y compet|t|ve.
1here are lmpllcaLlons of Lhe 'free lunches' (securlLles LhaL are underprlced LhaL Lhey represenL
obvlous bargaln.) 1hls no-free lunch proposlLlon has several lmpllcaLlons:

CompeLlLlon leads Lo a k|sk return trade off, ln whlch securlLles LhaL offer hlgher expecLed
reLurn also lmpose greaLer rlsk on lnvesLors. 1he presence of rlsk, however, lmplles LhaL acLual
reLurns can dlffer conslderably from expecLed reLurns aL Lhe beglnnlng of Lhe lnvesLmenL perlod.
CompleLlon among securlLy analysL also promoLes flnanclal markeLs LhaL are nearly
lnformaLlonal efflclenL (Market eff|c|ency) meanlng LhaL prlces reflecL all avallable lnformaLlon
concernlng Lhe value of Lhe securlLy. ln Lhe efflclenL markeL Lhere ls a cholce beLween passlve
and acLlve managemenL:
Act|ve management
llndlng undervalued securlLles
1lmlng Lhe markeL
ass|ve management
no aLLempL Lo flndlng undervalued securlLles
no aLLempL Lo Llme
Poldlng dlverslfled porLfollo
asslve lnvesLmenLs sLraLegles make sense ln nearly efflclenL markeLs.

|ayers |n f|nanc|a| markets
llrms neL borrowers
Pouseholds neL savers
CovernmenL neL savers and borrowers

I|nanc|a| |ntermed|ar|es
llnanclal lnLermedlarles pool lnvesLor funds and lnvesL Lhem. 1helr servlces are ln demand
because small lnvesLors cannoL efflclenLly gaLher lnformaLlon, dlverslLy and monlLor porLfollos.
1he flnanclal lnLermedlary sells hls own securlLles Lo Lhe small lnvesLors. 1he lnLermedlary lnvesL
Lhe funds Lhus ralsed, uses Lhe proceeds Lo pay back Lhe small lnvesLors and proflLs from Lhe
dlfference (spread)
!"+"*' '/"*9&
8ecenL Lrends ln flnanclal markeLs lnclude globallzaLlon, securlLlzaLlon, flnanclal englneerlng of
asseLs, and growLh of lnformaLlon and compuLer neLworks.
G|oba||zat|on 1endency Loward a worldwlde lnvesLmenL envlronmenL, and Lhe lnLegraLlon of
naLlonal caplLal markeLs
Secur|t|zat|on oollng loans for varlous purposes lnLo sLandardlzed securlLles backed by Lhose
loans, whlch can Lhen be Lraded llke any oLher securlLy
I|nanc|a| eng|neer|ng creaLlng and deslgnlng securlLles wlLh cusLom-Lallored characLerlsLlcs

1he flnanclal crlsls showed Lhe lmporLance of sysLemaLlc rlsk. 1he rlsk lnherenL Lo Lhe enLlre
markeL or markeL segmenL. Also known as "un-dlverslflable rlsk" or "markeL rlsk.

2 Asset C|asses and I|nanc|a| Instruments

1) I|xed |ncome market:
Money market. o sobsectot of tbe flxeJ-locome motket. lt cooslsts of vety sbott-
tetm Jebt secotltles tbot osoolly ote blqbly motketoble. Mooy of tbese secotltles
ttoJe lo lotqe Jeoomlootloos, ooJ so ote oot of tbe teocb of loJlvlJool lovestots.
Mooey motket fooJs, bowevet ote eoslly occesslble to smoll lovestots.
o 1reasury 8|||s (1-bllls, or [usL bllls) " mosL markeLable of all money
markeL lnsLrumenLs. SlmplesL form of borrowlng: 1he governmenL
ralses money by selllng bllls Lo Lhe publlc. AL maLurlLy Lhe holder geLs
Lhe face value. 1-bllls have lnlLlal maLurlLles of 28, 91 or 182 days. 1-bllls
are very llquld and sold aL low LransacLlon cosL and wlLh noL much prlce
rlsk. 1he asked prlce ls Lhe prlce you would have Lo pay Lo buy a 1-blll.
1he bld prlce ls Lhe sllghLly lower prlce you would recelve lf you wanLed
Lo sell a blll Lo a dealer. 1he bld-asked spread ls Lhe dlfference beLween
Lhese prlces.
o Cert|f|cates of Depos|t (CD) " A Llme deposlL wlLh a bank. 1lme
deposlLs may noL be wlLhdrawn on demand. 1he bank pays lnLeresL and
prlnclpal Lo Lhe deposlLor only aL Lhe end of Lhe flxed Lerm of Lhe Cu.
CLs lssued ln denomlnaLlons greaLer Lhan 100.000.
o Commerc|a| aper " Large, well-known companles ofLen lssue Lhelr
own shorL-Lerm unsecured debL noLes raLher Lhan borrow dlrecLly from
banks. 1hese noLes are called commerclal papers. Commerclal paper
maLurlLles range up Lo 270 days. usually lL ls lssued ln mulLlples of
100.000.
o 8ankers' Acceptances " sLarLs as an order Lo a bank's cusLomer Lo pay
a sum of money aL a fuLure daLe, Lyplcally wlLhln 6 monLhs. When Lhe
bank endorses Lhe order for paymenL as accepLed", lL assumes
responslblllLy for ulLlmaLe paymenL Lo Lhe holder of Lhe accepLance. AL
Lhls plnL, Lhe accepLance may be Lraded ln secondary markeLs llke any
oLher clalm on Lhe bank. very safe asseLs.
o Lurodo||ars " are dollar-denomlnaLed deposlLs aL forelgn banks or
forelgn branches of Amerlcan banks. 8y locaLlng ouLslde Lhe unlLed
sLaLes, Lhese banks escape regulaLlon by Lhe lederal 8eserve.
o kepos and keverses repos" or 8s" " 1he dealer sells governmenL
securlLles Lo an lnvesLor on an overnlghL basls, wlLh an agreemenL Lo
buy back Lhose securlLles Lhe nexL day aL a sllghLly hlgher prlce. 1erm
repo " Lhe same buL loan can be 30 days or more. 8everse repo: ls Lhe
mlrror lmage of a repo. uealer flnds an lnvesLor holdlng governmenL
securlLles and buys Lhem, agreelng Lo sell Lhem back aL a speclfled
hlgher prlce on a fuLure daLe.
o Iedera| Iunds. " banks malnLaln deposlLs of Lhelr own aL a federal
reserve bank. Lach member bank of Lhe federal reserve sysLem (led) ls
requlred Lo malnLaln a mlnlmum balance ln a reserve accounL wlLh Lhe
led. lunds ln Lhe bank's reserve accounL are called federal funds, or fed
funds. ln Lhe federal funds markeL, banks wlLh excess funds lend Lo
Lhose wlLh a shorLage. 1hese loans, whlch are usually overnlghL
LransacLlons, are arranged aL a raLe of lnLeresL called Lhe federal funds
raLe.
o 8rokers' Ca||s " lndlvlduals who buy sLocks on margln borrow parL of
Lhe funds Lo pay for Lhe sLocks from Lhelr broker. 1he broker ln Lurn
may borrow Lhe funds from a bank, agreelng Lo repay Lhe bank
lmmedlaLely (on call) lf Lhe bank requesLs lL. 1he raLe pald on such loans
ls usually abouL 1 hlgher Lhan Lhe raLe on shorL-Lerm 1-bllls.
o 1he LI8Ck Market. 1he London lnLerbank Cffered 8aLe (Ll8C8) ls Lhe
raLe aL whlch large banks ln London are wllllng Lo lend money among
Lhemselves. Lu8l8C8 (Luropean lnLerbank Cffered 8aLe) aL whlch banks
ln Lhe euro zone are wllllng Lo lend euros among Lhemselves.
o ?lelds on Money markeL lnsLrumenLs: AlLhough mosL money markeL
securlLles are of low rlsk, Lhey are noL rlsk-free.
1he bond market " ls composeJ of looqet-tetm bottowloq ot Jebt losttomeots
tboo tbose ttoJe lo tbe mooey motket. 1bls motket locloJes:
o 1reasury Notes and 8onds " 1he u.S. governmenL borrows funds ln
large parL by selllng 1reasury noLes and Lreasury bonds. 1-noLe
maLurlLles range up Lo 10 years, whereas bonds are lssued wlLh
maLurlLles ranglng from 10 Lo 30 years. 8oLh make semlannual lnLeresL
paymenLs called coopoo poymeots. AlLhough noLes and bonds are sold
ln denomlnaLlons of 1000 par value, Lhe prlces are quoLed as a
percenLage of par value (a bld prlce of 98.3313 should be lnLerpreLed as
98.3313 of par, or 983313 for Lhe 1000 par value securlLy.
o Inf|at|on-rotected 1reasury 8onds " LeasL rlsky. CovernmenL bonds
LhaL are llnked Lo an lndex of Lhe cosL of llvlng ln order Lo provlde Lhelr
clLlzens wlLh an effecLlve way Lo hedge lnflaLlon rlsk. lnflaLlon-proLecLed
Lreasury bonds are called 1lS (1reasury lnflaLlon roLecLed SecurlLles).
1he real lnLeresL raLes you earn on Lhese securlLles are rlsk-free lf you
hold Lhem Lo maLurlLy.
o Iedera| Agency Dept " Some governmenL agencles lssue Lhelr own
securlLles Lo flnance Lhelr acLlvlLles. 1hese agencles usually are formed
Lo channel credlL Lo a parLlcular secLor of Lhe economy LhaL congress
belleves mlghL noL recelve adequaLe credlL Lhrough normal prlvaLe
sources. 1hese securlLles are consldered exLremely safe asseLs, and Lhelr
yleld spread above Lreasury securlLles ls usually small.
o Internat|ona| bonds "Many flrms borrow abroad and many lnvesLors
buy bonds from forelgn lssuers. ln addlLlon Lo naLlonal caplLal markeLs,
Lhere ls a Lhrlvlng lnLernaLlonal caplLal markeL, largely cenLered ln
London. ln conLrasL Lo bonds LhaL are lssued ln forelgn currencles, many
flrms lssue bonds ln forelgn counLles buL ln Lhe currency of Lhe lnvesLor.
o Mun|c|pa| 8onds " Are lssued by sLaLe and local governmenLs. 1hey
are slmllar Lo 1reasury and corporaLe bonds excepL LhaL Lhelr lnLeresL
lncome ls exempL from federal lncome LaxaLlon. Llke Lreasury bond,
munlclpal bonds vary wldely ln maLurlLy. MaLurlLles range up Lo 30
years. 1he key feaLure of munlclpal bonds ls Lhelr Lax-exempL sLaLus.
8ecause lnvesLors pay nelLher federal nor sLaLe Laxes on Lhe lnLeresL
proceeds, Lhey are wllllng Lo accepL lower ylelds on Lhese securlLles.
r(1-1)= afLer Lax raLe avallable.
o Corporate 8onds "CorporaLe bonds are Lhe means by whlch prlvaLe
flrms borrow money dlrecLly from Lhe publlc. 1hese bonds are slmllar ln
sLrucLure Lo 1reasury lssues (Lhey Lyplcally pay seml-annual coupons
over Lhelr llves and reLurn Lhe face value Lo Lhe bondholder aL maLurlLy.
1hey dlffer mosL lmporLanLly from Lreasury bonds ln Lhe degree of rlsk.
# Secured bonds: whlch have speclflc collaLeral backlng Lhem ln
Lhe evenL of flrm bankrupLcy
# Debentures: unsecured bonds, whlch have no collaLeral
# Subord|nated debentures, have a lower-prlorlLy clalm Lo Lhe
flrm's asseLs ln Lhe evenL of bankrupLcy.
CorporaLe bonds someLlmes come wlLh opLlons aLLached.
Ca||ab|e bonds glve Lhe flrm Lhe opLlon Lo repurchase Lhe bond
from Lhe holder aL a sLlpulaLed call prlce.
Convert|b|e bonds glve Lhe bondholder Lhe opLlon Lo converL
each bond lnLo a sLlpulaLed number of shares of sLock.
o Mortgages and Mortgage-backed secur|t|es " unLll Lhe 1970s almosL
all home morLgages were wrlLLen for a long Lerm (13-30 year) wlLh a flxed
lnLeresL raLe over Lhe llfe of Lhe loan, wlLh equal flxed monLhly paymenLs.
1hese so-called convenLlonal morLgages are sLlll Lhe mosL popular, buL a
dlverse seL of alLernaLlve morLgage deslgns has developed. llxeJ-tote
mottqoqes have posed dlfflculLles Lo lenders ln years of lncreaslng lnLeresL
raLes. AJjostoble tote mottqoqe: was a response Lo Lhls lnLeresL raLe rlsk.
Mottqoqe-bockeJ secotlty: ls elLher an ownershlp clalm ln a pool of
morLgages or an obllgaLlon LhaL ls secured by such a pool. MorLgage lenders
orlglnaLe loans and Lhen sell packages of Lhese loans ln Lhe secondary
markeL. lor Lhls reason, Lhese morLgage-backed securlLles are called pass-
Lroughs.
2) Lqu|ty secur|t|es
Common stock as ownersh|p shares " also known as equ|ty secur|t|es or equ|t|es,
represenL ownershlp shares ln a corporaLlon. Lach share of common sLock enLlLles
lLs owner Lo one voLe on any maLLer of corporaLe governance LhaL are puL Lo voLe
aL a annual meeLlng and Lo a share ln Lhe flnanclal beneflLs of ownershlp. A board
of dlrecLors elecLed by Lhe shareholders conLrols Lhe corporaLlon. 1he board
selecLs managers who run Lhe corporaLlon on a day-Lo-day basls. Managers have
Lhe auLhorlLy Lo make mosL buslness declslons wlLhouL Lhe board's speclflc
approval. voLe by proxy = empowerlng anoLher parLy Lo voLe ln Lhelr name. 1he
common sLock of mosL large corporaLlons can be boughL or sold freely on one or
more sLock exchanges. A corporaLlon whose sLock ls noL publlcly Lraded ls sald Lo
be closely held. ln mosL closely held corporaLlons, Lhe owners of Lhe flrm also Lake
an acLlve role ln lLs managemenL. 1herefore, Lakeovers are generally noL an lssue.
o Character|st|cs of Common stock:
# 1) keslJool clolm " sLockholders are Lhe lasL ln llne of all
Lhose who have a clalm on Lhe asseLs and lncome of Lhe
corporaLlon.
# 2) llmlteJ lloblllty " unllke owners of unlncorporaLed
buslnesses, whose credlLors can lay clalm Lo Lhe personal
asseLs of Lhe owner (house, car, furnlLure), corporaLe
shareholders may aL worsL have worLhless sLock. 1hey are
noL personally llable for Lhe flrm's obllgaLlons.
Stock market L|st|ngs: 1he n?SL ls one of several markeLs ln whlch lnvesLors
may buy or sell shares of sLock. 1he dlvldend yleld ln only parL of Lhe reLrun
on a sLock lnvesLmenL. lL lgnores prospecLlve caplLal galns (l.e., prlce
lncreases) or losses. Low dlvldend flrms presumably offer greaLer prospecLs
for caplLal galns. 1he /L raLlo, or prlce-earnlngs raLlo ls Lhe raLlo of Lhe
currenL sLock prlce Lo lasL year's earnlngs per share.
referred stock: has feaLures slmllar Lo boLh equlLy and debL. Llke a bond lL
promlses Lo pay Lo lLs holder a flxed amounL of lncome each year. lnsLead
preferred dlvldends are usually cumulaLlve, LhaL ls, unpald dlvldends
cumulaLe and musL be pald ln full before any dlvldends may be pald Lo
holders of common sLock. referred sLock also dlffers from bonds ln Lerms
of lLs Lax LreaLmenL for Lhe flrm. 8ecoose ptefetteJ stock poymeots ote
tteoteJ os JlvlJeoJs totbet tboo lotetest, tbey ote oot tox JeJoctlble
expeoses fot tbe fltm, tbls JlsoJvootoqe ls somewbot offset by tbe foct tbot
cotpototloos moy excloJe 70X of JlvlJeoJs tecelveJ ftom Jomestlc
cotpototloos lo tbe compototloo of tbelt toxoble locome. loJlvlJool lovestots
coo oot ose tbe 70X tox exclosloo. Lven Lhough preferred sLock ranks afLer
bonds ln Lerms of Lhe prlorlLy of lLs clalms Lo Lhe asseLs of Lhe flrm ln Lhe
evenL of corporaLe bankrupLcy, ptefetteJ stock ofteo sells ot lowet ylelJs
tboo Jo cotpotote booJs. referred sLock may be callable by Lhe lssulng
flrm, Lhan Lhey are called /"9""0#:$". lL also may be converLlble lnLo
common sLock aL some speclfled converslon raLlo.
Depos|tory rece|pts " Amerlcan ueposlLory 8ecelpLs, or Au8s are
cerLlflcaLes Lraded ln u.S. markeLs LhaL represenL ownershlp ln shares of a
forelgn company.

Stock and bond market |ndexes.
Dow Iones Averages " 30 large blue-chlp" corporaLlons. Slnce 1896. uow measures
Lhe reLurn (excludlng dlvldenLds) on a porLfollo LhaL holds one share of each sLock, lL ls
called a pr|ce-we|ghted average (example page 41).
Standard & oor's Indexes (S& S00)" represenL an lmprovemenL over Lhe uow !ones
Average ln Lwo ways. (1) lL ls a more broadly based lndex of 300flrms. (2) lL ls a market
va|ue-we|ghted |ndex. (example blz 43). AcLually, mosL lndexes Lhese days use a
modlfled verslon of markeL-value welghLs. 8aLher Lhan welghLlng by LoLal markeL value,
Lhey welghL by Lhe markeL value of free floaL, LhaL ls by Lhe value of shares LhaL are
freely Lradable among lnvesLors. lor example, Lhls procedure does noL counL shares
held by foundlng famllles or governmenLs. 1he dlsLlncLlon ls more lmporLanL ln !apan
and Lurope, where a hlgher fracLlon of shares are held ln such nonLraded porLfollos.
lnvesLors Loday can easlly buy markeL lndexes for Lhelr porLfollos. Cne way ls Lo
purchase shares ln muLual funds LhaL hold shares ln proporLlon Lo Lhelr represenLaLlon
ln Lhe S& or anoLher lndex. 1hese |ndex funds yleld a reLurn equal Lo LhaL lndex and so
provlde a low-cosL passlve lnvesLmenL sLraLegy for equlLy lnvesLors.
Cther U.S. market-va|ue |ndexes "
o New ork Stock Lxchange (markeL-value welghLed, all n?SL-llsLed sLocks)
o Nat|ona| Assoc|at|on of Secur|t|es Dea|ers (more Lhan 3000 over Lhe counLer
(C1C) flrms Lraded on Lhe nasdaq markeL.
o W||sh|re S000 (ulLlmaLe u.S. equlLy lndex, markeL value of all n?SL and Amex
(Amerlcan SLock Lxchange) plus acLlvely Lraded nasdaq sLocks. Cver 6000
sLocks.
Iore|gn and |nternat|ona| stock market |ndexes:
o nlkkl ([apan)
o l1SL (uk)
o uAx (Cermany)
o Pang Seng (Pong kong)
o 1Sx (Canada)
A leader ln consLrucLlng lnLernaLlonal lndexes has been MSCl (Morgan SLanley
CaplLal lnLernaLlonal) whlch compuLe over 30 counLry lndexes and several reglonal
lndexes.
8ond Market Ind|cators: Mettll lyocb, lebmoo 8totbets and 5olomoo 5mltb 8otoey are
Lhe Lhree well known bond lndexes. 1he ma[or problem wlLh bond markeL lndexes ls
LhaL Lrue raLes of reLurn on many bonds are dlfflculL Lo compuLe because Lhe
lnfrequency wlLh whlch Lhe bonds Lrade make rellable up-Lo-daLe prlces dlfflculL Lo
obLaln. 1he prlces may dlffer from Lrue markeL values.

3) Der|vat|ve Markets
Cne of Lhe mosL slgnlflcanL developmenLs ln flnanclal markeLs ln recenL years has been Lhe
growLh of fuLures, opLlons, and relaLed derlvaLlves. 1hese lnsLrumenLs provlde payoffs LhaL
depend on Lhe values of oLher asseLs such as commodlLy prlces, bond and sLock prlces, or
markeL lndex values. lor Lhls reason Lhese lnsLrumenLs someLlmes are called derlvaLlve asseLs or
conLlngenL clalms.
;4').*&
o Ca|| opt|on " glves lLs holder Lhe rlghL Lo purchase an asseL for a speclfled
prlce, called Lhe exerclse or sLrlke prlce, on or before a speclfled explraLlon daLe.
Lach opLlon conLracL ls for Lhe purchase of 100 shares. Powever, quoLaLlons are
made on a per-share basls. 1he holder of Lhe call need noL exerclse Lhe opLlon.
lL wlll be proflLable Lo exerclse only lf Lhe markeL value of Lhe asseL LhaL may be
purchased exceeds Lhe exerclse prlce.
o ut Cpt|on " Clves lLs holder Lhe rlghL Lo sell an asseL for a speclfled exerclse
prlce on or before a speclfled explraLlon daLe. Cnly exerclsed lf lLs holder can
dellver an asseL worLh less Lhan Lhe exerclse prlce ln reLurn for Lhe exerclse
prlce.
o Iuture contracts " ls an obllgaLlon Lo buy or sell an asseL aL a sLlpulaLed fuLures
prlce on a maLurlLy daLe. 1he long poslLlon, whlch commlLs Lo purchaslng, galns
lf Lhe asseL value lncreases whlle Lhe shorL poslLlon, whlch mommlLs Lo
purchaslng, loses.
3 now secur|t|es are traded

r|mary market: new lssues markeLed Lo publlc by lnvesLmenL bankers.
Secondary market: Lradlng among prlvaLe lnvesLors.
1wo ptlmoty lssoes.
llO - sLocks lssued by a formerly prlvaLely owned company selllng sLock Lo Lhe publlc for
Lhe flrsL Llme.
5eosooeJ oew lssoes - lssues offered by companles LhaL already have floaLed equlLy.
ubllc offerlng: Lo general lnvesLlng publlc vs. rlvaLe placemenL: Lo few wealLhy or lnsLlLuLlonal
lnvesLors (reduce llquldlLy).

Investment banker: underwrlLer, makes prospecLus. llrms commlLmenL: lssulng flrm sells
securlLles Lo underwrlLlng syndlcaLe for Lhe publlc offerlng prlce less a spread, underwrlLer
assumes full rlsk vs. besL-efforLs agreemenL: bank agrees Lo help, buL does noL acLually buy Lhe
securlLles.

Shelf-reglsLraLlon: reglsLer securlLles and gradually sell Lhem Lo Lhe publlc for 2 years.

IC: lnvesLors lndlcaLe Lhelr lnLeresL vla a book, book bulldlng. Shares of lCs are allocaLed Lo
lnvesLors ln parL based on Lhe sLrengLh of each lnvesLor's expressed lnLeresL ln Lhe offerlng. lCs
are commonly underprlced (represenL a cosL of Lhe lssue). lCs have been poor long-Lerm
lnvesLmenLs. non-lssuers show beLLer relaLlve performance.

Shares are trade on
1. naLlonal and local securlLles exchanges
n?SL, Amex: membershlps (seaLs, ma[orlLy owned by large full-servlce brokerage flrms).
2. Lhe over-Lhe-counLer markeL
no membershlp requlremenLs, no llsLlng requlremenLs for securlLles, nASuAC
SecurlLy dealers quoLe prlces aL whlch Lhey are wllllng Lo buy/sell securlLles.
8ld prlce: prlce dealer wllllng Lo buy. Ask: prlce dealer wllllng Lo sell.
nASuAC has 3 levels of subscrlbers: level 1: for flrms deallng, may enLer bld/ask prlces. Level 2:
recelve all bld/ask prlces buL cannoL enLer Lhelr own. Level 3: recelve only medlan bld/ask
prlces.
3. dlrecL Lradlng beLween Lwo parLles

1hlrd markeL: refers Lo Lradlng of exchange-llsLed securlLles on Lhe C1C markeL.
1he fourLh markeL refers Lo dlrecL Lradlng beLween lnvesoLrs ln exchange-llsLed securlLles
wlLhouL beneflL of a broke (ellmlnaLes bld/ask spread, greaLer speed and anonymlLy).

8ond Lradlng, n?SL AuLomaLed 8ond SysLem, ma[orlLy Lradlng ln over-Lhe counLer markeL
among bond dealers.

arLlclpanLs ln Lradlng on exchanges (read also pg 80):
Commlsslon brokers: seaL brokerage flrm vs. floor brokers: lndependenL members of Lhe
exchange who handle Lhelr own seaLs and handle work for commlsslon brokers.
SpeclallsL: cenLral Lo Lradlng process, malnLalns a markeL ln one or more llsLed securlLles.
1ypes of orders:
Market orders: lmmedlaLely buy/sell aL currenL markeL prlce.
L|m|t buy order: execuLe when prlce falls below llmlL.
L|m|t se|| order: sell as soon as prlce goes above llmlL.
Stop-|oss order: sell of prlce falls below sLlpulaLed level.
Stop-buy order: buy when prlce rlses above glven llmlL. (1hese Lrades ofLen accompany shorL
sales).

- 8lock houses: brokerage flrms LhaL help flnd poLenLlal buyers/sellers of large block Lrades.
- Slnce !une '93, an order execuLed on exchange musL be seLLled wlLhln 3 worklng days.

ulsadvanLage of decenLrallzed dealer markeL: lnvesLlng publlc ls vulnerable Lo Lradlng Lhrough,
whlch refers Lo Lhe pracLlce of dealers Lo Lrade wlLh Lhe publlc aL Lhelr quoLed bld/ask prlces
even lf oLher cusLomer have offered Lo Lrade aL beLLer prlces.

1rad|ng costs:
lull-servlce brokers - provlde lnfo and advlce vs. dlscounL brokers - no frllls.
- mlnlmum charge regardless of Lrade
- brokers commlsslon
- lmpllclL cosL: bld-ask spread
- lmpllclL cosL: prlce concesslon lnvesLor may be forced Lo make for Lradlng ln quanLlLy
LhaL exceeds quanLlLy dealer ls wllllng Lo Lrade aL posLed bld/ask prlce.
ConLroversy: exLenL beLLer execuLlon (slze effecLlve bld-ask spread and amounL lmpacL ln
markeL) on Lhe n?SL offseLs Lhe generally lower expllclL cosLs ln oLher markeLs.
aylng for order flow: paylng a broker for dlrecL Lrade Lo parLlcular dealer.

8uylng on margln: acL of Laklng on brokers' call loans. Margln ln accounL: porLlon of Lhe
purchase prlce conLrlbuLed by lnvesLor, remalnder ls borrowed from broker. 1he securlLles are
Lhe collaLeral.
ercentage marg|n: raLlo of Lhe neL worLh (equlLy) Lo Lhe markeL value of Lhe securlLles.
Marg|n: equlLy ln sLock / value of sLock.
Ma|ntenance marg|n: *nr shares - amounL borrowed / * nr shares (page 91)

ShorL sale: allows lnvesLors Lo proflL from decllne ln securlLy's prlce. ShorL sales are only
permlLLed when lasL recorded change ln sLock prlce ls poslLlve. (margln calls on shorL sales - pg.
93)

4 Mutua| Iunds and other |nvestment compan|es

8enef|ts Investment compan|es
- tecotJ keeploq
- Jlvetslflcotloo / Jlvlslblllty (lnvesL ln many dlfferenL securlLles " lnvesLmenL company
acLs llke one blg lnvesLor)
- ptofessloool moooqemeot (skllls)
- lowet ttoosoctloo costs (large numbers)

neL AsseL value (nAv) = (markeL value of asseLs - llablllLles) / # shares ouLsLandlng

2 types of Investment compan|es

(1) unlL lnvesLmenL LrusLs
- redeemable LrusL cerLlflcaLes
- pools of money lnvesLed ln a porLfollo (flxeJ for Lhe llfe of a fund)
- unmanaged (= lower fees)

(2) Managed lnvesLmenL companles
(2o) closeJ-eoJ

When lnvesLor cashes ouL he/she sells
shares Lo oLher lnvesLors on organlzed
exchanges, Lhrough brokers, so prlce can
dlffer from nAv.
(a looJ ls a sales charge pald Lo seller)


Cther |nvestment organ|zat|ons
(2b) Opeo-eoJ (Motool fooJs)

When lnvesLor cashes ouL he/she sells
shares back Lo fund aL nAv





- Commlngled funds
o arLnershlps of lnvesLors LhaL pool funds
o Cne managemenL flrm organlzes parLnershlps for a fee

- 8eal esLaLe lnvesLmenL LrusLs (8Ll1s)
o (1) equlLy LrusL, lnvesLs ln real esLaLe dlrecLly
o (2) morLgage LrusLs, lnvesL ln prlmarlly morLage & consLrucLlon loans

- Pedge funds (feaLures,)
o rlvaLe parLnershlps (only 1 SLC regulaLlon)
o Lock-ups (perlods LhaL lnvesLmenLs cannoL be wlLhdrawn
o Plghly volaLlle

Mutua| Iunds (2b)
- lnvesLmenL pollcles (descrlbed ln prospecLus)
o money markeL funds
o equlLy funds
o bond funds
o lnLernaLlonal funds
o balanced funds
o asseL allocaLlon & flexlble funds (sLock & bonds " no parLlcular rlsk, lnvesL ln
poslLlve forecasLs)
o lndex funds

Iees (cosL of lnvesLmenLs ln muLual funds)
1. lronL-end load (charge pald when buylng shares " usually Lo broker, < 8,3)
2. 8ack-end load (charge pald when selllng shares " also called cootloqeot JeffeteJ soles
cbotqes
3. CperaLlng expenses (charge for operaLlng porLfollo)
4. 12 b-1 charges (funds charges Lhese Lo pay brokers)
o Concernlng 3 & 4 " fees are deducLed from asseLs, noL bllled
o Loads (1 & 2) are pald once, 12b-1 charges (4) are pald annually
o lees (1 - 4) are commonly pald for oJvlse

kate of keturn = (nAv1 - nAv0 + lncome & caplLal galn dlsLrlbuLlon) / nAv0
= Cross reLurn (underlylng porLfollo ln ) - LoLal expense raLlo ()

- lgnores commlsslon
- ls affecLed by fund's expenses and 12 b-1 fees.

5oft Jollots
- SLockbroker reLurns parL of Lhe Lradlng commlsslon Lo Lhe fund, whlch ls an advanLage
Lo Lhe muLual fund because,
- 1hese purchases wlLh sofL dollars are noL lncluded ln Lhe fund expenses, Lherefore make
lL hard for lnvesLors Lo compare fund expenses

LaLe Lradlng
8uy shares afLer closure of markeL (4.00 p.m.) aL nAv lf aL 4.30 p.m. some poslLlve news ls
announced, nexL mornlng nAv wlll rlses.
- 8C8 Lo mosL shareholders drops
- LaLe Lraders pay managemenL fee Lo brokers and Lherefore Lhey (Lhe managers) allow lL.

Market t|m|ng
u.S. & !apanese markeL close aL dlfferenL Llmes. lf u.S. markeL mumps slgnlflcanLly, Lhe
!apanese wlll Loo Lhe nexL mornlng

Changes Lo overcome Lhese pracLlces,
- 4.00 pm botJ cotoff (no Lradlng afLer 4.00)
- lolt voloe ptlcloq (blg changes ln u.S. are ad[usLed ln !apanese nAv)
- Jemptloo fees (rapld Lradlng = buy & sell wlLhln 1 week cosL > 2 fee)

lnvesL Lhrough a muLual fund " Llmlng of sale ls noL ln your hands, Lherefore no Lax
managemenL posslble, lf hlgh totoovet (raLlo of Lradlng acLlvlLy / asseLs of porLfollo) " caplLal
galns or losses are reallzed consLanLly and Llmlng of Lax obllgaLlon wlll be hard " Lax lnefflclenL.

Lxchange - traded funds (L1Is)
CffshooLs of muLual funds LhaL allow lnvesLors Lo Lrade lndex-porLfollos as shares of sLock.
AdvanLages:
1. muLual funds can only be boughL aL end of Lhe day (when nAv ls calculaLed), L1ls Lhe
enLlre day
2. can be sold shorL & on marglns
3. Lax advanLage over muLual funds (sell shares Lo oLher Lraders p.110)
4. cheaper Lhan muLual funds (buy from broker, noL funds Lhemselves, so funds don'L have
markeLlng fees " whlch are normally expensed as commlsslons)

ulsadvanLages:
1. prlces can deparL from nAv (more expenslve)
2. L1ls musL be purchased for a fee
S Lear|ng About keturn and k|sk from the n|stor|ca| kecord

Determ|nants of the |eve| of |nterest rates
Maln facLors LhaL deLermlne lnLeresL raLes:
1. 1he supply of funds from savers, prlmarlly households.
2. 1he demand for funds from buslnesses Lo be used Lo flnance lnvesLmenLs ln planL,
equlpmenL, and lnvenLorles (real asseLs or caplLal formaLlon)
3. 1he governmenL's neL supply of or demand for funds as modlfled by acLlons of Lhe
lederal 8eserve 8ank.

Nom|na| |nterest rate (8), ls Lhe growLh raLe of Lhe money and a rea| |nterest rate (r) ls Lhe
growLh of Lhe purchaslng power, r = 8 - l (l ls lnflaLlon)

1he exacL relaLlonshlp ls glven by 1+r = (1+8)/(1+l) " r = (8-1)/(1+l)

1hree baslc facLors - supply, demand, and governmenL acLlons - deLermlne Lhe real lnLeresL
raLe. 1he nomlnal raLe, whlch ls Lhe raLe we acLually observe, ls Lhe real raLe plus Lhe expecLed
raLe of lnflaLlon.

WlLh a hlgher expecLed lnflaLlon, Lhe nomlnal raLe oughL Lo lncrease Lo malnLaln Lhe same real
reLurn. 1hls ls Lhe so called llsher equaLlon: 8 = r + L(l)

1ax llablllLles are based on nomlnal lncome and Lhe Lax raLe deLermlned by Lhe lnvesLors' Lax
brackeL. Clven Lax raLe (L) and a nomlnal lnLeresL raLe (8), Lhe afLer Lax raLe ls 8(1-L). 1he real
afLer Lax raLe ls: 8(1-L) - l = (r+l)(1-L) - l = r(1-L) - lL
1hus Lhe afLer-Lax real raLe of reLurn falls as Lhe lnflaLlon raLe rlses.

Compar|ng rates of return for d|fferent ho|d|ng per|ods
Zero-coupon bonds are bonds LhaL are sold aL a dlscounL from par value and provlde Lhelr enLlre
reLurn from Lhe dlfference beLween Lhe purchase prlce and Lhe ulLlmaLe repaymenL of par
value. Clven Lhe prlce, (1), of a Lreasury bond wlLh $100 par value and maLurlLy of 1 years, we
calculaLe Lhe LoLal rlsk-free reLurn as Lhe percenLage lncrease ln Lhe value of Lhe lnvesLmenL
over Lhe llfe of Lhe bond: r
f
(1) = (100/(1)) - 1

1o compare reLurns on lnvesLmenLs wlLh dlfferenL Llme horlzons, we re-express each totol
reLurn as a tote of reLurn for a common perlod. 1yplcally Lhls ls expressed as an effect|ve annua|
rate (LAk), deflned as Lhe percenLage lncreased ln funds over a 1-year horlzon.
lor half-year lnvesLmenL: 1+LA8 = (r
f
(0,3))
2
, and for a 23 year lnv: (1+LA8)
23
= r
f
(23)
" 1+LA8 = [1+r
f
(1)]
1/1

lor raLes on shorL Lerm lnvesLmenLs use Lhe annua| percentage rate (Ak)
" A8 = [(1+LA8)
1
-1]/1

1o flnd r
cc
(conLlnuously compoundlng raLe) Lhe LA8: ln(1+LA8) = r
cc
(slmply puL:exp(1*r
cc
)
k|sk and k|sk rem|ums
no|d|ng per|od return (nk) = (Lndlng prlce of a share - 8eglnnlng prlce +Cash dlvldend)/
8eglnnlng prlce

1he percenL reLurn from dlvldends ls called Lhe dlvldend yleld, and so Lhe dlvldend yleld plus Lhe
caplLal galns ls Lhe P8.

LxpecLed reLurn ls Lhe sum of Lhe probablllLy of a scenarlo p(s) Llmes Lhe P8 r(s):
L(r) = _p(s)r(s) and o
2
= _p(s)[r(s)-L(r)]
2

s

s
1he expecLed reward ls measured as Lhe dlfference beLween Lhe expecLed P8 and Lhe r|sk-free
rate, Lhe raLe you can earn by leavlng money ln rlsk-free asseLs such as 1-bllls or Lhe bank. 1hls
dlfference ls called Lhe r|sk prem|um. 1he dlfference beLween Lhe octool reLurn and Lhe rlsk-free
raLe ls called Lhe excess return. 1he rlsk premlum ls Lhe expecLed excess reLurn and Lhe
sLandard devlaLlon of Lhe excess reLurn ls an approprlaLe measure of lLs rlsk.

1|me Ser|es Ana|ys|s
When hlsLorlcal daLa ls used, each observaLlon ls LreaLed as an equally llkely scenarlo". So wlLh
o observaLlon, we subsLlLuLe equal probablllLles of magnlLude 1/o for each p(s) from Lhe
expecLed reLurn formula. 1he expecLed reLurn, (t), ls Lhen esLlmaLed by Lhe arlLhmeLlc average
of Lhe sample raLes of reLurn:
L(r) = _
n
s=1
p(s)r(s) = 1/3_
n
s=1
r(s)

varlance = expecLed value of squared devlaLlons
o
2
= _p(s)[r(s)-L(r)]
2
uslng hlsLorlcal daLa, Lhe varlance ls estlmoteJ as:
2
1
2
]
_
) ( [
1
!
=
" =
n
s
r s r
n
#
1hls equaLlon ls downward blased. 1he reason ls LhaL we have Laken devlaLlons from Lhe
arlLhmeLlc average, lnsLead of Lhe unknown, Lrue expecLed value, L(r), and have lnLroduced a blL
of an esLlmaLlon error. 1he blas can be ellmlnaLed by mulLlplylng Lhe arlLhmeLlc average of Lhe
squared devlaLlon by Lhe facLor n/(n-1):
2
1
_
2
] ) ( [
1
*
1
!
=
"
#
$
%
&
'
(
"
=
n
j
r s r
n n
n
) =
2
_
1
] ) ( [
1
1
r s r
n
n
j
!
=
"
"

o =
2
_
1
] ) ( [
1
1
r s r
n
n
j
!
=
"
"


keward-totVar|ab|||ty kat|o
1he lmporLance of Lhe Lrade-off beLween reward and rlsk suggesLs LhaL we measure Lhe
aLLracLlon of an lnvesLmenL porLfollo by Lhe raLlo of lLs rlsk premlum Lo Lhe Su of lLs excess
reLurn " Sharpe kat|o (for porLfollos) = 8lsk premlum/Su of excess reLurn.


1. 1he Norma| D|str|but|on
A smaller sLandard devlaLlon means LhaL posslble ouLcomes clusLer more
around Lhe mea, whlle a hlgher Su lmplles more dlffuse dlsLrlbuLlon.
A measure of asymmeLry called skew uses Lhe raLlo of Lhe average cobeJ
devlaLlons from Lhe mean, called Lhe Lhlrd momenL, Lo Lhe cubed sLandard
devlaLlon Lo measure any asymmeLry of skewness" of a dlsLrlbuLlon " Skew =
L[r(s) - L(r)]
3
/o
3
When Lhe dlsLrlbuLlon ls poslLlvely skewed, Lhe Su overesLlmaLes rlsk, because
exLreme poslLlve devlaLlons from expecLaLlon neverLheless lncrease Lhe
esLlmaLe volaLlllLy. Conversely, and more lmporLanLly, when Lhe dlsLrlbuLlon ls
negaLlvely skewed, Lhe Su wlll underesLlmaLe Lhe rlsk.
When Lhe Lalls of a dlsLrlbuLlon are faL, Lhere ls more probablllLy mass ln Lhe
Lalls of Lhe dlsLrlbuLlon Lhan predlcLed by Lhe normal dlsLrlbuLlon. kurtos|s ls a
measure lf Lhe degree of faL Lalls. " kurLosls = (L[r(s) - L(r)]
4
/o
4
) - 3

<=>?@ 4#5" ABB@ )& :#&"9 .* -)53/" =>C #*9 '#$D& #:.3' 8)&'./)+#$ 9#'#> <=>E .* $.*5F'"/0
)*G"&'0"*'& )& *.' 0"*').*"9 )* '8" &$)9"& #*9 )& *.' )04./'#*' )* 3*9"/&'#*9)*5 -.$$.7)*5
+8#4'"/& H&"" -..'*.'" 4#5" A=AI

6 k|sk and r|sk avers|on

8lsk averslon and speculaLlon are noL conslsLenL.
A prospecL LhaL has a zero rlsk premlum ls called a falr game. lnvesLors, who are rlsk averse
re[ecL lnvesLmenL porLfollos LhaL are falr game or worse. A rlsk-averse lnvesLor penallzes" Lhe
expecLed raLe of reLurn of a rlsky porLfollo by a cerLaln percenLage Lo accounL for Lhe rlsk
lnvolved.
uLlllLy, welfare - hlgher uLlllLy values are asslgned Lo porLfollos wlLh more aLLracLlve rlsk-reLurn
proflles.
Commonly employed uLlllLy funcLlon: u = L(r) - 0.003A!
2

A: lndex of lnvesLor's rlsk averslon. 1he exLenL Lo whlch varlance lowers uLlllLy depends on A.
1he uLlllLy provlded by rlsk-free porLfollo ls raLe of reLurn on LhaL porLfollo, no penallzaLlon for
rlsk.
cettoloty epolvoleot tote of a porLfollo ls LhaL raLe LhaL rlsk-free lnvesLmenLs would need Lo
offer wlLh cerLalnLy be consldered equally aLLracLlve as Lhe rlsky porLfollo.
8lsk-neuLral lnvesLors [udge rlsky prospecLs solely by Lhelr expecLed raLe of reLurn.
A rlsk-lover ls wllllng Lo engage ln falr games and gambles.
Mean-varlance CrlLerlon: A domlnaLes 8 lf L(r
A
) "L(r
8
) and !
A
# !
8
and aL leasL one lnequallLy ls
sLrlcL.

CuadranL 2 and 3 (see pg. 172) deslrablllLy depends on exacL naLure of lnvesLor's rlsk averslon.

Pedglng: lnvesLlng ln an asseL wlLh a payoff paLLern LhaL offseLs exposure Lo a parLlcular source
of rlsk. lL lnvolved Lhe purchase of a rlsky asseL LhaL ls negaLlvely correlaLed wlLh Lhe exlsLlng
porLfollo.
ulverslflcaLlon: lnvesLmenLs are made ln a varleLy of asseLs Lo LhaL exposure Lo rlsk of any
parLlcular securlLy ls llmlLed.

orLfollo maLhemaLlcs:
Mean/expecLed reLurn of osset ls probablllLy-welghLed average of reLurn ln all scenarlos.
L(r) = $ r(s)r(s)
varlance: $ r(s) * [r(s) - L(r)]
2

8aLe of reLurn of pottfollo ls welghLed average of raLes of reLurn of each asseL
When rlsky asseL ls comblned wlLh rlsk-free asseL, porLfollo sLandard devlaLlon equal rlsky
asseL's sLandard devlaLlon mulLlplled by porLfollos proporLlon lnvesLed ln rlsky asseL: !
porLfollo
=
e.g. 0.3*!
rlsky


AsseLs wlLh reLurns LhaL' are lnversely assoclaLed wlLh Lhe lnlLlal rlsky poslLlon are powerful
hedge asseLs. 1o quanLlfy hedglng poLenLlal of an asseL: use Lhe concepL of covarlance and
correlaLlon. Covarlance: measures how much Lhe reLurns of 2 rlsky asseLs move ln Landem.
Cov(r
A
,r
8
) = $ r(s) [r
A
(s) - L(r
A
)] [r
8
(s) - L(r
8
)]
CorrelaLlon coefflclenL: scales Lhe covarlance Lo a value beLween -1 and +1.
% = cov(r
A
,r
8
) / (!
A*
!
8
)
Large negaLlve correlaLlon: move lnversely.

When 2 rlsky asseLs wlLh var !
A
2
and !
8
2
are comblned lnLo a porLfollo wlLh welghLs w
A
and w
8
:
porLfollo varlance =!

2
= w
A
2
!
A
2
+ w
8
2
!
8
2
+ 2 w
A
* w
8
* Cov(r
A
,r
8
)
7 Cpt|ma| k|sky ortfo||os

1he lnvesLmenL declslon can be vlewed as a Lop-down process of Lhree sLeps:
- CaplLal allocaLlon beLween Lhe rlsky porLfollo and rlsk-free asseLs
- AsseL allocaLlon across broad asseL classes
- SecurlLy selecLlon of lndlvldual asseLs wlLhln each asseL class
1he ulLlmaLe goal of Lhls lnvesLmenL process ls Lo achleve Lhe opLlmal caplLal allocaLlon
accordlng Lo Lhe lnvesLors rlsk averslon and Lhe expecLaLlons for Lhe rlsk-reLurn Lrade-off of Lhe
opLlmal rlsky porLfollo. 1he opLlmal rlsky porLfollo ls Lhe comblnaLlon of rlsky asseLs LhaL
provldes Lhe besL rlsk-reLurn Lrade-off.

When you only lnvesL ln one sLock you are exposed Lo a loL of rlsk. 8y addlng more sLocks Lo
your porLfollo, baslc dlverslflcaLlon, you can reduce Lhe rlsk. When Lhe flrm-speclflc lnfluences
on Lwo sLocks dlffer, dlverslflcaLlon should reduce porLfollo rlsk. 8y addlng more and more
sLocks Lo your porLfollo, Lhe volaLlllLy of Lhe porLfollo conLlnues Lo decrease. ulLlmaLely,
however, we cannoL decrease rlsk any furLher because all flrms are affecLed by common
macroeconomlc facLors. 1he rlsk LhaL remalns even afLer exLenslve dlverslflcaLlon ls called
markeL rlsk (or sysLemaLlc rlsk or nondlverslflable rlsk). 1he rlsk LhaL can be ellmlnaLed ls called
unlque rlsk, flrm-speclflc rlsk, non-sysLemaLlc rlsk or dlverslflable rlsk.
1he reducLlon of rlsk Lo very low levels ln Lhe case of lndependenL rlsk sources ls called Lhe
lnsurance prlnclple, because of Lhe noLlon LhaL an lnsurance company depends on Lhe rlsk
reducLlon achleved Lhrough dlverslflcaLlon.

orLfollos of Lwo rlsky asseLs are relaLlvely easy Lo analyze, and Lhey lllusLraLe Lhe prlnclples and
conslderaLlons LhaL apply Lo porLfollos of many asseLs. We conslder a bond porLfollo, denoLed u,
and a sLock fund, L. A proporLlon (w
u
) ls lnvesLed ln Lhe bond fund, and Lhe remalnder ls
lnvesLed ln de sLock fund (1 - w
u
or w
L
). 1he raLe of reLurn wlll be:
k
p
= w
u
t
u
- w

t

1he expecLed reLurn on Lhe porLfollo ls a welghLed average of expecLed reLurns on Lhe lndlvldual
securlLles:
(t
p
) = w
u
(t
u
) - w

(t

)
1he varlance of Lhe Lwo-asseL porLfollo ls:
o
2
p
= w
2
u
o
2
u
- w
2

o
2

- 2w
u
w

cov(t
u
,t

)
where:
o
2
u
= cov(t
u
,t
u
) and
o
2

= cov(t

,t

)
1hls means LhaL Lhe varlance of Lhe porLfollo ls a welghLed sum of covarlances, and each welghL
ls Lhe producL of porLfollo proporLlons of Lhe palr of asseLs ln Lhe covarlance Lerm.
1he goal of dlverslflcaLlon ls Lhe reducLlon of rlsk, whlch means a lower sLandard devlaLlon. 1hus
wlLh Lwo asseLs, Lhe porLfollo sLandard devlaLlon should be lower, unless Lhe Lwo asseLs are
perfecLly correlaLed. 1o see Lhls, noLlce LhaL Lhe covarlance can be compuLed from Lhe
correlaLlon coefflclenL:
cov(t
u
,t

) = p
u
o
u
o


1herefore,
o
2
p
= w
2
u
o
2
u
- w
2

o
2

- 2w
u
w

o
u
o

p
u
8ecause Lhe covarlance ls hlgher, porLfollo varlance ls hlgher when p
u
ls hlgher. ln Lhe case of
perfecL poslLlve correlaLlon, p
u
= 1, Lhe rlghL hand slde of Lhe equaLlon above slmpllfles Lo:
o
p
= w
u
o
u
- w

1hls explalns LhaL Lhe sLandard devlaLlon of Lhe porLfollo wlLh perfecL correlaLlon ls [usL Lhe
welghLed average of Lhe componenL sLandard devlaLlons. ln all oLher cases, Lhe correlaLlon
coefflclenL ls less Lhan 1, maklng porLfollo sLandard devlaLlon less Lhan Lhe welghLed average of
Lhe componenL sLandard devlaLlons. So porLfollos of less Lhan perfecLly correlaLed asseLs always
offer beLLer rlsk-reLurn opporLunlLles Lhan Lhe lndlvldual componenL securlLles on Lhelr own.
1he lowesL posslble sLandard devlaLlon ls when Lhe correlaLlon coefflclenL ls -1. 1hls glves:
o
2
p
=( w
u
o
u
- w

)
2

whlch solves for:
w
u
= o

/ (o
u
- o

)
w

= o
u
/ (o
u
- o

) = 1 - w
u


A porLfollo opporLunlLy seL shows all comblnaLlons of porLfollo expecLed reLurn and sLandard
devlaLlon LhaL can be consLrucLed from Lhe Lwo avallable asseLs.

When you can also lnvesL ln rlsk-free 1-bllls Lhe goal ls Lo consLrucL Lhe porLfollo wlLh Lhe hlghesL
reward-Lo-varlablllLy (Sharpe) raLlo. 1hls can be done graphlcally by drawlng a llnear llne from
Lhe rlsk-free raLe Lo Lhe Lop of Lhe porLfollo opporLunlLy seL. 1he sLeepesL posslble llne wlll yleld
Lhe hlghesL reward-Lo-varlablllLy aL Lhe polnL of lnLersecL.
S
p
= [L(r
p
) - r
f
] / o
p


ln Lhe case of Lwo rlsky asseLs, Lhe soluLlon of Lhe welghLs of Lhe opLlmal rlsky porLfollo, , can
be shown Lo be as follows:
w
u
=
[L(r
u
) - r
f
]o
2
L
- [L(r
L
) - r
f
]Cov(r
u
,r
L
)
[L(r
u
) - r
f
] o
2
L
+ [L(r
L
) - r
f
] o
2
u
- [L(r
u
) - r
f
+ L(r
L
) - r
f
]Cov(r
u
,r
L
)
w
L
= 1 - w
u


now LhaL we have Lhe opLlmal rlsky porLfollo we can consLrucL Lhe opLlmal compleLe porLfollo
by uslng Lhe lndlvldual lnvesLors rlsk averslon Lo flnd Lhe percenLage LhaL should be lnvesLed ln
Lhe rlsky porLfollo.
y =
L(r
p
) - r
f

Ao
2

When Lhere are more Lhan Lwo rlsky asseLs we Lake a sllghLly dlfferenL approach. lnsLead of
calculaLlng all posslblllLles for all asseLs, we consLrucL a mlnlmum-varlance fronLler of rlsky
asseLs. 1hls fronLler ls a graph of Lhe lowesL posslble varlance LhaL can be aLLalned for a glven
porLfollo expecLed reLurn. 1he parL of Lhe fronLler LhaL lles above Lhe global mlnlmum-varlance
porLfollo ls called Lhe efflclenL fronLler of rlsky asseLs.

SeparaLlon properLy refers Lo Lhe facL LhaL Lhe porLfollo cholce problem may be separaLed lnLo
Lwo Lasks. 1he flrsL Lask ls Lhe deLermlnaLlon of Lhe opLlmal rlsky porLfollo. 1hls porLfollo ls Lhe
same for all cllenLs, regardless of rlsk averslon. 1he second Lask, allocaLlon of Lhe compleLe
porLfollo Lo 1-bllls versus Lhe rlsky porLfollo, depends on personal preference.

Conslderlng dlverslflcaLlon and rlsk reducLlon, lL ls lmporLanL Lo reallse LhaL Lhe conLrlbuLlon Lo
porLfollo rlsk of a parLlcular securlLy wlll depend on Lhe covarlance of LhaL securlLy's reLurn wlLh
Lhose of oLher asseLs, and oot on Lhe securlLy's varlance.

ulverslflcaLlon ls based on spreadlng your wealLh over mulLlple asseLs. 1he lnsurance lndusLry
does Lhls as well. 1hey do noL reduce rlsk by addlng more of Lhe same lnsurances buL lnsLead
Lhey add dlfferenL pro[ecLs Lo reduce LoLal rlsk. lor large pro[ecLs, Lhe underwrlLers even engage
ln rlsk sharlng. 1hls means LhaL mulLlple underwrlLers wlll each Lake only a small parL ln a pro[ecL
so LhaL none of Lhem bears all Lhe rlsk. 1he boLLom llne ls LhaL porLfollo rlsk managemenL ls
abouL Lhe allocaLlon of a flxed lnvesLmenL budgeL Lo asseLs LhaL are noL perfecLly correlaLed.

9 1he Cap|ta| Asset r|c|ng Mode|

PeL CAM model ls een belangrl[k lnsLrumenL van modern flnanclal economlcs. PeL model geefL
een precleze voorspelllng van de relaLle Lussen heL rlslco van een asseL en de expecLed reLurn.
ule relaLle dlenL 2 funLles:
- PeL geefL een benchmark raLe of reLurn om mogell[ke lnvesLerlngen Legen elkaar af Le
wegen.
- PeL model helpL om een goede schaLLlng Le maken van de expecLed reLurn on asseLs dle
nog nleL verhandeld zl[n ln de markL.

9.1 1he CAM

PeL CAM ls 12 [aar na de foundaLlon of modern porLfollo managemenL door Parry MarkowlLz
onLwlkkeld. ue grondleggers zl[n Sharpe, LlnLner en Mossln. CndersLaande punLen Lonen de
slmpllfylng assumpLlons dle LoL heL CAM lelden.

- Lr zl[n veel lnversLeerders, elk meL een elgen wealLh dle kleln ls vergeleken bl[ dle van
alle lnvesLeerders samen. lnvesLeerders zl[n prlce-Lakers.
- Alle lnvesLeerders plannen voor een dezelfde holdlng perlod.
- Lr kan alleen geinvesLeerd worden ln openbaar verhandelde asseLs zoals sLocks en
bonds. Cok kunnen lnvesLeerders geld (ulL)lenen Legen een vasL, rlsk-free percenLage.
- lnvesLeerders beLalen geen Laxes en LransacLlon cosLs.
- Alle lnvesLeerders zl[n raLlonal mean-varlance opLlmlzers, ze gebrulken allemaal de
MarkowlLz porLfollo selecLlon model.
- Alle lnvesLeerders analyseren securlLles op dezelde manler en hebben heLzelfde
economlsche beeld van de wereld.

8ovensLaande aannames geven ons lnzlchL ln heL equlllbrlum ln securlLy markeLs. Pleronder
sLaaL heL equlllbrlum samengevaL

- Alle lnvesLeerders klezen ervoor om een porLfollo van rlsky asseLs Le houden, ln
proporLles dle overeenkomen meL de represenLaLle van de asseLs ln de markeL porLfollo
(M), dle alle verhandeldbare asseLs bevaL. MeL rlsky asseLs worden sLocks bedoeld. uus:
de proporLle van leder sLock ln de markeL porLfollo ls gell[k aan de markeL value van daL
sLock gedeeld door de LoLale markeL value van alle sLocks.
- M llgL nleL alleen op de efflclenL fronLler, lL also wlll be Lhe Langency porLfollo Lo Lhe
opLlmal caplLal allocaLlon llne, derlved by each lnvesLor. uaardoor ls de CML de besLe
aLLalnable caplLal allocaLlon llne. Alle lnvesLeerders houden M als hun opLlmal rlsky
porLfollo, ze verschlllen alleen ln de hoeveelheld gelnvesLeerd kaplLaal erln versus ln de
rlsk-free asseL.
- ue rlsk premlum van M sLaaL ln verhoudlng meL heL rlslco en de rlslco aversle van de
lnvesLor: L(8m) - 8f = ! m
- ue rlsk premlum van lndlvlduele asseLs sLaaL ln verhoudlng meL de rlsk premlum van M,
en de 8eLa van heL asseL.

! l = Cov(8l, 8m)
! m

ue rlsk premlum van lndlvlduele asseLs ls

L(8l) - 8f = Cov(8l, 8m) [L(8m-8f)] = ! l [L(8m)- 8f]
! m

ue bl[drage van een sLock aan heL rlslco van de markLporLfollo (M) kan heL besL gemeLen
worden aan de hand van de covarlanLle meL dle porLfollo. Zle hlervoor equaLlon 9.3 op blz
299.

ue reward Lo rlsk raLlo voor lnvesLeren ln M ls markeL rlsk premlum = L(8m) - 8f
MarkeL varlance ! m
ulL wordL ook wel de markeL prlce of rlsk genoemd, omdaL heL de exLra reLurn weergeefL
dle lnvesLeerders vragen voor de porLfollo rlsk. Len baslsprlnclpe van equlllbrlum ls daL alle
lnvesLmenLs dezelfde reward Lo rlsk raLlo hebben. ue reward Lo rlsk raLlo van een sLock en
van de markeL porLfollo moeLen dus overeen komen (equaLlon 9.6).

ue expecLed reLurn beLa relaLlonshlp ls de bekendsLe vergell[klng van heL CAM.

L(8l) = 8f + ! l [L(8m)- 8f]

8eLa's groLer dan 1 worden gezlen als agressleve sLocks (de reacLle op de markL ls hoger
dan gemlddeld).

ue expecLed reLurn-beLa relaLlonshlp wordL graflsch weergegeven als de SecurlLy MarkeL
Llne (SML), zle flguur 9.2 op blz 302. ue helllng sLelL de rlsk premlum van de markeL porLfollo
voor. ue CaplLal MarkeL Llne (CML) graphs Lhe rlsk premlums of efflcleot pottfollos
(porLfollos composed of Lhe markeL and rlsk-free asseL), as a funcLlon of porLfollo sLandard
devlaLlon. ue SML graphs Lhe rlsk premlums of loJlvlJool ossets as a funcLlon of asseL rlsk.
ue SML dlenL als benchmark voor de presLaLle van de lnvesLerlngen. 8l[ een gegeven rlslco
(ln de vorm van de beLa) LoonL de SML de requlred raLe of reLurn. PeL verschll Lussen de
verwachLe raLe of reLurn en de falr raLe of reLurn (de raLe of reLurn bepaald door de SML) ls
de Alpha (zle flguur 9.3).

9.2 CAM and the |ndex mode|

CAM behandeld expecLed reLurns, maar lk werkell[kheld kunnen we alleen dlngen zeggen
over de reallzed reLurn. Cm van expecLed reLurns naar reallzed reLurns Le gaan wordL heL
lndex model gebrulkL: 8l = ! l + ! l 8m + el (9.10 op blz 306).
Plerbl[ sLaaL de 8m voor de reallzed reLurn van de markeL porLfollo, en nleL voor de
expecLed reLurn. ue beLa cofflclenL van heL lndex model ls gell[k aan de beLa van heL
expecLed reLurn model.
! l = Cov(8l, 8m)
! m

ue lndex model speclflcaLlon ls L(8l) - 8f = ! l + ! l [L(8m)- 8f]. Als we deze vergell[ken meL
de expecLed reLurn speclflcaLlon dan zlen we daL bl[ daL model de facLor Alpha ls
weggelaLen. CAM voorspelL namell[k daL Alpha 0 ls voor alle asseLs (er ls geen excess
reLurn). CAM sLelL daL de verwachLe waarde van Alpha nul ls, voor alle securlLles. PeL lndex
model van CAM zegL daL de reallzed value van Alpha rond de nul llgL, bl[ een groep
hlsLorlcal observed reLurns. PeL lndex model wordL ook wel heL markeL model genoemd.

9.3 Is the CAM pract|ca|?

Als heL CAM model valld ls daL zou dlL beLekenen daL een lndex waarln alle verhandelbare
securlLles zlLLen ook valld ls (punL 3, paragraaf 9.1). Alle alpha's zouden ln daL geval ook 0
moeLen zl[n, maar daL ls nleL Le verwachLen ln real markeLs. CAM kan beLer worden gezlen als
'Lhe besL avallable model Lo explaln raLes of reLurn on rlsky asseLs'. Len securlLy ls mlsprlced als
de alpha nleL-nul ls. Cverprlclng vlndL plaaLs als alpha beneden nul ls. underprlclng als alpha
boven nul ls. ln de verondersLelllng daL CAM heL besLe beschlbare model ls, moeLen
lnvesLeerders een lndex vlnden om mee Le werken en macro analyse Loepassen om mlsprlced
securlLles Le ldenLlflceren (meer hlerover ln hoofdsLuk 8).

CAM ls nleL goed LesLable omdaL de hypoLheLlsche markeL porLfollo nleL waar Le nemen ls. Zo
zl[n bl[voorbeeld real esLaLe en prlvaLely held buslnesses onderdeel van dle markeL porLfollo,
maar zeer slechL waar Le nemen.

CAM LesLs worden ulLgevoerd rond de expecLed reLurn - beLa relaLlonshlp (omdaL de markeL
porLfollo nleL waar Le nemen ls) en laLen zlen daL de verondersLelllng daL alpha 0 ls, on[ulsL ls. Lr
wordL waargenomen daL low-beLa securlLles hoge alphas hebben en hlgh-beLa securlLles lage
alphas hebben.

PeL ls welllchL verrassend daL heL CAM, ondanks zl[n LekorLkomlngen, een veelgebrulkLe norm
ln de uS en andere onLwlkkelde landen ls. Lr zl[n Lwee oorzaken:

1. Lr ls geen beLere meLhode voor heL erkennen van sysLemaLlc en flrm speclflc rlsk.
2. ue cenLrale ulLkomsL van CAM (de efflclency van de markeL porLfollo), ls nleL zo gek
wanL heL aanLal fondsen daL heL beLer doeL dan de markLporLfollo ls nleL grooL.


9.S Lxtens|ons of the CAM

PeL CAM maakL gebrulk van slmpllfylng assumpLlons. uoor dle assumpLlons aan Le passen kan
heL CAM ulLgebreld worden. Zo onLsLaaL heL Zero-8eLa Model (blz 313), een model daL
aangepasL ls voor human caplLal en prlvaLely held buslnesses (blz 314) en een mulLlperlod model
(blz 316). Zle heL boek voor meer dlepgang.

9.S L|qu|d|ty and the CAM

ue llquldlLy van een asseL ls heL gemak en de snelheld waarmee heL Legen een eerll[ke markeL
value verkochL kan worden. Cnderdeel van llquldlLy zl[n de kosLen van heL aangaan van de
LransacLle (de bld-ask spread). llllquldlLy wordL gemeLen aan de hand van de dlscounL op de
markeL value dle de verkoper moeL accepLeren als heL asseL snel verkochL moeL worden. uealers
ln over Lhe counLer markeLs geven prl[zen aan waarLegen zl[ een securlLy wlllen kopen (bld) of
verkopen (ask), en bepalen dus ook de llquldlLy van een securlLy. ue bld-ask spread ls de
vergoedlng dle zl[ krl[gen voor heL verlenen van deze dlensL. MeL de elecLronlsche handel van
Legenwoordlg moeL nog sLeeds rekenlng worden gehouden meL de bld-ask spread (denk maar
aan llmlL-orders). ue dlscounL ln een securlLy prlce door llllquldlLy kan aardlg oplopen (zle blz
319 en 320 voor een rekenvoorbeeld).
lnvesLeerders kunnen ook een compensaLle vragen voor llquldlLy rlsk. PeL kan namell[k
gebeuren daL een asseL mlnder llqulde wordL, op heL momenL daL men er vanaf wll. LqulLlon
9.13 (blz 321) laaL heL model van Achara en edersen zlen waarbl[ de expexLed reLurn van een
securlLy afhangL van de kevel en rlsk of llquldlLy.
10 Arb|trage r|c|ng 1heory and mu|t|factor mode|s of r|sk and
return

l recommend LhaL you look aL all Lhe examples ln Lhe LexLbook for a beLLer undersLandlng of Lhe
formulas and especlally Lhe arblLrage prlclng meLhod. ?ou have Lo see Lhe calculaLlons Lo
undersLand Lhe arblLrage opporLunlLles. ay speclal aLLenLlon Lo flgure 10.2, example 10.4 and
10.6.

10.1 Mu|t|factor mode|s: an overv|ew

lacLor models are Lools LhaL allow us Lo descrlbe and quanLlfy Lhe dlfferenL facLors LhaL affecL
Lhe raLe of reLurn on a securlLy durlng any Llme perlod. As noLed ln chapLer 8, uncerLalnLy ln
asseL reLurns has Lwo sources: a macroeconomlc (common) facLor and flrm-speclflc evenLs. 1he
common facLor ls consLrucLed Lo have zero expecLed value, slnce we use ls Lo measure oew
lnformaLlon. 1he acLual reLurn on flrm l wlll equal lLs lnlLlally expecLed reLurn (L(8l)) plus a (zero
expecLed) random amounL aLLrlbuLable Lo economy wlde evenLs (ll) plus anoLher (zero
exoecLed value) aLLrlbuLable Lo flrm-speclflc evenLs (el). l ls Lhe devlaLlon of Lhe common facLor
from lLs expecLed value, l ls Lhe senslLlvlLy of Lhe flrm Lo LhaL facLor and el ls Lhe flrm-speclflc
dlsLurbance.
1hus, Lhe slngle facLor model looks llke:

8l = L(8l) + ll + el

A mulLlfacLor model allows for several facLors Lo lnfluence Lhe reLurn on a securlLy. lor example,
suppose LhaL Lwo lmporLanL macroeconomlc sources of rlsk are growLh ln Cu an lnLeresL 8aLes.
1he mulLlfacLor model Lhen looks llke:

8l = L(8l) + lgdp Cu + llr l8 + el

1he mulLlfacLor model ls no more Lhan a Jesctlptloo of Lhe facLor LhaL affecL securlLy reLurns.
1he quesLlon lefL unanswered ls where L(r) comes from. 1hls ls where Lhe SML from Lhe CAM
comes ln.
L(8) = 8f + ! [L(8m)- 8f] can be rewrlLLen as L(r) = 8f + 8m where 8m sLand for Lhe rlsk
premlum of Lhe markeL porLfollo. As polnLed ln chapLer 8, beLa ls Lhe exposure of a sLock or
porLfollo Lo macroeconomlc rlsk facLors. 1herefore, one lnLerpreLaLlon of SML ls LhaL lnvesLors
are rewarded for Lhelr exposure Lo macro rlsk, buL noL for Lhe exposure Lo flrm speclflc rlsk ( Lhe
el ln Lhe equaLlons above).

1he expecLed raLe of reLurn ln a Lwo facLor economy would be Lhe sum of:

1. 1he rlsk-free raLe (8f)
2. 1he senslLlvlLy Lo Cu rlsk (gdp) Llmes Lhe rlsk premlum for Cu rlsk
3. 1he senslLlvlLy Lo lnLeresL raLe rlsk (lr) Llmes Lhe rlsk premlum for lnLeresL raLe rlsk

1he mulLlfacLor SML can be wrlLLen down as: (L)r = 8f + gdp 8gdp + lr 8lr

10.2 Arb|trage pr|c|ng theory

!usL llke CAM, ArblLrage rlclng 1heory (A1) predlcLs a SML llnklng expecLed reLurns Lo rlsk,
buL Lhe paLh lL Lakes Lo Lhe SML ls dlfferenL. A1 relles on Lhree proposlLlons:

- SecurlLy reLurns can be descrlbed by a facLor model
- 1here are sufflclenL securlLles Lo dlverslfy away ldlosyncraLlc rlsk
- Well-funcLlonlng securlLy markeLs do noL allow for Lhe perslsLence of arblLrage
opporLunlLles.

An arblLrage opporLunlLy would arlse ls shares of a sLock sold for Lwo dlfferenL prlces on Lwo
dlfferenL exchanges. 8lskless proflL could be made by buylng a share of l8M on Lhe n?SL for 30$
en selllng lL aL Lhe nasdaq for 60$ aL Lhe same momenL.

now we look aL Lhe rlsk of a well dlverslfled porLfollo. ue flrm-speclflc rlsk becomes neglecLlble
so LhaL only sysLemaLlc rlsk remalns. 1he raLe of reLurn of Lhls porLfollo ls:

8p = L(8p) + p l + ep
where p = _Wl l ls Lhe welghLed average of Lhe l of Lhe n securlLles and
ep = _Wl el

1he sysLemaLlc and nonsysLemaLlc varlance of Lhls porLfollo can be seen aL page 337 and 338.
1he larger Lhe amounL of dlfferenL sLocks, Lhe more Lhe nonsysLemaLlc varlance approaches Lo
zero and Lhus: Lhe less nonsysLemaLlc rlsk. 8ecause of Lhls we can conclude LhaL Lhe reLurn on a
we|| d|vers|f|ed porLfollo equals:

8p = L(8p) + p l

8ecause nonfacLor (speclflc) rlsk can be dlverslfled away, only facLor (macroecnonomlc) rlsk
should command a rlsk premlum ln markeL equlllbrlum. 1o fully undersLand Lhls and Lo vlsuallze
Lhe arblLrage opporLunlLy, you have Le read pages 339 en 340. 1he one facLor SML ls Lhe same
as Lhe CAM, as can be seen on page 341.

10.3 Ind|v|dua| asset and the A1
8ead 'Lhe A1 and Lhe CAM' on page 343 of Lhe book Le see Lhe dlfferences beLween CAM
and A1.

10.4 A mulLlfacLor A1

So far we have assumed Lhere's only one sysLemaLlc facLor affecLlng sLock reLurns. 1hls ls Lo
slmpllsLlc. A Lwo-facLor A1 woul look llke:

8l = L(8l) + l1 l1 + l2 l2 + el

lacLor 1 was Lhe Cu growLh and facLor 3 was Lhe lnLeresL raLe decllne. Lach facLor has zero
expecLed value because each measures Lhe sotptlse ln Lhe sysLemaLlc varlable raLher Lhan Lhe
level of Lhe varlable. Ll also has zero expecLed value.

A porLfollo C, can be formed by lnvesLlng ln oLher porLfollo's. lor example 1 and 2. When one
decldes Lo lnvesL p1 ln one porLfollo and p2 ln anoLher and 1 - p1 - p2 ln 1-bllls, porLfollo C
wlll haven an expecLed reLurn of :

L(8q) = 8f + p1 [L(81)-8f] + p2 [L(82)-8f]



10.S Where shou|d we |ook for factors?

Cne shorLcomlng of Lhe A1 ls LhaL lL glves no guldance concernlng Lhe deLermlnaLlon of Lhe
relevanL rlsk facLors or Lhelr rlsk premlums. 1wo prlnclples gulde us when we speclfy a
reasonable llsL of facLors. llrsL, we wanL Lo llmlL ourselves Lo sysLemaLlc facLors wlLh
conslderable ablllLy Lo explaln securlLy reLurns. Second, we wlsh Lo choose facLors LhaL seem
llkely Lo be lmporLanL rlsk facLors (lnvesLors wlll demand meanlngful rlsk-premlums Lo bear
exposure of Lhose sources of rlsk). Chen, 8oll and 8oss composed a seL of facLors LhaL mlghL be
consldered (see page 346). Also Lhe lama and lrench Lhree facLor model mlghL be consldered
(see page 347).

10.6 1he mu|t|factor CAM and the A1

A mulLlfacLor exLenslon of Lhe slngle facLor CAM, Lhe lCAM, ls a model of Lhe rlsk-reLurn
Lrade-off LhaL predlcLs Lhe same markeLllne as Lhe A1.

L(8l) = 8f + lm [L(8m)-8f] + le [L(8e)-8f]
12 8ehav|ora| I|nance and 1echn|ca| Ana|ys|s

1he efflclenL markeL hypoLhesls makes Lwo lmporLanL predlcLlons. llrsL, lL lmplles LhaL securlLy
prlces properly reflecL whaLever lnformaLlon ls avallable Lo lnvesLors. Second, lL lmplles LhaL
acLlve Lraders wlll flnd lL dlfflculL Lo ouLperform passlve sLraLegles. 1o do so would requlre
dlfferenLlal lnslghL whlch, ln a hlghly compeLlLlve markeL, ls hard Lo come by.

8ehavloural flnance looks aL how real people make declslons, ln conLrasL wlLh convenLlonal
Lheorles LhaL usually lgnore Lhls. Lrrors ln lnformaLlon can lead lnvesLors Lo mlsesLlmaLe Lhe Lrue
probablllLles of posslble evenLs or assoclaLed raLes of reLurn. 1hese blases lnclude:
- lorecasLlng errors (puL Loo much welghL ln recenL experlence)
- Cverconfldence (overesLlmaLlon of preclslon of our own bellefs or forecasLs)
- ConservaLlsm (people are Loo slow ln updaLlng Lhelr bellefs ln response Lo new
evldence)
- Sample slze neglecL and represenLaLlveness (people do noL commonly Lake lnLo accounL
Lhe slze of a sample)

Lven lf all Lhe lnformaLlon ls correcL, lndlvlduals sLlll make less-Lhan-fully raLlonal declslons uslng
LhaL lnformaLlon. Some behavloural blases are:
- lramlng (declslons are affecLed by how cholces are framed)
- MenLal accounLlng (speclflc form of framlng, separaLe cerLaln declslon e.g. dlfferenL
lnvesLmenL sLyle for lnvesLmenL accounL and savlngs accounL)
- 8egreL avoldance (people have more regreL (blame Lhemselves more) for a wrong
declslon when LhaL declslon was unconvenLlonal)
- rospecL Lheory (hlgher wealLh provldes hlgher saLlsfacLlon, buL aL a dlmlnlshlng raLe.
1herefore lnvesLors wlll re[ecL rlsky prospecLs LhaL don'L offer a rlsk premlum)

LlmlLs Lo arblLrage
- lundamenLal rlsk (underprlced sLocks are noL cerLaln Lo reLurn Lo Lhelr 'real' value
wlLhln days. Managers may be [udged on shorL-Lerm performance)
- lmplemenLaLlon cosLs (shorL selllng Lo explolL overprlced securlLles cosLs money and Lhe
securlLles may have Lo be reLurned before Lhe sLock has dropped Lo lLs real value)
- Model rlsk (perhaps Lhe model used Lo calculaLe Lhe over or underprlclng ls faulLy)

1echnlcal analysls aLLempLs Lo explolL recurrlng and predlcLable paLLerns ln sLock prlces Lo
generaLe superlor lnvesLmenL performance. lor example, lnvesLors ofLen hold on Lo loslng
lnvesLmenLs (dlsposlLlon effecL). 1hls can lead Lo momenLum ln sLock prlces even lf fundamenLal
values follow a random walk.

1he uow 1heory ls Lhe grandfaLher of all Lrend analysls. lL clalms LhaL Lhree forces
slmulLaneously affecL sLock prlces:
1. 1he prlmary Lrend ls Lhe long-Lerm movemenL of prlces, lasLlng from several monLhs Lo
several years.
2. Secondary (or lnLermedlaLe) Lrends are caused by shorL-Lerm devlaLlons of prlces. 1hese
are ellmlnaLed vla correcLlons when prlces reverL back Lo Lrend values.
3. 1erLlary (or mlnor) Lrends are dally flucLuaLlons of llLLle lmporLance

Movlng averages are average levels of a sLock or lndex over a glven lnLerval of Llme. lL ls
compuLed by addlng Lhe newesL value every day (or week) and dropplng Lhe oldesL value. When
Lhe markeL breaks Lhrough Lhe movlng average llne, lL ls Laken as a bulllsh slgnal because lL
slgnlfles a shlfL from a falllng Lrend Lo a rlslng Lrend. AlLernaLlvely, when prlces fall below Lhe
movlng average lL's consldered Llme Lo sell.

1he breadLh of Lhe markeL ls a measure of Lhe exLenL Lo whlch movemenL ln a markeL lndex ls
reflecLed wldely ln Lhe prlce movemenLs of all Lhe sLocks ln Lhe markeL.

MarkeL volume ls also someLlmes used Lo measure Lhe sLrengLh of a markeL rlse or fall.
lncreased lnvesLor parLlclpaLlon can be vlewed as a measure of Lhe slgnlflcance of Lhe
movemenL. 1he Lrln sLaLlsLlc ls deflned as:
1rln =
volume decllnlng / number decllnlng
volume advanclng / number advanclng

1rln, Lherefore, ls Lhe raLlo of average volume ln decllnlng lssues Lo average volume ln advanclng
lssues. 8aLlos above 1.0 are consldered bearlsh because Lhe falllng sLocks would Lhen have
hlgher average volume Lhan Lhe advanclng sLocks, lndlcaLlng neL selllng pressure.

1he confldence lndex ls Lhe raLlo of Lhe average yleld on 10 Lop-raLed corporaLe bonds dlvlded
by Lhe average yleld on 10 lnLermedlaLe grade corporaLe bonds. When bond Lraders are
opLlmlsLlc abouL Lhe economy Lhey requlre smaller defaulL premlums on lower raLed debL.
Pence Lhe yleld spread wlll narrow and Lhe confldence lndex wlll approach 100. Plgher values
Lherefore, are bulllsh slgnals.

1he uL/Call raLlo ls also a Lool used Lo measure Lhe markeL senLlmenL. Many Lechnlclans see an
lncrease ln Lhe raLlo as bearlsh, as lL lndlcaLes growlng lnLeresL ln puL opLlons as a hedge agalnsL
markeL decllnes.















13 Lmp|r|ca| ev|dence on secur|ty returns

N8. Nlet/ooowelljks bebooJelJ lo colleqe!!!

ln Lhls chapLer some emplrlcal evldence of Lhe CAM and SML are presenLed.

AlLhough Lhe slngle facLor expecLed reLurn-beLa relaLlonshlp has noL been conflrmed by
sclenLlflc sLandards, lLs use ls already commonplace ln economlc llfe. Larly LesL of Lhe slngle
facLor CAM re[ecLed Lhe SML, flndlng LhaL nonsysLemaLlc rlsk dld explaln average securlLy
reLurns. LaLer LesL conLrolllng for Lhe measuremenL error ln beLa found LhaL nonsysLemaLlc rlsk
does noL explaln porLfollo reLurns buL also LhaL Lhe esLlmaLed SML ls too f|at compared wlLh
LhaL Lhe CAM would predlcL.

8oll's crlLlque lmplled LhaL Lhe usual CAM LesL ls a LesL only of Lhe mean varlance efflclency of a
prespeclfled markeL proxy and Lherefore LhaL LesL of Lhe llnearlLy of Lhe expecLed reLurn beLa
relaLlonshlp do noL bear on Lhe valldlLy of Lhe model. 1esLs of Lhe mean-varlance efflclency of
professlonally managed porLfollos agalnsL Lhe benchmark of a prespeclfled markeL lndex
conform wlLh 8oll's crlLlque ln LhaL Lhey provlde evldence on Lhe efflclency of Lhe prespeclflc
markeL lndex. Lmplrlcal evldence suggesL LhaL mosL professlonally managed porLfollos are
ouLperformed by markeL lndexes, whlch lends welghL Lo accepLance of Lhe efflclency of Lhose
lndexes and hence Lhe CAM. Work wlLh economlc facLors suggesLs LhaL facLors such as
unanLlclpaLed lnflaLlon do play a role ln Lhe expecLed reLurn-beLa relaLlonshlp of securlLy
reLurns.

1esLs of Lhe slngle-lndex model LhaL accounL for human cap|ta| and cyc||ca| var|at|ons ln asseL
beLas are far more conslsLenL wlLh Lhe slngle-lndex CAM and A1. 1hese LesLs suggesL LhaL
macro-economlc varlables are noL necessary Lo explaln expecLed reLurns. Moreover, anomalles
such as effecLs of slze and book-Lo-markeL raLlos dlsappear once Lhese varlables are accounLed
for.

volaLlllLy of sLock reLurns ls consLanLly changlng. Lmplrlcal evldence on sLock reLurns musL
accounL for Lhls phenomenon. ConLemporary researchers use Lhe varlaLlons of Lhe A8CP
(auLoregresslve condlLlonal heLeroskedasLlclLy model) algorlLhm Lo esLlmaLe Lhe level of
volaLlllLy and lLs effecL on mean reLurns.

Lqu|ty prem|um puzz|e: orlglnaLes from Lhe observaLlon LhaL equlLy reLurns exceeded Lhe rlsk-
free raLe Lo an exLenL LhaL ls lnconslsLenL wlLh reasonable levels of rlsk averslon - aL leasL when
average raLes of reLurn are Laken Lo represenL expecLaLlons. lama and lrench show LhaL Lhe
puzzle emerges prlmarlly from excess reLurns of Lhe pasL 30 years. AlLernaLlve esLlmaLes of
reLurns on sLocks were hlgh because of unexpecLed large caplLal galns. 1he sLudy suggesLs LhaL
fuLure excess reLurns wlll be lower Lhan reallzed ln recenL decades.


14 8ond r|ces and |e|ds

A bond ls a securlLy LhaL ls lssued ln connecLlon wlLh a borrowlng arrangemenL. 1he borrower
lssues a bond Lo Lhe lender for some amounL of cash. 1he arrangemenL obllgaLes Lhe lssuer Lo
make speclfled paymenLs Lo Lhe bondholder on speclfled daLes. When Lhe bond maLures, Lhe
lssuer repays Lhe debL by paylng Lhe bondholder Lhe bond's par va|ue (eq. lL's face va|ue). 1he
coupon rate of Lhe bond deLermlnes Lhe lnLeresL paymenL: 1he annual paymenL ls Lhe coupon
raLe Llmes Lhe bond's par value. 2ero-coupon bonds are lssued wlLhouL coupon paymenLs.
1hese bonds are lssued aL prlces conslderably below par value, and Lhe lnvesLor's reLurn comes
solely from Lhe dlfference beLween lssue prlce and Lhe paymenL of par value aL maLurlLy.

lf a bond ls purchased beLween coupon paymenLs, Lhe buyer musL pay Lhe seller for accrued
lnLeresL, Lhe proraLed share of Lhe upcomlng semlannual coupon.

payments coupon between s day #
payment coupon last since days #
2
ate r oupon c Annual
Interest Accrued + =

1ype of bonds:
Callable (corporaLe) bond: An opLlon ln Lhe bond LhaL allows Lhe lssuer of Lhe bond Lo
buy back Lhe bond ln Lhe fuLure aL an ln advance speclfled prlce. (reduces Lhe value of
Lhe bond). 1o compensaLe lnvesLors for Lhls rlsk, callable bonds are lssued wlLh hlgher
coupons and promlsed ylelds Lo maLurlLy Lhan noncallable bonds.
ConverLlble bond: glves Lhe holder of Lhe bond Lhe rlghL Lo converL bonds lnLo company
sLock aL a pre-speclfled relaLlve prlce of bonds per sLock. (lncreases value of Lhe bond).
uLLable bond: allows Lhe holder of Lhe bond Lo exLend Lhe maLurlLy of Lhe bond beyond
Lhe pre-agreed maLurlLy. (lncreases Lhe value of Lhe bond).
lloaLlng raLe bond: speclfles coupon raLe as Lhe Llme-varylng shorL raLe + a (flxed)
premlum. 1he lnLeresr paymenLs are Lled Lo some measure of currenL markeL raLes.
referred sLock: sLock wlLh flxed dlvldends (perpeLulLy) wlLh speclal rlghLs. Llke bonds,
preferred sLock promlses Lo pay a speclfled sLream of dlvldends. unllke bonds, Lhe
fallure Lo pay Lhe promlsed dlvldends does noL resulL lncorporaLe bankrupLcy. lnsLead,
Lhe dlvldends cumulaLe, and Lhe common sLockholders may noL recelve any dlvldends
unLll Lhe preferred sLockholders have been pald ln full. unllke lnLeresL paymenLs on
bonds, dlvldends on preferred sLock are noL consldered Lax-deducLlble expenses Lo Lhe
flrm. Cn Lhe oLher hand, Lhere ls an offseLLlng Lax advanLage Lo preferred sLock.
lnLernaLlonal bonds: lotelqo booJs are lssued by a borrower from a counLry oLher Lhan
Lhe bond ls sold. 1he bond ls denomlnaLed ln Lhe currency ln whlch lL ls markeLed. oto
booJs are bonds LhaL are lssued ln Lhe currency of one counLry, buL are sold ln oLher
naLlonal markeLs.

8ond r|c|ng
1o value a securlLy, we dlscounL lLs expecLed cash flow by Lhe approprlaLe dlscounL raLe. 1he
cash flows form a bond conslsLs of coupon paymenLs unLll Lhe maLurlLy daLe plus Lhe flnal
paymenL of par value. 1herefore,
8ond value = resenL value of coupons + resenL value of par value

1he bond value can be wrlLLen as:
!
=
+
+
+
=
N
1 i
N i
bond
) r 1 (
F
) r 1 (
F ) 2 / R (
) t ( P
ln whlch n ls Lhe number of half-years over whlch Lhe bond runs, 8 denoLes Lhe coupon raLe ln
per annum Lerms and l denoLes Lhe face value of Lhe bond.

1he prlce of Lhe bond can be wrlLLen as: F
) r 1 (
1
) r 1 (
1
1
r
1
F ) 2 / R ( ) t ( P
N N
bond
+
+
!
"
#
$
%
&
'
'
(
)
*
*
+
,
+
- =
(annulLy facLor) + (v facLor)

1etmlooloqy lo tbe epootloos ls tbe some os oseJ Jotloq lectotes ooJ noL os wtltteo lo tbe
book!!!!

AL a hlgher lnLeresL raLe, Lhe presenL value of Lhe paymenLs Lo be recelved by Lhe bondholder ls
lower. When lnLeresL raLes rlse, bond prlces musL fall because Lhe presenL value of Lhe bond's
paymenLs ls obLalned by dlscounLlng aL a hlgher lnLeresL raLe.

A general rule ln evaluaLlng bond prlce rlsk ls LhaL, keeplng all facLors Lhe same, Lhe longer Lhe
maLurlLy of Lhe bond, Lhe greaLer Lhe senslLlvlLy of prlce Lo flucLuaLlons ln Lhe lnLeresL raLe. 1hls
ls why shorL Lerm 1reasury securlLles such as 1-bllls are consldered Lo be safesL. 1hey are free
noL only of defaulL rlsk buL also largely of prlce rlsk aLLrlbuLable Lo lnLeresL raLe volaLlllLy.

8ond y|e|ds
# 1he y|e|d to matur|ty ls deflned as Lhe lnLeresL raLe LhaL makes Lhe presenL value of Lhe
bond's paymenLs equal Lo lLs prlce. 1he bond ls held Llll maLurlLy.


# A ca||ab|e bond may be reLlred prlor Lo Lhe maLurlLy daLe. 8onds are Lyplcally called
when Lhe markeL raLes have decreased relaLlve Lo Lhe markeL raLe used Lo prlce Lhe
bond.
# 1he Current y|e|d measures Lhe comlng yleld from holdlng Lhe bond


# 1he kea||zed compound y|e|d ls Lhe LoLal average reLurn on lnvesLmenL from holdlng
Lhe bond Llll maLurlLy. (ulfference wlLh yleld Lo maLurlLy ls Lhe facL LhaL markeL lnLeresL
raLes wlll change over Llme). Can only be calculaLed aL Lhe end of Lhe llfe of a bond.
lorecasLlng Lhe reallzed compound yleld over varlous holdlng perlods or lnvesLmenL
horlzons ls called hor|zon ana|ys|s

0
) r 1 (
F
) r 1 (
F ) 2 / R (
) t ( P
N
1 i
N i
bond
=
+
+
+
!
"
=
) t ( P
F . R
) t ( yield current
bond
=
?leld Lo maLurlLy depends only on Lhe bond's coupon, Lhe cotteot prlce, and par value aL
maLurlLy. All of Lhese varlables are observable Loday. ln conLrasL, Lhe P8 ls Lhe raLe of reLurn
over a parLlcular lnvesLmenL perlod and depends on Lhe markeL prlce of Lhe bond aL Lhe end of
Lhe holdlng perlod.
Defau|t k|sk and 8ond r|c|ng
8ond defaulL rlsk, usually called cred|t r|sk, ls measured by varlous flrms (e.g. S&, Moody's) and
ln whlch a Lop raLlng ls AAA. 1hose raLed 888 are consldered |nvestment-grade bonds, whereas
lower raLed bonds are classlfled as specu|at|ve-grade or [unk bonds.

Determ|nants of 8ond Safty:
1. covetoqe totlos - 8aLlos of company earnlngs Lo flxed cosLs
2. levetoqe totlos - A Loo-hlgh leverage raLlo (debL-Lo-equlLy) lndlcaLes excesslve
lndebLedness.
3. llpolJlty totlos - mosL common are Lhe currenL raLlo and Lhe qulck raLlo, whlch measure
Lhe flrm's ablllLy Lo pay bllls comlng due wlLh lLs mosL llquld asseLs.
4. ltofltoblllty totlos - Measures of raLes of reLurn on asseLs or equlLy.
3. cosb flow-to-Jebt totlo - 1hls ls Lhe raLlo of LoLal cash flow Lo ouLsLandlng debL.

A bond ls lssued wlLh an loJeotote whlch ls Lhe conLracL beLween Lhe lssuer and Lhe bond
holder. Some resLrlcLlons ln Lhe lndenLure lnclude:
Slnklng lunds - esLabllshlng a slnklng fund, glves Lhe lssuer of Lhe bond Lhe opLlon Lo
spread Lhe burden of paylng Lhe bonds par value over several years.
SubordlnaLlon of lurLher uebL - 1o prevenL flrms from harmlng bondholders,
subordlnaLlon clauses resLrlcL Lhe amounL of addlLlonal borrowlng.
ulvldend 8esLrlcLlons - 1hese llmlLaLlons proLecL Lhe bondholders because Lhey force
Lhe flrm Lo reLaln asseLs raLher Lhan paylng Lhem ouL Lo shareholders.
CollaLeral - CollaLeral can Lake several forms, buL lL represenLs a parLlcular asseL of Lhe
flrm LhaL Lhe bondholders recelve lf Lhe flrm defaulLs on Lhe bond.

1o compensaLe for Lhe posslblllLy of defaulL, corporaLe bonds musL offer a defau|t prem|um.
1he defaulL premlum ls Lhe dlfference beLween Lhe promlsed yleld on a corporaLe bond and Lhe
yleld of an oLherwlse-ldenLlcal governmenL bond LhaL ls rlskless ln Lerms of defaulL.
1S 1he 1erm Structure of Interest kates

1erm sLrucLure of lnLeresL raLes: sLrucLure of lnLeresL raLes for dlscounLlng cash flows of
dlfferenL maLurlLles.
ShorL lnLeresL raLe: lnLeresL raLe for a glven Llme lnLerval.
?leld curve: graph lf yleld Lo maLurlLy as funcLlon of Llme Lo maLurlLy.
SpoL raLe: yleld Lo maLurlLy on zero-coupon bonds LhaL prevalls Loday for a perlod correspondlng
Lo maLurlLy of Lhe zero.
(?lelds are averages of Lhe lnLeresL raLes ln each perlod)
8ond sLrlpplng+ prlclng ln world wlLh cerLalnLy: ylelds Lo maLurlLy can dlffer for bonds of Lhe
same maLurlLy lf Lhelr coupon raLes dlffer.
ure yleld curve: relaLlonshlp yleld Lo maLurlLy & Llme Lo maLurlLy for zero-coupon bonds. When
lnLeresL raLe movemenLs are known wlLh cerLalnLy, and all bonds are properly prlced, all wlll
provlde equal 1-yr raLes of reLurn.

lorward lnLeresL raLe: (1+f
n
) = (1+y
n
)
n
/ (1+y
n-1
)
n-1

1he lnLeresL raLe LhaL acLually wlll prevall ln Lhe fuLure need noL equal Lhe forward raLe. lL ls noL
even necessarlly Lhe case LhaL Lhe forward raLe equals Lhe expecLed value of Lhe fuLure shorL
lnLeresL raLe.
lorward raLe: lnLeresL raLe LhaL would need Lo prevall ln Lhe second year Lo make Lhe long- and
Lhe shorL-Lerm lnvesLmenLs equally aLLracLlve, lgnorlng rlsk. When we accounL for rlsk: clear LhaL
lnvesLor wlll shy away form long-Lerm bond unless lL offers expecLed reLurn greaLer Lhan LhaL of
Lhe 1-yr bond.
lf lndlvlduals are shorL Lerm lnvesLors, bonds musL have prlces LhaL make f
2
greaLer Lhan L(r
2
).
lorward raLe wlll embody premlum: llquldlLy premlum: compensaLes for Lhe uncerLalnLy abouL
prlce aL whlch LhaL wlll be able Lo sell long-Lerm bonds aL end of year. lf all lnvesLors were long-
Lerm lnvesLors: now forward raLe less Lhan expecLed fuLure spoL raLe. WheLher forward raLes
wlll equal expecLed fuLure shorL raLes depends on lnvesLors' wllllngness Lo bear lnLeresL raLe
rlsk, & wllllngness Lo hold bonds LhaL do noL correspond Lo Lhelr lnvesLmenL horlzons.

LxpecLaLlons hypoLhesls: forward raLe equals markeL consensus expecLaLlon of Lhe fuLure shorL
lnLeresL raLe, f
2
= L(r
2
), llquldlLy premlums = 0. (upward sloplng curve: evldence lnvesLors
anLlclpaLe lncreases ln lnLeresL raLes).
LlquldlLy preference Lheory of Lerm sLrucLure: belleve LhaL shorL-Lerm lnvesLors domlnaLe Lhe
markeL, so LhaL forward raLe exceeds Lhe expecLed shorL raLe, poslLlve llquldlLy premlum.

ulrecL relaLlonshlp beLween yleld on varlous maLurlLles and forward lnLeresL raLes:
1+y
n
= [(1+r
1
)*(1+f
2
)*(1+f
3
)(1+f
n
)]
1/n
.
?leld curve ls upward sloplng, when forward raLe for comlng perlod ls greaLer Lhan yleld aL LhaL
maLurlLy.
1o ralse Lhe yleld Lo maLurlLy, an above-average forward raLe musL be added Lo Lhe oLher raLes
ln Lhe averaglng compuLaLlon. WhaL accounLs for hlgher forward raLe: (f
n
= L(r
n
) + llquldlLy
premlum) expecLed rlse ln lnLeresL raLes, or a hlgher requlred premlum for holdlng longer-Lerm
bonds.

1he usually observed upward slope of yleld curve, especlally for shorL maLurlLles, ls Lhe emplrlcal
basls for Lhe llquldlLy premlum docLrlne LhaL long-Lerm bonds offer a poslLlve llquldlLy premlum.
lf Lerm premlums, spread yleld on long- and shorL-Lerm bonds, generally are poslLlve, Lhen
anLlclpaLed decllnes ln raLes could accounL for a downward-sloplng yleld curve. Why mlghL
lnLeresL raLes fall: 2 facLors: real raLe and lnflaLlon premlum.

lorward lnLeresL raLe conLracL: consLrucL a synLheLlc forward loan, sell (1+f
2
) 2-yr zeros for every
1-yr zero LhaL you buy. 1hls makes lnlLlal cash flow zero.

lor coupon bonds: LreaL each coupon paymenL as a separaLe mlnl-zero-coupon bond.

Why do noL all bond prlces conform Lo a common dlscounL funcLlon LhaL seLs prlce equal Lo
presenL value 1axes, opLlons lnvesLors have Lo sell early (also call provlslon).
16 Manag|ng 8ond ortfo||os

1. 8ond prlces and yleld are lnversely relaLed: as ylelds lncrease, bond prlce wlll fall, as ylelds
fall, bond prlces rlse.
2. An lncrease ln a bond's yleld Lo maLurlLy resulLs ln a smaller prlce change Lhan a decrease ln
yleld of equal magnlLude.
3. rlces of long-Lerm bonds Lend Lo be more senslLlve Lo lnLeresL raLe changes Lhan prlces of
shorL-Lerm bonds.
4. 1he senslLlvlLy of bond prlces Lo changes ln ylelds lncreases aL a decreaslng raLe as maLurlLy
lncreases. ln oLher words, lnLeresL raLe rlsk ls less Lhan proporLlonal Lo bond maLurlLy.
3. lnLeresL raLe rlsk ls lnversely relaLed Lo bond's coupon raLe. rlces of hlgh-coupon bonds are
less senslLlve Lo changes ln lnLeresL raLes Lhan prlces of low-coupon blnds.
6. 1he senslLlvlLy of a bond's prlce Lo a change ln lLs yleld ls lnversely relaLed Lo Lhe yleld Lo
maLurlLy aL whlch Lhe bond ls currenLly selllng.
LxplanaLlon rule 3: ln some sense a zero-coupon bond represenLs a longer-Lerm bond Lhan an
equal-Llme-Lo-maLurlLy coupon bond. A coupon bond can be vlewed as a porLfollo" of coupon
paymenLs, hence Lhe effecLlve maLurlLy of bond ls some average of Lhe maLurlLles of all cash
flows pald ouL by bond.

Macaulay's duraLlon: (=average maLurlLy measure of bond's promlsed cash flows) compuLed as
welghLed average of Lhe Llmes Lo each coupon or prlnclpal paymenL made by Lhe bond.
WelghL assoclaLed wlLh each paymenL should be relaLed Lo lmporLance of paymenL Lo value of
bond. WelghL w
L
= Cl
L
/ (1+y)
L
/ bond prlce
Macaulay's duraLlon formula: u = L * w
L
.

uuraLlon ls a key concepL ln flxed-lncome porLfollo managemenL - 3 reasons :
1. lL ls a slmple summary sLaLlsLlc of Lhe effecLlve average maLurlLy of porLfollo
2. lL Lurns ouL Lo be essenLlal Lool ln lmmunlzlng porLfollos from lnLeresL raLe rlsk
3. duraLlon ls a measure of Lhe lnLeresL raLe senslLlvlLy of porLfollo.
When lnLeresL raLes change, proporLlonal bond's prlce can be relaLed Lo change ln yleld ln
maLurlLy: / = - u * [(1+y) / 1+y]
racLloners use: modlfled duraLlon u*= u/(1+?) and say / = - u* y.

WhaL deLermlnes duraLlon: (3 key facLors: Llme Lo maLurlLy, coupon raLe, yleld Lo maLurlLy)
1. 1he duraLlon of a zero-coupon bond equals lLs Llme Lo maLurlLy.
2. Poldlng maLurlLy consLanL, a bond's duraLlon ls hlgher when Lhe coupon raLe ls lower.
3. Poldlng Lhe coupon raLe consLanL, a bond's duraLlon generally lncreases wlLh lLs Llme Lo
maLurlLy. uuraLlon always lncreases wlLh Llme Lo maLurlLy for bonds selllng aL par or aL a
premlum Lo par.
4. Poldlng oLher facLors consLanL, Lhe duraLlon of a coupon bond ls hlgher when Lhe bon's
yleld Lo maLurlLy ls lower.
3. 1he duraLlon of a level perpeLulLy ls: duraLlon perpeLulLy = (1+y) / y.
6. 1he duraLlon of a level annulLy ls: duraLlon annulLy = (1+y)/y - (1/(1+y)
1
-1)
7. uuraLlon of a coupon bond = (1+y)/y - ((1+y) +1(c-y)) / (c [1+y]
1
-1) + y)
8. lor coupon bonds selllng aL par value, 7. slmpllfles Lo: (1+y)/y [1- (1/(1+y)
1
)]

uuraLlon lmplles llnear relaLlonshlp beLween bond prlces and ylelds, however Lhls ls noL Lhe
case. 1he duraLlon approxlmaLlon always undersLaLes Lhe value of Lhe bond, lL underesLlmaLes
Lhe lncrease ln bond prlce when Lhe yleld falls, and lL overesLlmaLes Lhe decllne ln prlce when
Lhe yleld rlses. CurvaLure o Lhe prlce-yleld curve: convexlLy.
AccounLlng for convexlLy: / = - u* y + *convexlLy * (y)
2
.

ConvexlLy ls a deslrable LralL. 8onds wlLh greaLer convexlLy galn more ln prlce when ylelds fall
Lhan Lhey lose when yleld rlse. CosLs for lnvesLors: Lhey wlll have Lo pay more and accepL lower
yleld on bonds wlLh greaLer convexlLy.
Callable bonds: also reglon of negaLlve convexlLy (prlce-yleld curve ls below Langency llne):
unaLLracLlve asymmeLry: lnLeresL raLes lncreases resulL ln larger prlce decllne Lhan Lhe prlce galn
Lo an lnLeresL raLe decrease of equal magnlLude.
ConvenLlon on Wall SLreeL ls Lo compuLe effecLlve duraLlon of bonds wlLh embedded opLlons:
LffecLlve duraLlon = - / / r, r=assumed lncrease ln raLes - assumed decrease ln raLes and
= prlce aL lncrease - prlce aL decrease.

asslve bond managemenL:
-lndexlng sLraLegy: repllcaLe performance of glven bond lndex. roblems: lndex ls very broad
based (more Lhan 3000 securlLles), rebalanclng problems (bonds drop from lndex when
maLurlLy,1yr), bonds generaLe lnLeresL lncome -musL be relnvesLed. use sLraLlfled/cellular
approach (bonds ln cell consldered homogenous)
-lmmunlzaLlon Lechnlques: seek Lo esLabllsh a zero-rlsk proflle: sLraLegles used by lnvesLors Lo
shleld Lhelr overall flnanclal sLaLus from exposure Lo lnLeresL raLe flucLuaLlons. ldea behlnd
lmmunlzaLlon ls LhaL duraLlon-maLched asseLs and llablllLles leL Lhe asseL porLfollo meeL Lhe
flrm's obllgaLlons desplLe lnLeresL raLe movemenLs.
llxed-lncome lnvesLors face 2 offseLLlng Lypes of lnLeresL raLe rlsk: prlce rlsk and relnvesLmenL
rlsk. lor a horlzon equal Lo Lhe porLfollo's duraLlon, prlce rlsk and relnvesLmenL rlsk exacLly
cancel ouL.
uuraLlon maLchlng balances Lhe dlfferences beLween Lhe accumulaLed value of Lhe coupon
paymenLs (relnvesLmenL rlsk) and Lhe sale value of Lhe bond (prlce rlsk). Pence: when lnLeresL
raLes fall, Lhe coupons grow less Lhan ln Lhe base case, buL Lhe galn on Lhe sale of Lhe bonds
offseLs Lhls and vlce versa.

Powever for greaLer changes ln Lhe lnLeresL raLe, pv curves dlverge. 1hls reflecLs facL LhaL fund
acLually shows a small surplus. lf obllgaLlon was lmmunlzed, why surplus ln fund ConvexlLy
Coupon bond has greaLer convexlLy Lhan Lhe obllgaLlon lL funds. Pence: lmporLanL Lo rebalance
lmmunlzed porLfollos. Lven lf lnLeresL raLes do noL change, asseL duraLlons wlll change solely
because of passage of Llme.
ConsLrucLlon lmmunlzed porLfollo: 1. CalculaLe duraLlon of llablllLy. 2. CalculaLe duraLlon of asseL
porLfollo. 3. llnd asseL mlx LhaL seLs duraLlons equal. 4. lully fund Lhe obllgaLlon (dlfference v
and lv zero-coupon bond). 3. 8ebalance

uedlcaLlon sLraLegy: Cash flow maLchlng on a mulLlperlod basls. Cl maLchlng: auLomaLlcally
lmmunlze porLfollo from lnLeresL raLe movemenLs because Cl from bond and obllgaLlon exacLly
offseL each oLher. no need for rebalanclng.
roblems lmmunlzaLlon: duraLlon ls sLrlcLly valld only for flaL yleld curve (all paymenLs
dlscounLed aL common lnLeresL raLe), noL flaL: replace Cl/(1+y)
L
by pv of Cl (pv=dlscounLed aL
raLe from yleld curve correspondlng Lo daLe of parLlcular Cl).
Moreover, duraLlon maLchlng wlll only lmmunlze porLfollos for parallel shlfLs ln yleld curve and
lmmunlzaLlon can be lnapproprlaLe goal ln an lnflaLlonary envlronmenL.

1wo sources of poLenLlal value ln acLlve bond managemenL: forecasLlng lnLeresL raLe,
ldenLlflcaLlon relaLlve mlsprlclng. AcLlve bond porLfollo sLraLegles:
1. SubsLlLuLlon swap: exchange of 1 bond for a nearly ldenLlcal subsLlLuLe (Lemporarlly
mlsprlclng - dlscrepancy - proflL opporLunlLy: mlnd equallLy of credlL rlsk)
2. lnLermarkeL spread swap: when lnvesLors belleves yleld spread beLween 2 secLors of bond
markeL ls Lemporarlly ouL of llne. (spread hlgh - evenLually narrows)
3. 8aLe anLlclpaLlon swap: pegged Lo lnLeresL raLe forecasLlng. lf lnvesLors belleve raLes wlll fall,
Lhey wlll swap lnLo bonds of longer duraLlon.
4. ure yleld plckup swap: pursued as a means of lncreaslng reLurn by holdlng hlgher-yleld
bonds. When yleld curve ls upward sloplng, yleld plckup swap enLalls movlng lnLo longer-
Lerm bonds (3. 1ax swap: explolL some Lax advanLage)
Porlzon analysls: lnLeresL raLe forecasLlng: see example pg. 349.
ConLlngenL lmmunlzaLlon: mlxed passlve-acLlve sLraLegy: see example pg. 349. Mlnlmum
accepLable Lermlnal value x/(1+r)
1
: Lrlgger polnL. 1hen acLlve sLraLegy ls ceased: lmmunlzaLlon
sLraLegy ls lnlLlaLed.

lnLeresL raLe swap: conLracL 2 parLles: exchange a serles of Cl
llnanclal englneerlng: lnverse floaLers, o & lC sLrlps (pg 333-333)

24 ortfo||o erformance Lva|uat|on

1he ar|thmet|c average of a porLfollo ls esLlmaLed for Lhe expecLed raLe of reLurn of a porLfollo
for Lhe nexL quarLer. 1hls value ls also called Lhe lnLernal raLe of reLurn.
1he geometr|c average of a porLfollo, whlch can dlffer subsLanLlally from Lhe arlLhmeLlc, ls Lhe
consLanL quarLerly reLurn over Lhe quarLers LhaL would yleld Lhe same LoLal or cumulaLlve
reLurn. Lach reLurn has an equal welghL ln Lhe geomeLrlc average. lor Lhls reason, Lhe
geomeLrlc average ls referred Lo as a t|me-we|ghted average.
(example page 832)

Ad[ust|ng return for r|sk
LvaluaLlng performance based on average reLurn alone ls noL very useful. 8eLurns musL be
ad[usLed for rlsk. 1he slmplesL way Lo ad[usL reLurns for porLfollo rlsk ls Lo compare raLes of
reLurn wlLh Lhose of oLher lnvesLmenL funds wlLh slmllar rlsk characLerlsLlcs. Powever, such
ranklngs can be mlsleadlng. lor example lf Lhe porLfollo characLerlsLlcs are noL Lruly comparable.
MeLhods of rlsk-ad[usLed performance evaluaLlon uslng mean-varlance crlLerla came on sLage
slmulLaneously wlLh Lhe caplLal asseL prlclng model (CAM). !ack 1reynor, Wllllam Sharpe and
Mlchael !ensen recognlzed lmmedlaLely Lhe lmpllcaLlons of Lhe CAM for raLlng Lhe
performance of managers. 1wo reasons LhaL Lhe rlsk-ad[usLed performance measures are noL so
popular are (1) Cenerally negaLlve casL Lo Lhe performance sLaLlsLlcs. (2) Mean-varlance may
have suffered relaLes Lo lnLrlnslc problems ln Lhe measures.
lor now however, we can caLalog some posslble rlsk-ad[usLed performance measures for a
porLfollo, , and examlne Lhe clrcumsLances ln whlch each measure mlghL be mosL relevanL.
1) Sharpe measure dlvldes average porLfollo excess reLurn over Lhe sample perlod by Lhe
sLandard devlaLlon of reLurns over LhaL perlod. lL measures Lhe reward Lo (LoLal)
volaLlllLy Lrade-off.
2) 1reynor's measure (llke sharpe's) glves excess reLurn per unlL of rlsk, buL lL uses
sysLemaLlc rlsk lnsLead of LoLal rlsk.
3) Iensen's measure ls Lhe average reLurn on Lhe porLfollo over and above LhaL predlcLed
by Lhe CAM, glven Lhe porLfollo's beLa and Lhe average markeL reLurn. !ensens's
measure ls Lhe porLfollo's alpha value.
4) 1he |nformat|on rat|o dlvldes Lhe alpha of Lhe porLfollo by Lhe nonsysLemaLlc rlsk of Lhe
porLfollo called Lracklng error" ln Lhe lndusLry. lL measures abnormal reLurn per unlL of
rlsk LhaL ln prlnclple could be dlverslfled away by holdlng a markeL lndex porLfollo.
Lach measure has some appeal, buL each does noL necessarlly provlde conslsLenL assessmenLs
of performance, slnce Lhe rlsk measures used Lo ad[usL reLurns dlffer subsLanLlally.

A varlanL of Sharpe's measure was proposed by graham and Parvey. 1helr approach has been
dubbed Lhe M2 measure (for Mod|g||an|-Squared). Llke Sharpe raLlo, Lhe M2 measure focuses
on LoLal volaLlllLy as a measure of rlsk, buL lLs rlsk-ad[usLed measure of performance has Lhe
easy lnLerpreLaLlon of a dlfferenLlal reLurn relaLlve Lo Lhe benchmark lndex. 1o compuLe Lhe M2
we lmaglne LhaL a managed porLfollo, , ls mlxed wlLh a poslLlon ln 1-bllls so LhaL Lhe ad[usLed"
porLfollo maLches Lhe volaLlllLy of a markeL lndex such as Lhe S& 300. 1he ad[usLed porLfollo,
we call *, would Lhan have Lhe same sLandard devlaLlon as Lhe lndex. We now may compare
Lhelr performance slmply by comparlng reLurns. (1o compuLe Lhe M2 see example blz
833,formula ls Lhere as well.)

1he approprlaLe performance measure depends on Lhe role of Lhe porLfollo Lo be evaluaLed.
ApproprlaLe performance measures are as follows:
a) Sharpe: when Lhe porLfollo represenLs Lhe enLlre lnvesLmenL fund.
b) Informat|on rat|o: when Lhe porLfollo represenLs Lhe acLlve porLfollo Lo be opLlmally
mlxed wlLh Lhe passlve porLfollo.
c) 1reynor or Iensen: when Lhe porLfollo represenLs one sub-porLfollo of many. (1reynor's
performance measure ls appeallng because when an asseL ls parL of a large lnvesLmenL
porLfollo, one should welgh lLs mean excess reLurn agalnsL lLs sysLemaLlc rlsk raLher Lhan
agalnsL LoLal rlsk Lo evaluaLe conLrlbuLlon Lo performance)
lormules en ulLleg sLaan op blz 838.

erformance measurement for hedge funds
lL's qulLe clear LhaL a hedge fund should never serve as a sole lnvesLmenL vehlcle for any
lndlvldual lnvesLor. lnsLead, we musL LreaL a hedge fund as an acLlve porLfollo LhaL ls added Lo a
basellne well-dlverslfled porLfollo. We wlll Lread Lhe equlLy porLfollo as Lhe basellne componenL
of Lhe lnvesLor's porLfollo Lo whlch we may conslder addlng hedge funds ln Lhe search for
addlLlonal alpha, someLlmes called porLable alpha. 1hls framework ls wldely adopLed ln Lhe
lnvesLmenL lndusLry.
Accordlng Lo Lhe formulas on page 863, you should use Lhe lnformaLlon raLlo Lo measure
performance of hedge funds.
nowever, |t |s we|| to pause to cons|der severa| prob|ems |n eva|uat|ng |nvestments
performance of hedge funds.
1) 1hey seem Lo have subsLanLlally non||near factor exposures noL capLured by sLandard
llnear lndex models. 1hls lmplles LhaL rlsk ls noL consLanL and LhaL esLlmaLed alphas wlll
be blased lf we use a sLandard, llnear lndex model. 1he beLas Lyplcally dlffer by
subsLanLlal marglns and down-markeL beLas Lend Lo be hlgher Lhan up-markeL beLas.
1hls ls preclsely whaL lnvesLors presumably do noL wanL: hlgher markeL senslLlvlLy when
Lhe markeL ls weak.
2) Pedge funds also pose problems because Lhey Lend Lo hold less-llquld asseLs for whlch
markeL prlces are less readlly avallable. When asseLs are noL acLlvely Lraded, Lhe hedge
fund musL esLlmaLe lLs value ln order Lo calculaLe raLes of reLurn. Such procedures resulL
ln ser|a| corre|at|on. Serlal correlaLlon ls evldence of llquldlLy problems.
3) Santa C|aus effect, hedge funds reporL average reLurns ln uecember LhaL are more Lhan
double Lhelr average reLurns ln oLher monLhs. 1hls ls because Lhan Lhe performance
lncenLlve fees klck ln. lf funds Lake advanLage of llllquld markeLs Lo manage reLurns,
Lhen performance measuremenL becomes almosL lmposslble.
4) Pedge funds Lend Lo hold more llllquld asseLs Lhan oLher lnsLlLuLlonal lnvesLors such as
muLual funds. 1hey can do so because of share resLrlcLlons such as lock-up provlslons
LhaL commlL lnvesLors Lo keep Lhelr lnvesLmenL ln Lhe fund for some perlod of Llme. lL ls
lmporLanL Lo contro| for ||qu|d|ty when evaluaLlng performance. lf lL ls lgnored, whaL
may be no more Lhan falr compensaLlon for llllquldlLy may appear Lo be Lrue alpha"
LhaL ls, rlsk-ad[usLed abnormal reLurns.

Market t|m|ng: ln Lhls pure form, markeL Llmlng lnvolves shlfLlng funds beLween a markeL-lndex
porLfollo and a safe asseLs, such as 1-bllls or a money markeL fund, dependlng on wheLher Lhe
markeL as a whole ls expecLed Lo ouLperform Lhe safe asseL. 1o slmpllfy, suppose LhaL an
lnvesLor holds only Lhe markeL-lndex porLfollo and 1-bllls.
no markeL Llmlng: beLa ls consLanL
MarkeL Llmlng: beLa lncreases wlLh expecLed markeL excess reLurn

Maln polnL: 1he shlfLlng mean and varlance of acLlvely managed porLfollos make lL even harder
Lo assess performance. A Lyplcal example ls Lhe aLLempL of porLfollo managers Lo Llme Lhe
markeL, resulLlng ln ever-changlng porLfollo beLas.

Sty|e Ana|ys|s was lnLroduced by Wllllam Sharpe. A well-known sLudy concluded LhaL 91.3 of
Lhe varlaLlon ln reLurns of 82 muLual funds could be explalned by Lhe funds' asseL allocaLlon Lo
bllls, bonds, and sLocks. 1he 8-square of Lhe regresslon would measure Lhe percenLage of reLurn
varlablllLy aLLrlbuLable Lo sLyle or asseL allocaLlon, whlle Lhe remalnder of reLurn varlablllLy
would be aLLrlbuLable elLher Lo securlLy selecLlon or Lo markeL Llmlng by perlodlc changes ln Lhe
asseL-class welghLs.

Morn|ng Star kat|ng Mehtod: compares each fund Lo a peer group represenLed by a sLyle
porLfollo wlLhln four asseL classes. 8lsk-ad[usLed raLlngs (8A8) are based on fund reLurns relaLlve
Lo Lhe peer group and used Lo award each fund one Lo flve sLars based on Lhe rank of lLs 8A8.
MornlngsLar lnC. ls Lhe premler source of lnformaLlon on muLual funds. SLars are glven
accordlng Lo Lhe funds percenLlle.

erformance eva|uat|on has two very bas|c prob|ems:
1) Many observaLlons are needed for slgnlflcanL resulLs even when porLfollo mean and
varlance are consLanL.
2) ShlfLlng parameLers when porLfollos are acLlvely managed makes accuraLe performance
evaluaLlon all Lhe more eluslve.
We can noL overcome Lhese dlfflculLles compleLely, bus we need Lo do Lhe followlng:
1) Maxlmlze Lhe number of observaLlons by Laklng more frequenL reLurn readlngs.
2) Speclfy Lhe exacL makeup of Lhe porLfollo Lo obLaln beLLer esLlmaLes of Lhe rlsk
parameLers aL each observaLlon perlod.
SLlll even wlLh more daLa, an lnsldlous problem LhaL wlll conLlnue Lo compllcaLe performance
evaluaLlon ls survlvorshlp blas. Slnce poorly performlng muLual funds are regularly closed down,
sample daLa wlll lnclude only survlvlng funds. Survlvorshlp blas also affecLs broad-markeL
lndexes used as bogey porLfollos and generaLes upward blased reLurns LhaL are harder Lo beaL.

erformance attr|but|on procedures:
8aLher Lhan focus on rlsk-ad[usLed reLurns, pracLloners ofLen wanL slmply Lo ascerLaln whlch
declslons resulLed ln superlor or lnferlor performance. Superlor lnvesLmenL performance
depends on an ablllLy Lo be ln Lhe rlghL securlLles aL Lhe rlghL Llme. ALLrlbuLlon sLudles sLarL from
Lhe broadesL asseL allocaLlon cholces and progresslvely focus on ever-flner deLalls of porLfollo
cholce.
Common aLLrlbuLlon procedures parLlLlon performance lmprovemenLs Lo asseL allocaLlon, secLor
selecLlon and securlLy selecLlon. erformance ls assessed by calculaLlng deparLures of porLfollo
composlLlon from a benchmark or neuLral porLfollo.
2S ortfo||o performance eva|uat|on
Pandlg om zelf naar alle grafleken Le kl[ken heL hoofdsLuk lnLerpreLeerd grafleken en Labellen [e
hebL heL zo doorgelezen.
J$.:#$ 0#/D"'&
( dlL ls vooral ln grafleken af Le lezen)
us markeLs are only a parL of Lhe world porLfollo. lnLernaLlonal caplLal markeLs offer lmporLanL
opporLunlLles for porLfollo dlverslflcaLlon wlLh enhanced rlsk-reLurn characLerlsLlcs.
us markeLs ls 39.2 of all markeLs ln 2003
us markeL share ls down from 49 ln 2000.
lor a passlve sLraLegy one could argue LhaL a porLfollo of equlLles of [usL Lhe slx counLrles wlLh
Lhe largesL caplLallzaLlon would make up 71.3 ln 2003 of Lhe world porLfollo and may be
sufflclenLly dlverslfled. 1hls argumenL wlll noL hold for an acLlve porLfollo LhaL seeks Lo LllL
lnvesLmenLs Loward promlslng asseLs. AcLlve porLfollo wlll naLurally lnclude many sLock or even
lndexes of emerglng markeLs. CounLrles wlLh larger relaLlve caplLallzaLlon of equlLles wlll Lend Lo
be rlcher. 1he graph shows (page 901) LhaL a 1 procenL lncrease ln Lhe raLlo of markeL
caplLallzaLlon Lo Cu ls assoclaLed wlLh an lncrease ln per caplLa Cu of 0.91. CounLrles below
Lhls regresslon llne such as lndonesla and aklsLan suffered from deLerloraLlon of Lhe buslness
envlronmenL due Lo pollLlcal sLrlfe and or governmenL pollcles LhaL resLrlcLed Lhe prlvaLe secLor.
nome country b|as
Pome counLry blas ls Lhe excess welghL of your counLry relaLlve Lo lLs welghL ln Lhe oLherwlse
efflclenL porLfollo.
eople would expecL LhaL lnvesLor would be aware of Lhe opporLunlLles offered by lnLernaLlonal
lnvesLlng. ?eL ln pracLlce lnvesLor porLfollos noLorlously overwelghL home counLry sLock
compared Lo a neuLral lndexlng sLraLegy and underwelghL or even compleLely lgnore forelgn
securlLles
Issues
WhaL ls Lhe rlsk of lnvesLlng ln forelgn securlLles
Pow do you measure benchmark reLurn on forelgn lnvesLmenLs
Are Lhere beneflLs Lo dlverslflcaLlon ln forelgn securlLles
k|sk factors
CpporLunlLles ln lnLernaLlonal markeLs do noL come free wlLh rlsk. 8lsk facLors LhaL are unlque
Lo lnLernaLlonal lnvesLmenLs are: exchange raLe rlsk and counLry speclflc rlsk
1 Iore|gn Lxchange rate r|sk ls varlaLlon ln Lhe reLurn relaLlve Lo changes ln Lhe relaLlve value of
domesLlc and forelgn currency. 1he LoLal reLurn ls Lhe reLurn lnvesLmenL reLurn and reLurn on
forelgn exchange. lL ls noL posslble Lo compleLely hedge a forelgn lnvesLmenL. 8uL ln Lhe conLexL
lnLernaLlonal porLfollos exchange raLe rlsk may be parLly dlverslflable. (1he evldence comes from
correlaLlon coefflclenL). An lnvesLor could hedge an exchange raLe rlsk uslng a forward or fuLure
conLracL ln forelgn exchange. luLure and forward markeLs are used Lo ellmlnaLe Lhe rlsk of
holdlng anoLher asseL. 8uL a perfecL hedge ln noL posslble unless Lhe forelgn currency raLe of
reLurn ls known.
8eLurn ln Lhe uS ls a funcLlon of Lwo facLors:
1 reLurn ln Lhe forelgn markeL
2 reLurn on Lhe forelgn exchange
2 Country spec|f|c r|sk
ln prlnclple securlLy analysls aL Lhe macroeconomlc lndusLry and flrm speclflc level ls slmllar ln
all counLrles. Such analysls alms Lo provlde esLlmaLes of expecLed reLurns and rlsk of lndlvldual
asseLs and porLfollos. 1o achleve Lhe same quallLy of lnformaLlon abouL asseLs ln a forelgn
counLry ls by naLure more dlfflculL and hence more expenslve. Powever Lhe rlsk of comlng by
false or mlsleadlng lnformaLlon ls greaLer. Conslder example Amerlcan lnvesLors ln lndonesla or
an lndonesla lnvesLor lnvesLlng ln Amerlca. lor Lhe Amerlcan lnvesLor lL ls more dlfflculL,
because Lhe uS lnvesLmenL envlronmenL ls more LransparenL Lhan LhaL of lndonesla.
o||t|ca| r|sk serv|ces group rat|ngs kS's
8ank counLrles wlLh respecL Lo flnanclal, economlc and pollLlcal rlsk. 1hey asslgn composlLe
raLlng from very hlgh rlsk Lo very low rlsk based on Lhe above elemenLs. 1hey are dlvlded lnLo
flve caLegorles: very low rlsk (100-80) low rlsk (79.9-70) moderaLe rlsk (69.9-60), hlgh rlsk (39.9-
30) very hlgh rlsk (less Lhan 30). 1he composlLe rlsk raLlng ls a welghLed average of Lhe Lhree
measures (flnanclal, economlc, pollLlcal rlsk). ollLlcal ls measured aL a scale of 100-0 en flnanclal
and economlc on scale of 30-0. 1he Lhree measures are added and dlvlded by Lwo Lo obLaln Lhe
composlLe raLlngs.
,*G"&'0"*' )* "0"/5)*5 0#/D"'& /)&D)"/
1he graph shows 23.3 LhaL lnvesLmenL ln emerglng markeLs ls largely rlskler Lhan ln developed
counLrles, aL leasL as measured by volaLlllLy of reLurns.
Craph 23.3 shows LhaL lnvesLlng ln emerglng markeLs provlded hlgher average reLurn Lhan
lnvesLlng ln developed counLrles. 1hls daLa ls far from concluslve slnce flve-year averages are
sub[ecL Lo conslderable lmpresslon. Also a hlgher sLandard devlaLlon ls noL a good measure of
rlsk. 1he rlsk of a slngle markeL can be measured by Lhe covarlance of Lhe overall porLfollo.
K)G"/&)-)+#').* :"*"-)'&
A correlaLlon coefflclenL of Lhe hedged (local currency) and unhedged (us dollar) reLurns are
very slmllar, conflrmlng LhaL hedglng currencles ls noL a slgnlflcanL lssue ln lnLernaLlonally well-
dlverslfled porLfollos.

1he correlaLlon coefflclenLs beLween sLock lndexes of one counLry and bond porLfollos of
anoLher are very low, suggesLlng LhaL lncome porLfollos LhaL are balanced beLween sLock and
bonds would greaLly beneflL from lnLernaLlonal dlverslflcaLlon.
llgure 23.7 suggesLs LhaL lnLernaLlonal dlverslflcaLlon can reduce Lhe sLandard devlaLlon of a
slngle sLock Lo abouL 12.

1he basellne Lechnlque for consLrucLlng efflclenL porLfollos ls Lhe efflclenL fronLler. A useful
efflclenL fronLler ls consLrucLed from expecLed reLurns and an esLlmaLe of Lhe covarlance maLrlx
of reLurns. 1he beneflL from Lhls efflclenL dlverslflcaLlon ls reflecLed ln Lhe curvaLure of Lhe
efflclenL fronLler. CLher Lhlngs equal Lhe lower Lhe covarlance across sLocks, Lhe greaLer Lhe
curvaLure of Lhe efflclenL fronLler and Lhe greaLer Lhe rlsk reducLlon for any deslred expecLed
reLurn.

8ecenL reallzed reLurns could be hlghly mlsleadlng esLlmaLes of expecLed fuLure reLurns, Lhey
are more useful for measurlng prospecLlve rlsk. 1here are Lwo reasons for Lhls.
1 markeL efflclency lmplles LhaL sLock prlces wlll be dlfflculL Lo predlcL wlLh any accuracy, buL no
such lmpllcaLlon applles Lo rlsk measures.
2 lL ls a sLaLlsLlcal facL LhaL errors ln esLlmaLes of sLandard devlaLlon and correlaLlon from
reallzed daLa are of a lower order of magnlLude Lhan esLlmaLes of expecLed reLurn. lor Lhese
reasons, uslng rlsk esLlmaLes from reallzed reLurns does noL exaggeraLe as much Lhe poLenLlal
beneflLs from dlverslflcaLlon. llgure 23.9 shows a reallsLlc assessmenL LhaL reveals modesL buL
slgnlflcanL beneflLs from lnLernaLlonal dlverslflcaLlon uslng only developed counLrles.

1he model of 8oll predlcLs LhaL a macroeconomlc shock would affecL all counLrles and LhaL
dlverslflcaLlon can only mlLlgaLe counLry speclflc evenLs. Cur besL guess Lherefore ls LhaL Lhe
dlverslflcaLlon beneflLs shown by Lhe world CAM model are reallsLlc.

In conc|us|on from the graphs:
1 vlJeoce sbows Jlvetslflcotloo ls beoeflclol.
2 lt ls posslble to expooJ tbe efflcleot ftootlet oboes tbe Jomestlc motket ftootlet.
J lt ls posslble to teJoce tbe systemotlc tlsk level below tbe Jomestlc ooly level

L"/-./0#*+" #''/):3').*
lf we focus on an lnvesLor wlLh a passlve porLfollo. 1helr ob[ecLlve ls Lo maxlmlze dlverslflcaLlon
wlLh llmlLed expense and efforL. lL appears LhaL for a passlve lnvesLor, Lhe beneflLs of
lnLernaLlonal dlverslflcaLlon are noL whaL Lhey are commonly purporLed Lo be. erhaps Lhe
noLorlous home blas lsn'L a blas aL all, [usL a commonsense response Lo Lhese sorLs of resulLs.
lor acLlve lnvesLors lnLernaLlonal lnvesLlng offers greaLer opporLunlLles. lnLernaLlonal lnvesLlng
calls for speclallzaLlon ln addlLlonal flelds of analysls: currency, counLry and worldwlde lndusLry,
as well as greaLer unlverse for sLock selecLlon.

AcLlve and lnLernaLlonal lnvesLlng as well as passlve requlres benchmark porLfollo. Cne wldely
used lndex of non-uS sLock ls Lhe Luropean, AusLrallan, lar LasL lndex compuLed by Morgan
SLanley CaplLal lnLernaLlonal.

An lssue LhaL someLlmes arlses ln LhaL lnLernaLlonal conLexL ls Lhe approprlaLeness off markeL-
caplLallzaLlon welghLed schemes ln Lhe consLrucLlon of lnLernaLlonal lndexes. CaplLallzaLlon
welghLlng ls far and away Lhe mosL common approach. Some argue LhaL ls mlghL noL Lhe besL
welghlng scheme ln an lnLernaLlonal conLexL. 1hls ls ln parL because dlfferenL counLrles have
dlfferlng proporLlons of Lhelr corporaLe secLor organlzed aL publlcly Lrade flrms.

Some argue LhaL ls would be more approprlaLe Lo welghL lnLernaLlonal lndexes by Cu raLher
Lhan markeL caplLallzaLlon. 1he [usLlflcaLlon for Lhls vlew ls LhaL an lnLernaLlonally dlverslfled
porLfollo should purchase shares ln proporLlon Lo Lhe broad asseL base of each counLry, and Cu
mlghL be a beLLer measure of Lhe lmporLance of a counLry ln Lhe lnLernaLlonal economy LhaL Lhe
value of lLs ouLsLandlng sLock

Several world markeL lndexes can form a basls for passlve lnLernaLlonal lnvesLlng. AcLlve
lnLernaLlonal lnvesLlng managemenL can be parLlLloned lnLo Lhe followlng:
Currency se|ect|on AsseL allocaLlon ln whlch Lhe lnvesLor chooses among lnvesLmenLs
denomlnaLed ln dlfferenL currencles.
Country se|ect|on Lype of acLlve lnLernaLlonal managemenL LhaL measures Lhe conLrlbuLlon Lo
performance aLLrlbuLable Lo lnvesLlng ln Lhe beLLer-performlng sLock markeLs of Lhe world.
Stock se|ect|on An acLlve porLfollo managemenL Lechnlque LhaL focuses on advanLageous
selecLlon of parLlcular sLocks raLher Lhan on broad asseL allocaLlon cholces.
Cash and bond se|ect|on AsseL allocaLlon ln whlch Lhe cholce ls beLween shorL-Lerm cash
equlvalenLs and longer-Lerm bonds.