ESSENTIALS of INVESTMENTS bod05175_fm_i-xxvi.indd i 9/3/07 4:09:38 PM The McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate Stephen A. Ross Ross, Westerfield and Jaffe Saunders and Cornett Franco Modigliani Professor of Finance Corporate Finance Financial Institutions Management: A and Economics Eighth Edition Risk Management Approach Sloan School of Management Ross, Westerfield, Jaffe, and Jordan Sixth Edition Massachusetts Institute of Technology Corporate Finance: Core Principles and Saunders and Cornett Consulting Editor Applications Financial Markets and Institutions: An First Edition Introduction to the Risk Management Ross, Westerfield, and Jordan Approach FINANCIAL MANAGEMENT Essentials of Corporate Finance Third Edition Adair Sixth Edition Excel Applications for Corporate Finance Ross, Westerfield and Jordan INTERNATIONAL FINANCE First Edition Fundamentals of Corporate Finance Eun and Resnick Block and Hirt Eighth Edition International Financial Management Foundations of Financial Management Shefrin Fourth Edition Twelfth Edition Behavioral Corporate Finance: Decisions Kuemmerle Brealey, Myers, and Allen that Create Value Case Studies in International Principles of Corporate Finance First Edition Entrepreneurship: Managing and Ninth Edition White Financing Ventures in the Global Brealey, Myers, and Allen Financial Analysis with an Electronic Economy Principles of Corporate Finance, Concise Calculator First Edition Edition Sixth Edition First Edition REAL ESTATE Brealey, Myers, and Marcus INVESTMENTS Brueggeman and Fisher Fundamentals of Corporate Finance Adair Real Estate Finance and Investments Fifth Edition Excel Applications for investments Thirteenth Edition Brooks First Edition Corgel, Ling and Smith FinGame Online 5.0 Bodie, Kane, and Marcus Real Estate Perspectives: An Introduction Bruner Essentials of Investments to Real Estate Case Studies in Finance: Managing for Seventh Edition Fourth Edition Corporate Value Creation Bodie, Kane, and Marcus Ling and Archer Fifth Edition Investments Real Estate Principles: A Value Approach Chew Eighth Edition Second Edition The New Corporate Finance: Where Hirt and Block Theory Meets Practice Fundamentals of Investment FINANCIAL PLANNING Third Edition Management AND INSURANCE DeMello Ninth Edition Allen, Melone, Rosenbloom, and Mahoney Cases in Finance Hirschey and Nofsinger Retirement Plans: 401(k)s, IRAs, Second Edition Investments: Analysis and Behavior and Other Deferred Compensation Grinblatt (editor) First Edition Approaches Stephen A. Ross, Mentor: Influence Jordan and Miller Tenth Edition through Generations Fundamentals of Investments: Valuation Altfest Grinblatt and Titman and Management Personal Financial Planning Financial Markets and Corporate Fourth Edition First Edition Strategy Harrington and Niehaus Second Edition FINANCIAL INSTITUTIONS Risk Management and Insurance Helfert AND MARKETS Second Edition Techniques of Financial Analysis: A Guide Rose and Hudgins Kapoor, Dlabay, and Hughes to Value Creation Bank Management and Financial Focus on Personal Finance: An Active Eleventh Edition Services Approach to Help You Develop Successful Higgins Seventh Edition Financial Skills Analysis for Financial Management Rose and Marquis Second Edition Eighth Edition Money and Capital Markets: Financial Kapoor, Dlabay, and Hughes Kester, Ruback, and Tufano Institutions and Instruments in a Global Personal Finance Case Problems in Finance Marketplace Eighth Edition Twelfth Edition Tenth Edition bod05175_fm_i-xxvi.indd ii 9/3/07 4:09:41 PM ESSENTIALS of INVESTMENTS Seventh Edition ZVI BODIE Boston University ALEX KANE University of California, San Diego ALAN J. MARCUS Boston College Boston Burr Ridge, IL Dubuque, IA New York San Francisco St.
Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto bod05175_fm_i-xxvi.indd iii 9/3/07 4:09:42 PM ESSENTIALS OF INVESTMENTS Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2008, 2007, 2004, 2001, 1998, 1995, 1992 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 WCK/WCK 0 9 8 7 ISBN 978-0-07-340517-9 MHID 0-07-340517-5 Executive editor: Michele Janicek Developmental editor II: Christina Kouvelis Marketing manager: Ashley Smith Managing editor: Lori Koetters Lead production supervisor: Michael R. McCormick Senior designer: Cara David Lead media project manager: Cathy L.
Tepper Cover design: Eric Kass, funnel.tv Interior design: Jenny El-Shamy Typeface: 10/12 Times Roman Compositor: Laserwords Private Limited Printer: Quebecor World Versailles Inc. Library of Congress Cataloging-in-Publication Data Bodie, Zvi. Essentials of investments / Zvi Bodie, Alex Kane, Alan J. paper) ISBN-10: 0-07-340517-5 (alk.com bod05175_fm_i-xxvi.indd iv 9/3/07 4:09:44 PM To our wives and eight wonderful daughters.
bod05175_fm_i-xxvi.indd v 9/3/07 4:09:45 PM ABOUT THE AUTHORS Zvi Bodie Boston University Zvi Bodie is Professor of Finance and Economics at Boston University School of Management. He holds a PhD from the Massachusetts Institute of Technology and has served on the finance faculty at Harvard Business School and MIT’s Sloan School of Management. Professor Bodie has published widely on pension finance and investment strategy in leading professional journals. His books include Foundations of Pension Finance, Pensions in the U.
Economy, Issues in Pension Economics, and Financial Aspects of the U. His textbook Investments, co-authored with Alex Kane and Alan Marcus, is the market leader and is used in certification programs of the Financial Planning Association and the Society of Actuaries. His textbook Finance is co-authored by Nobel Prize–winning economist Robert C. Professor Bodie is a member of the Pension Research Council of the Wharton School, University of Pennsylvania.
His latest book is Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals. Alex Kane University of California, San Diego Alex Kane is Professor of Finance and Economics at the Graduate School of International Relations and Pacific Studies at the University of California, San Diego. He has been Visiting Professor at the Faculty of Economics, University of Tokyo; Graduate School of Business, Harvard; Kennedy School of Government, Harvard; and Research Associate, National Bureau of Economic Research. An author of many articles in finance and management journals, Professor Kane’s research is mainly in corporate finance, portfolio management, and capital markets.
Marcus Boston College Alan Marcus is Professor of Finance in the Wallace E. Carroll School of Management at Boston College. He received his PhD from MIT, has been a Visiting Professor at MIT’s Sloan School of Management and Athens Laboratory of Business Administration, and has served as a Research Fellow at the National Bureau of Economic Research, where he participated in both the Pension Economics and the Financial Markets and Monetary Economics Groups. Professor Marcus also spent two years at the Federal Home Loan Mortgage Corporation (Freddie Mac), where he helped to develop mortgage pricing and credit risk models.
Professor Marcus has published widely in the fields of capital markets and portfolio theory. He currently serves on the Research Foundation Advisory Board of the CFA Institute. vi bod05175_fm_i-xxvi.indd vi 9/3/07 4:09:45 PM ESSENTIALS of INVESTMENTS bod05175_fm_i-xxvi.indd i 9/3/07 4:09:38 PM BRIEF CONTENTS Part ONE 13 Equity Valuation 401 ELEMENTS OF INVESTMENTS 1 14 Financial Statement Analysis 442 1 Investments: Background and Issues 2 Part FIVE DERIVATIVE MARKETS 479 2 Asset Classes and Financial Instruments 24 15 Options Markets 480 3 Securities Markets 55 16 Option Valuation 517 4 Mutual Funds and Other Investment 17 Futures Markets and Risk Companies 89 Management 552 Part TWO Part SIX PORTFOLIO THEORY 115 ACTIVE INVESTMENT 5 Risk and Return: Past MANAGEMENT 587 and Prologue 116 18 Performance Evaluation and Active 6 Efficient Diversification 149 Portfolio Management 588 7 Capital Asset Pricing and Arbitrage 19 Globalization and International Pricing Theory 192 Investing 621 8 The Efficient Market Hypothesis 231 20 Taxes, Inflation, and Investment 9 Behavioral Finance and Technical Strategy 657 Analysis 262 21 Investors and the Investment Process 681 Part THREE Appendixes DEBT SECURITIES 289 A References 701 10 Bond Prices and Yields 290 B References to CFA Questions 707 11 Managing Bond Portfolios 333 Index I-1 Part FOUR SECURITY ANALYSIS 369 12 Macroeconomic and Industry Analysis 370 vii bod05175_fm_i-xxvi.indd vii 9/3/07 4:09:46 PM CONTENTS Part ONE Brokers’ Calls 29 ELEMENTS OF INVESTMENTS 1 Federal Funds 29 The LIBOR Market 29 1 Investments: Background and Yields on Money Market Instruments 29 Issues 2 2.2 The Bond Market 30 1.1 Real Assets versus Financial Assets 3 Treasury Notes and Bonds 30 1.2 A Taxonomy of Financial Assets 5 Inflation-Protected Treasury Bonds 31 1.3 Financial Markets and the Economy 6 Federal Agency Debt 32 The Informational Role of Financial Markets 6 International Bonds 32 Consumption Timing 6 Municipal Bonds 32 Allocation of Risk 7 Corporate Bonds 35 Separation of Ownership and Mortgages and Mortgage-Backed Securities 35 Management 7 2.3 Equity Securities 37 Corporate Governance and Corporate Ethics 9 Common Stock as Ownership Shares 37 1.4 The Investment Process 9 Characteristics of Common Stock 38 1.5 Markets Are Competitive 10 2.9 Stock Market Listings 38 The Risk-Return Trade-Off 10 Preferred Stock 39 Efficient Markets 11 Depository Receipts 39 1.4 Stock and Bond Market Indexes 40 Financial Intermediaries 12 Stock Market Indexes 40 Investment Bankers 14 Dow Jones Averages 40 1.7 Recent Trends 15 Standard & Poor’s Indexes 44 Globalization 15 Other U. Market Value Indexes 45 Securitization 16 Equally Weighted Indexes 46 Financial Engineering 17 Foreign and International Stock Market Computer Networks 18 Indexes 46 1.8 Outline of the Text 19 Bond Market Indicators 46 Summary 20 2.5 Derivative Markets 46 Options 46 2 Asset Classes and Financial Futures Contracts 50 Instruments 24 Summary 51 2.1 The Money Market 25 Treasury Bills 25 3 Securities Markets 55 Certificates of Deposit 27 3.1 How Firms Issue Securities 56 Commercial Paper 28 Investment Banking 56 Bankers’ Acceptances 28 Shelf Registration 57 Eurodollars 28 Private Placements 58 Repos and Reverses 28 Initial Public Offerings 58 viii bod05175_fm_i-xxvi.indd viii 9/3/07 4:09:46 PM Contents ix 3.2 How Securities Are Traded 60 Part TWO Types of Markets 61 PORTFOLIO THEORY 115 Types of Orders 62 Trading Mechanisms 64 5 Risk and Return: Past 3.
Securities Markets 66 and Prologue 116 Nasdaq 66 5.1 Rates of Return 117 The New York Stock Exchange 67 Measuring Investment Returns over Multiple Electronic Communication Networks 70 Periods 117 The National Market System 70 Conventions for Quoting Rates of Return 119 Bond Trading 71 5.2 Risk and Risk Premiums 120 3.4 Market Structure in Other Countries 71 Scenario Analysis and Probability London 71 Distributions 121 Euronext 72 Risk Premiums and Risk Aversion 123 Tokyo 72 The Sharpe (Reward-to-Volatility) Measure 124 Globalization and Consolidation of Stock Markets 72 5.3 The Historical Record 125 3.5 Trading Costs 73 Bills, Bonds, and Stocks, 1926–2006 125 3.6 Buying on Margin 74 5.4 Inflation and Real Rates of Return 131 3.7 Short Sales 77 The Equilibrium Nominal Rate of Interest 132 3.8 Regulation of Securities Markets 79 5.5 Asset Allocation across Risky and Risk-Free Self-Regulation 80 Portfolios 133 Regulatory Responses to Recent The Risky Asset 134 Scandals 80 The Risk-Free Asset 135 Circuit Breakers 82 Portfolio Expected Return and Risk 136 Insider Trading 82 The Capital Allocation Line 137 Summary 83 Risk Tolerance and Asset Allocation 138 4 Mutual Funds and Other 5.6 Passive Strategies and the Capital Market Investment Companies 89 Line 139 4.1 Investment Companies 90 Historical Evidence on the Capital Market 4.2 Types of Investment Companies 91 Line 140 Unit Investment Trusts 91 Costs and Benefits of Passive Investing 141 Managed Investment Companies 91 Summary 142 Other Investment Organizations 93 6 Efficient Diversification 149 4.1 Diversification and Portfolio Risk 150 Investment Policies 94 6.2 Asset Allocation with Two Risky Assets 152 How Funds Are Sold 96 Covariance and Correlation 152 4.4 Costs of Investing in Mutual Funds 97 Using Historical Data 155 Fee Structure 97 The Three Rules of Two-Risky-Assets Fees and Mutual Fund Returns 99 Portfolios 157 Late Trading and Market Timing 101 The Risk-Return Trade-Off with Two-Risky- Other Potential Reforms 102 Assets Portfolios 157 4.5 Taxation of Mutual Fund Income 102 The Mean-Variance Criterion 159 4.6 Exchange-Traded Funds 103 6.3 The Optimal Risky Portfolio with a Risk-Free 4.7 Mutual Fund Investment Performance: Asset 164 A First Look 104 6.
