Understanding Investments Theories and Strategies

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Understanding Investments: Theories and Strategies
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DOI: 10.4324/9781003027478
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Understanding Investments
This revised and fully expanded edition of Understanding Investments continues to incorporate the
elements of traditional textbooks on investments, but goes further in that the material is presented
from an intuitive, practical point of view, and the supplementary material included in each chapter
lends itself to both class discussion and further reading by students. It provides the essential tools
to navigate complex, global financial markets and instruments including relevant (and classic)
academic research and market perspectives.
The author has developed a number of key innovative features. One unique feature is its
economic angle, whereby each chapter includes a section dedicated to the economic analysis of that
chapter’s material. Additionally, all chapters contain sections on strategies that investors can apply
in specific situations and the pros and cons of each are also discussed. The book provides further
clarification of some of the concepts discussed in the previous edition, thereby offering a more
detailed analysis and discussion, with more real-world examples. The author has added new,
shorter text boxes, labeled “Market Flash” to highlight the use of, or changes in current practices
in the field; updates on strategies as applied by professionals; provision of useful information for
an investor; updates on regulations; and anything else that might be relevant in discussing and
applying a concept. This second edition also includes new sections on core issues in the field of
investments, such as alternative investments, disruptive technologies, and future trends in
investment management.
This textbook is intended for undergraduate students majoring or minoring in finance and also
for students in economics and related disciplines who wish to take an elective course in finance or
investments.
Nikiforos T. Laopodis is a finance professor at the School of Business and Economics’ Finance
Department at The American College of Greece. Dr Laopodis is widely published in the areas of
finance and economics on topics such as investments, monetary and fiscal policies, and financial
econometrics and in highly respected finance journals. Since 1995, he has been, and continues to
be, a regular participant in the Eastern Finance Association, Financial Management Association (US
and Int’l) and later in the European Financial Management Association.
Understanding
Investments
Theories and Strategies
SECOND EDITION
Nikiforos T. Laopodis
Second edition published 2021
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
52 Vanderbilt Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2021 Nikiforos T. Laopodis
The right of Nikiforos T. Laopodis to be identified as author of this work has

been asserted by him in accordance with sections 77 and 78 of the Copyright,
Designs and Patents Act 1988.
All rights reserved. No part of this book may be reprinted or reproduced or

utilised in any form or by any electronic, mechanical, or other means, now
known or hereafter invented, including photocopying and recording, or in
any information storage or retrieval system, without permission in writing
from the publishers.
Trademark notice: Product or corporate names may be trademarks or

registered trademarks, and are used only for identification and explanation
without intent to infringe.
First edition published by Routledge 2013
British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data

Names: Laopodis, Nikiforos, 1961– author.
Title: Understanding investments : theories and strategies / Nikiforos T.
Laopodis.
Description: Second Edition. | New York : Routledge, 2020. | Revised
edition of the author’s Understanding investments, 2012. | Includes
bibliographical references and index.
Identifiers: LCCN 2020005134 (print) | LCCN 2020005135 (ebook) |
ISBN 9780367461683 (hardback) | ISBN 9780367461904 (paperback) |
ISBN 9781003027478 (ebook)
Subjects: LCSH: Investments. | Risk management. | Portfolio management. |
Securities. | Derivative securities.
Classification: LCC HG4521 .L3186 2020 (print) | LCC HG4521 (ebook) |
DDC 332.601—dc23
LC record available at https://lccn.loc.gov/2020005134
LC ebook record available at https://lccn.loc.gov/2020005135
ISBN: 978-0-367-46168-3 (hbk)

ISBN: 978-0-367-46190-4 (pbk)
ISBN: 978-1-003-02747-8 (ebk)
Typeset in Joanna MT
by Apex CoVantage, LLC
Visit the eResources: www.routledge.com/9780367461904

This edition of the book is dedicated to my special-needs son,
Haralabos, who was patiently waiting for me to finish writing so
we could start playing and learning.
Outline contents
Detailed contents ix
List of illustrations xxiii
Acknowledgmentsxxix
Preface to the second edition xxxi
Preface to the first edition xxxiii
Part I Investment basics 1

1 The investment framework 3
2 The investment decision process and investment strategies 31
3 Fundamentals of risk and return 63
Part II Financial markets, intermediaries, and instruments 93

4 The global financial environment 95
5 Money and capital market instruments and strategies 131
6 Investment bankers and investment companies 167
Part III Portfolio theory 209

7 Diversification and asset allocation 211
8 Efficient diversification and capital market theory 251
9 Market efficiency and behavioral finance 295
Part IV Equity portfolio management 331

10 Equity and fundamental analyses 333
11 Equity valuation and investment strategies 373
Part V Debt securities 411

12 Bond fundamentals and valuation 413
13 Bond portfolio management and performance evaluation 455
Part VI Derivative markets and other investments 489

14 Option markets and valuation models 491
15 Futures markets and strategies 533
16 Other investment topics and themes in investment management 567
Appendix 601
Index 607
Detailed contents
List of illustrations xxiii

Acknowledgmentsxxix
Preface to the second edition xxxi
Preface to the first edition xxxiii
Part I Investment basics 1

1 The investment framework 3
1.1 Introduction 4
1.2 The general financial and economic environment 4
1.2.1 Definition of investments 4
1.2.2 The general investment environment 5
1.2.2.1 Securities 5
1.2.2.2 Classification of securities 5
1.2.2.3 Types of investors 6
1.2.3 Financial markets and intermediaries 8
1.2.3.1 The roles of financial markets 8
1.2.3.2 The roles of financial intermediaries 9
1.3 The objectives and constraints of investors 10
1.3.1 The objectives of investors 10
MARKET FLASH Are you realizing your objectives? 11
1.3.2 The constraints of investors 12
1.4 The investment management process 12
1.5 The role of investment information 13
1.6 Agency and ethical issues in investing 15
1.6.1 Asymmetric information 15
MARKET FLASH Reducing asymmetric information 17
1.6.2 The agent-principal problem 17
MARKET FLASH Conflicts between managers and shareholders? 18
1.6.3 Ethics in the marketplace 18
1.6.4 Environmental, social, and governance 20
1.6.4.1 Social responsibility issues 20
1.6.4.2 Environmental issues 21
1.6.4.3 Corporate governance issues 21
1.7 So why study investments? 22
1.8 Chapter summary 23
1.9 The plan of the textbook 25
Applying economic analysis: Utility and efficiency 25
International focus: Causes and consequences of the financial crisis of 2008 25
Lessons of our times: Lessons of the global financial crisis 26
Key concepts 27
Questions and problems 28
x | Detailed contents
2 The investment decision process and investment strategies 31

2.1 Introduction 32
2.2 The investment process 32
2.2.1 The investor policy statement 32
2.2.2 The risk-return trade-off 33
2.2.3 The asset allocation step in the investment process 35
2.2.4 The security selection step in the investment process 36
MARKET FLASH What if the paradigm for long-term investing was to change? 37
2.3 General investment philosophies and strategies 37
2.3.1 Some prominent investment philosophies 37
2.3.2 What is your investment philosophy? 39
2.3.3 Some investment strategies 42
2.3.3.1 Top-down and bottom-up approaches to investing 42
2.3.3.2 Active and passive investment strategies 43
MARKET FLASH Active or passive investment strategy? 45
2.3.3.3 Other investment strategies 45
2.3.3.4 Dollar-cost averaging 46
2.3.3.5 Margin purchases and short sales 47
MARKET FLASH China cracks down on margin trading violations 48
MARKET FLASH Short sales gone bad 52
2.4 Types of markets and orders 53
2.4.1 Types of trading markets 53
2.4.2 Types of trading orders 53
MARKET FLASH Tick sizes 54
2.4.3 Finding the equilibrium price of a share 55
Applying economic analysis: Making investment decisions 58
International focus: Stocks or bonds amid a weak economic recovery? 58
Lessons of our times: Asset allocation lessons from Warren Buffett 58
Key concepts 59
3 Fundamentals of risk and return 63

3.1 Introduction 64
3.2 Measuring return 64
3.2.1 Holding period return 64
3.2.2 Return over multiple periods 66
3.2.2.1 Arithmetic mean 66
3.2.2.2 Geometric mean 67
3.2.2.3 The effective annual rate 68
3.2.2.4 Yield definitions and conventions 68
3.2.2.5 Real rate of return 69
3.2.2.6 Expected rate of return 70
3.3 Measuring risk 72
3.3.1 Calculating the risk of a single asset 72
MARKET FLASH Problems with negative interest rates 75
3.3.2 Required returns and risk aversion 76
3.3.3 Investor behavior and low interest rates 77
3.3.4 Sources of risk 78
3.3.5 Risk and investor economic decisions 79
Detailed contents | xi
3.3.6 Utility and wealth 80

3.3.7 Indifference curves and utility function 81
3.3.8 Indifference curves and risk aversion 84
Applying economic analysis: Is it worth pursuing further education? 84
International focus: Treasuries outperform stocks 85
Lessons of our times: The Reserve Primary Fund 86
Key concepts 86
Appendix: A brief review of the time value of money (TMV) 89
Part II Financial markets, intermediaries, and instruments 93

4 The global financial environment 95
4.1 Introduction 96
4.2 The functions of the global financial market 97
4.2.1 Economic function 97
4.2.2 Pricing function 98
4.2.3 Provision of services 99
4.2.4 Other functions 99
4.3 The securities exchanges 100
4.3.1 US organized stock exchanges 101
4.3.1.1 Types of brokers 102
4.3.1.2 NYSE operations 103
4.3.1.3 NYSE-related exchanges 104
4.3.2 US Over-the-counter securities markets 105
MARKET FLASH New index for OTC Markets Group 105
4.3.2.1 NASDAQ 105
4.3.2.2 Other OTC markets 106
4.3.2.3 How to read stock tables 106
4.3.3 Some US stock market indexes 107
4.3.4 Some international stock exchanges 108
MARKET FLASH European equity traders want a shorter trading day 109
4.3.5 The US bond market 110
4.3.6 The international bond market 111
4.4 Trading on the exchanges 112
4.4.1 Clearing procedures 112
4.4.2 Brokerage services 112
4.4.3 Trading costs 114
MARKET FLASH Charles Schwab eliminates trading commissions 115
MARKET FLASH Instances of front-running activities 117
4.4.4 Automatic trading mechanisms 117
MARKET FLASH SEC implements a Limit Up/Limit Down plan 119
4.5 Globalization and the regulatory structure of international stock markets 119
4.5.1 Globalization and trends 119
MARKET FLASH Delisting of Chinese stocks? 120
4.5.2 Investing internationally and international return 120
4.5.3 Regulatory structures in the US exchanges 122
Applying economic analysis: Costs and benefits of financial globalization (and trade) 123
International focus: New offerings by the London Stock Exchange 124
xii | Detailed contents
Lessons of our times: Lessons learned from financial crisis and recommendations
for financial institutions 124
Key concepts 125
Appendix: Calculating a stock market index 127
5 Money and capital market instruments and strategies 131

5.1 Introduction 132
5.2 The money market and its instruments 133
5.2.1 The money market and its characteristics 133
MARKET FLASH High demand for the international money market 133
5.2.2 Money market instruments 134
5.2.2.1 Nonmarketable securities 134
5.2.2.2 Marketable securities 134
MARKET FLASH The global market for commercial paper 139
MARKET FLASH Repo worries and bailout efforts 143
MARKET FLASH The debate on replacing the fed funds rate 145
MARKET FLASH Replacing LIBOR 147
5.2.2.3 Yields and spreads in money market instruments 148
5.3 The capital market and its instruments 149
5.3.1 The capital market and its characteristics 149
5.3.2 Fixed-income securities 150
5.3.2.1 Federal government bonds 150
5.3.2.2 Municipal securities 151
5.3.2.3 Agency bonds 152
5.3.2.4 Corporate bonds 153
5.3.3 Yields and spreads in capital market instruments 154
5.3.4 Equity securities 155
5.3.5 Derivative securities 156
5.4 Investment risks in financial markets 157
MARKET FLASH Climate-change investment risk 157
5.5 Some money and capital market investment strategies 158
5.5.1 Some money market investment strategies 158
5.5.2 Some capital market investment strategies 160
Applying economic analysis: Insider trading 161
International focus: The Greek debt crisis 162
Lessons of our times: Lessons from Iceland’s financial crisis 162
Key concepts 163
6 Investment bankers and investment companies 167

6.2 Investment banking 168
6.2.1 The primary market 168
6.2.2 Shelf Registration 170
6.2.3 The investment banker 170
MARKET FLASH Leading underwriters in the US 172
6.3 Initial public offering 172
6.3.1 IPO participants 172
6.3.2 IPO arrangements 173
Detailed contents | xiii
6.3.3 IPO documents 174

6.3.4 Road show and book building 174
6.3.5 Costs of IPO 175
6.3.6 Performance of IPOs 177
6.4 The investment companies industry 179
6.4.1 Functions of investment companies 180
6.4.2 Net asset value 181
6.4.3 Types of investment companies 182
6.4.3.1 Unit investment trust 182
6.4.3.2 Closed-end investment companies 183
MARKET FLASH The SEC requires CEF to disclose more 184
6.4.3.3 Open-end investment companies 185
6.4.3.4 Fee structure of mutual funds 187
6.4.3.5 Picking a mutual fund 190
MARKET FLASH Mutual fund expense ratios fell significantly 191
6.4.3.6 Growth of mutual funds 192
6.4.3.7 Performance of the mutual fund industry 193
6.5 Exchange-traded funds 194
6.5.1 Characteristics of ETFs 194
6.5.2 Regulation of ETFs 196
MARKET FLASH What is happening with ETFs? 197
6.6 Some strategies in mutual fund investments 197
6.6.1 Simple strategies 197
6.6.2 More robust strategies 198
6.7 Other types of investment companies 200
Applying economic analysis: Cost-benefit analysis at the ICI 202
International focus: Global IPOs 203
Lessons of our times: Bogle on the mutual fund industry 203
Key concepts 204
Part III Portfolio theory 209

7 Diversification and asset allocation 211
7.2 The diversification principle 212
7.2.1 Diversification types 213
7.2.1.1 Naïve or random diversification 213
7.2.1.2 International diversification 216
7.2.1.3 Efficient diversification 217
7.2.2 Covariance and correlation 217
7.3 The asset allocation decision 220
7.3.1 The process of asset allocation 220
7.3.2 Some strategies of asset allocation 222
7.3.3 Some approaches to asset allocation 222
7.3.4 Implementing asset allocation approaches 223
7.3.5 Asset allocation and risk tolerance 224
7.3.6 The importance of asset allocation 225
7.4 Examples of asset allocation 226
7.4.1 Risky portfolios and combined portfolios 226
7.4.2 Some practical problems of asset allocation 230
xiv | Detailed contents
7.4.3 The capital allocation line 231

7.4.4 Borrowing and lending opportunities on the CAL 233
7.4.5 The capital market line and investment strategies 235
MARKET FLASH Explaining the shifts from active to passive investing 236
7.4.6 Asset allocation and risk aversion 237
7.4.7 Some common diversification fallacies 238
Applying economic analysis: The principle of diversification 241
International focus: The importance and consequences importance of global
allocation decisions 241
Lessons of our times: Markowitz on the 2008 financial crisis 242
Key concepts 243
Appendix A: Review of regression analysis 245
Appendix B: How to compute the covariance and correlation in Excel 247
8 Efficient diversification and capital market theory 251

8.2 The Markowitz diversification approach 252
8.2.1 The Markowitz two-asset portfolio 254
8.2.1.1 Assumptions 254
8.2.1.2 Borrowing and lending 258
8.2.1.3 Generalizing risk to many assets 259
8.2.1.4 Dynamic correlations 259
MARKET FLASH Some reasons for high(er) correlations in recent years 260
8.2.2 The optimal risky portfolio and the capital allocation line 261
8.2.3 The efficient frontier 263
8.3 Capital market theory 265
8.3.1 The capital asset pricing model 265
8.3.1.1 SML vs. CML 265
8.3.1.2 Assumptions of the CAPM 266
8.3.1.3 Implications of the assumptions 266
8.3.1.4 Deriving CAPM 268
8.3.1.5 Interpreting the SML 269
8.3.1.6 The security characteristic line 271
8.3.1.7 Uses of CAPM 272
8.3.1.8 Criticism of CAPM 273
MARKET FLASH Why is CAPM still in use? 274
8.3.2 The arbitrage pricing theory 274
8.3.3 Comparing the CAPM and the APT 276
8.3.4 Some important multifactor models 278
8.3.5 Portfolio performance evaluation 279
8.4 CAPM, APT, and investment decisions 281
Applying economic analysis: Using utility theory to make a decision involving risk 282
International focus 283
Lessons of our times: The alpha-beta debate 284
Key concepts 285
Detailed contents | xv
Appendix A: How to find and graph the optimal two-asset portfolio using EXCEL 288
Appendix B: The single-index asset model 291
9 Market efficiency and behavioral finance 295

9.2 The efficient market hypothesis 296
9.2.1 The notion of market efficiency 296
9.2.2 The forms of market efficiency 298
9.2.3 Implications of the efficient market hypothesis 299
9.2.3.1 Implications for technical analysis 300
9.2.3.2 Implications for fundamental analysis 303
9.2.3.3 Implications for active and passive investment strategies 304
9.2.3.4 Implications for investment managers 305
9.2.3.5 Implications for asset pricing models 305
MARKET FLASH The 2013 Nobel Prize in Economics 306
9.2.3.6 Other implications 307
9.3 Anomalies and tests of market efficiency 308
9.3.1 Market anomalies 308
9.3.1.1 Return patterns 308
9.3.1.2 Short- and long-horizon returns 310
9.3.1.3 The size and P/E effects 311
9.3.1.4 Announcement effects 311
9.3.1.5 Other effects 313
9.3.2 Summary of market efficiency tests 313
9.3.3 Is the stock market efficient? 314
MARKET FLASH Market efficiency in the news 316
9.4 Behavioral finance 317
9.4.1 Biases in information processing 318
9.4.2 Biases in behavior 319
9.4.3 Models of human behavior 320
9.4.4 Implications for investment professionals 321
9.4.5 Implications for technical analysis 322
MARKET FLASH Contrarian investors and lessons 323
Applying economic analysis: Keynes’ beauty contest and investor behavior 324
International focus: Do central banks create bubbles? 324
Lessons of our times: The “noisy market” hypothesis 325
Key concepts 326
Part IV Equity portfolio management 331

10 Equity and fundamental analyses 333
10.2 Equity securities 334
10.2.1 Common stock characteristics 334
10.2.1.1 Shareholder equity 335
10.2.1.2 Shareholder rights 335
10.2.1.3 Voting privileges 336
10.2.1.4 Types of common stock 336
xvi | Detailed contents
MARKET FLASH Dual-class common stock 337

10.2.1.5 Dividends and splits 337
10.2.2 Preferred stock characteristics 339
10.2.2.1 Issuers of and investors in preferred stock 339
10.3 Stock market quotations 340
10.4 Management of an equity portfolio 341
10.4.1 Passive equity portfolio management 341
10.4.1.1 Individual investors 341
10.4.1.2 Institutional investors 342
10.4.2 Active equity portfolio management 345
10.4.2.1 Individual investors 345
10.4.2.2 Institutional investors 346
10.4.3 Equity styles 347
MARKET FLASH Some popular investing myths disputed 348
10.4.4 International equity investing 348
10.4.4.1 The global financial asset portfolio 349
10.5 Fundamental analysis 350
10.5.1 Macroeconomic analysis 350
10.5.1.1 Macroeconomic magnitudes 351
10.5.1.2 Economic policies 352
10.5.1.3 Recent Fed policies and the financial markets 356
MARKET FLASH Zero or negative interest rates and investments 358
10.5.1.4 The business cycle 359
10.5.2 Industry analysis 362
Applying economic analysis 365
International focus: Predicting the business cycle 366
Lessons of our times: Some dangers of investing 367
Key concepts 368
Appendix: Guidelines for conducting industry analysis 370
11 Equity valuation and investment strategies 373

11.2 Equity prices and returns 374
11.3 Some general valuation measures 378
11.3.1 Book value 378
11.3.2 Price/book value 379
11.3.3 Price/sales value 379
11.3.4 Liquidation value 379
11.3.5 Replacement value 380
11.4 The dividend discount model and its variants 380
11.4.1 The dividend discount model 381
11.4.2 The constant growth model 384
11.4.3 The multistage dividend growth model 386
11.4.3.1 Two-stage DDM 386
11.4.3.2 Three-stage DDM 388
11.4.3.3 Two-stage DDM with growth rate derived 388
11.4.4 Using earnings instead of dividends 390
11.4.4.1 Some strategies using earnings and dividends 393
Detailed contents | xvii
MARKET FLASH Is the P/E ratio dead? 394

11.5 Other equity valuation techniques 394
11.5.1 Present value of free cash flows 395
11.5.2 Option valuation approach 395
11.5.3 Economic profit 396
11.6 Other issues in equity valuation 397
11.6.1 The impact of inflation on stock values 397
MARKET FLASH Buffett’s advice on stock investing during inflationary periods 398
11.6.2 Information signals/content of dividends 399
11.6.3 The P/E ratio and the stock market 399
11.7 Some strategies on when to buy/sell equities 401
11.7.1 When to buy/sell a stock 402
Applying economic analysis: To give or not to give dividends? To cut or not
to cut dividends? 405
International focus: The crisis and fair-value accounting 405
Lessons of our times: Financial crises: Time to buy? 406
Key concepts 407
Part V Debt securities 411

12 Bond fundamentals and valuation 413
12.2 Overview of the global bond market 414
12.2.1 The international bond market 414
MARKET FLASH The US and Japanese government bond markets 415
12.2.2 The US bond market and its importance 416
12.3 Overview of bond basics 417
12.3.1 Features of a bond 417
12.3.2 Bond types and characteristics 417
12.3.2.1 By type of issuer 417
MARKET FLASH Ghana’s venture into the Eurobond market 423
12.3.2.2 By bond feature 424
12.3.2.3 By other characteristics 425
12.4 Bond pricing 427
12.4.1 Basic bond valuation formulas 427
12.4.2 The inverse relationship between prices and yields 429
12.4.3 Bond yield measures 433
12.5 Duration and convexity 436
12.5.1 Duration 436
12.5.2 Convexity 439
MARKET FLASH Focus on a bond’s negative convexity 441
12.6 The yield curve 441
MARKET FLASH Is a YC steepening good news for investors? 443
12.6.1 Significance of the yield curve 443
12.6.2 Theories explaining the shape of the yield curve 444
12.6.3 A simple strategy using the yield curve 447
Applying economic analysis: A bond’s reinvestment risk 448
International focus: Eurozone’s sovereign debt crisis 449
xviii | Detailed contents
Lessons of our times: Downgrading US debt 449

Key concepts 450
13 Bond portfolio management and performance evaluation 455

13.2 Overview of the bond investment management process 456
13.2.1 Identify investor objectives and constraints 457
13.2.2 Establish the investment policy 458
13.2.3 Select a bond portfolio management strategy 459
13.2.4 Monitor and evaluate portfolio performance 460
13.3 Passive bond investment strategies 461
13.3.1 Buy-and-hold portfolio strategy 461
13.3.2 Indexing bond strategies 462
13.3.2.1 Pure indexing strategy 462
13.3.2.2 Enhanced indexing strategy 463
13.3.3 Immunization strategy 463
13.3.3.1 Rebalancing 465
13.3.3.2 Dedication strategy 467
13.4 Active bond portfolio strategies 467
13.4.1 Interest rate anticipation strategy 468
13.4.2 Credit analysis 468
13.4.3 Valuation analysis 469
13.4.4 Bond swap strategies 469
13.4.4.1 Substitution swap 470
13.4.4.2 Yield swap 471
13.4.4.3 Quality swap 472
13.4.4.4 Other reasons for bond swapping 472
13.4.5 Yield curve strategies 472
13.4.6 Horizon analysis 474
13.4.7 Other active management strategies 475
13.4.7.1 Horizon matching technique 475
13.4.7.2 Contingent immunization 475
13.5 Bond portfolio performance measurement and evaluation 476
13.5.1 Bond portfolio performance measures 476
13.5.2 Bond portfolio performance evaluation 478
13.5.3 Performance attribution analysis 479
13.6 Bond market efficiency and bond portfolio management 481
13.6.1 Bond market efficiency 481
13.6.2 Implications for bond portfolio management 482
Applying economic analysis: Active or passive investment management? 483
International focus: Bond investments and strategies in and out of the EMU 483
Lessons of our times: Lessons for the European insurance industry 484
Key concepts 485
Part VI Derivative markets and other investments 489

14 Option markets and valuation models 491
14.2 An overview of the options market 492
Detailed contents | xix
14.2.1 Basic option concepts 493

14.2.1.1 Call and put option concepts 493
14.2.1.2 Profits and losses on options 494
14.2.1.3 Options payoffs at expiration 496
14.2.2 The market for options 498
14.2.2.1 The Options Clearing Corporation 499
MARKET FLASH New OCC tools 499
14.2.2.2 Options market participants 500
14.2.2.3 Options products 500
14.2.2.4 Securities with options 501
MARKET FLASH CLOs and leveraged loans 502
14.3 Some options trading strategies 502
14.3.1 Covered call 503
14.3.2 Protective put 504
14.3.3 Collar 506
14.3.4 Straddle 508
14.3.5 Married put 509
14.3.6 Spread strategies 509
14.3.7 Speculating with options 511
14.4 Option valuation 511
14.4.1 Fundamental option valuation concepts 512
14.4.2 Binomial option pricing 514
14.4.3 The Black-Scholes-Merton option valuation model 517
MARKET FLASH Did the VIX worsen market turmoil in 2018? 520
14.4.4 Using the Black-Scholes-Merton formula 521
14.4.5 Put-call parity formula 522
14.5 Using stock index options 523
Applying economic analysis: Purchasing stocks or options? 525
International focus: Global currency options volatility indexes 526
Lessons of our times: What, if anything, have big banks learned from rogue
derivatives traders? 526
Key concepts 527
15 Futures markets and strategies 533

15.2 The futures contract 534
15.2.1 Elements of futures contracts 535
15.2.2 The clearinghouse 536
15.2.3 Settlement and margin 538
15.2.4 Reversing trades 539
15.3 An overview of the futures market 540
15.3.1 Economic functions of the futures market 541
15.3.1.1 Price discovery 541
15.3.1.2 Risk reduction 541
15.3.1.3 Hedging 541
15.3.1.4 Speculating 541
15.3.1.5 Market organization 542
15.3.2 Regulation of futures markets 542
15.3.3 International futures exchanges 544
xx | Detailed contents
MARKET FLASH China’s overhaul of its futures market 545

15.3.4 The commodity futures market 545
15.4 Futures and spot prices 547
15.4.1 Spot futures parity 548
15.4.2 Basis risk 550
15.4.3 Short hedge 551
15.5 Financial futures contracts 551
15.5.1 Some financial futures contracts 552
15.5.1.1 Equity index futures 552
15.5.1.2 Interest rate futures 552
15.5.1.3 Currency futures 553
MARKET FLASH The CME group thinks robo-orders is the future 555
15.5.2 Information on financial futures 555
15.5.2.1 S&P futures vs. fair value 555
15.5.2.2 Leverage 557
15.6 Futures trading strategies 557
15.6.1 Hedging 557
15.6.2 Speculating 558
15.6.3 Program trading and index arbitrage 558
15.6.4 Using currency futures 560
15.6.5 Risk arbitrage 560
Applying economic analysis: Application of arbitrage 561
International focus: CME group’s push into global markets 562
Lessons of our times: OTC derivatives market reform 562
Key concepts 563
16 Other investment topics and themes in investment management 567

16.2 International parities and some strategies 568
16.2.1 Useful concepts 568
16.2.2 Interest rate parity 569
16.2.3 Carry trade 570
16.2.4 International arbitrage 571
16.3 Credit derivatives 572
16.3.1 The market for credit derivatives 572
16.3.2 Credit default swap 573
MARKET FLASH Calls for the termination of the CDS market 575
16.3.3 Total return swap 575
16.3.4 Asset swap 576
16.3.5 Collateralized debt obligation 577
16.4 Alternative investments 579
16.4.1 What are alternative investments? 579
16.4.2 Real estate investment trusts 580
16.4.3 Hedge funds 581
16.4.4 Private equity firms 582
MARKET FLASH Why private equity firms made fewer deals in 2019 583
16.4.5 Infrastructure funds 584
16.4.6 Other alternative investments 584
Detailed contents | xxi
16.5 Disruptive technologies 586

16.5.1 Cryptocurrencies 586
MARKET FLASH The risks of investing in cryptocurrencies 588
16.5.2 Fintech 589
16.5.3 Smart beta analytics 589
MARKET FLASH The continuing rise of smart beta strategies 590
16.5.4 Energy alternatives 590
16.6 Trends in investment management 591
16.6.1 Demographic shifts 591
16.6.2 Cannabis equities 591
16.6.3 Innovative pricing schemes 592
16.7 Putting it all together 592
Applying economic analysis: Traditional or alternative investments? 594
International focus: Credit default swaps and the European sovereign debt crisis 595
Lessons of our times: University endowments and alternative investments 596
Key concepts 597
Appendix 601
Index 607
Illustrations
Figures
Figure 1.1 Assets, liabilities, and net worth of households and nonprofits 8
Figure 2.1 The expected return-risk trade-off 34
Figure 2.2 Asset allocation and security selection 36
Figure 2.3 Asset allocation types 41
Figure 2.4 Top-down and bottom-up approaches to investing 43
Figure 2.5 Debit balances in customers’ securities margin accounts, 2019 48
Figure 2.6 Demand schedules 56
Figure 2.7 Supply schedules 56
Figure 2.8 Market price equilibrium 57
Figure 3.1 Annual returns of US stocks, Treasury bonds, and Treasury bills, 1960–2019 65
Figure 3.2 Compounded value of $1 invested in US stocks, Treasury bonds, and
Treasury bills, 1960–2019 66
Figure 3.3 The relationship between nominal interest rates and inflation, 1960–2019 70
Figure 3.4 The standard normal distribution 73
Figure 3.5 Histogram and statistics of Apple’s returns, daily, 1/1/2009–9/1/2019 74
Figure 3.6 Utility and wealth 80
Figure 3.7 A set of indifference curves for goods H and N 82
Figure 3.8 A set of indifference curves for risk and return 83
Figure 3.9 Indifference curves for investors with different degrees of risk 83
Figure 4.1 The circular flow of funds in financial markets 96
Figure 4.2 Securities and securities exchanges 100
Figure 4.3 Prices of seats at the NYSE, 2005 102
Figure 4.4 NYSE membership prices, 1869–2005 102
Figure 4.5 The size of the US bond market, 2nd quarter 2019 110
Figure 4.6 Global bond offerings by all countries, 2010:I–2019:I 112
Figure 5.1 Direct and indirect investing in securities 132
Figure 5.2 Asset-backed (ABCP), financial (FCP) and nonfinancial commercial
paper (NFCP) in the US 140
Figure 5.3 The effective federal funds rate, 2000–2019 (monthly) 144
Figure 5.4 3-month LIBOR, January 2009–September 2019 147
Figure 5.5 T-bill and commercial paper minus the federal funds rate, 2009–2019 149
Figure 5.6 Yield spreads between AAA, BAA, and the 10-year T-note, 2009–2019 155
Figure 6.1 Relationships among the firm, syndicate, and investors 171
Figure 6.2 The book-building process 175
Figure 6.3 Mutual funds held by individual and institutional investors, 2003–2018 179
Figure 6.4 Indirect investing 180
Figure 6.5 Total net assets by UIT category, 2007–2018 182
Figure 6.6 Worldwide classification of mutual funds by regions and fund type, 2018 188
Figure 6.7 Performance of all REITs relative to S&P 500 index 200
xxiv | Illustrations
Figure 7.1 Portfolio risk and number of securities 215

Figure 7.2 The benefits of international diversification 216
Figure 7.3 The asset allocation process 221
Figure 7.4 The strategic asset allocation process 221
Figure 7.5 A graphical illustration of the investor’s overall portfolio 232
Figure 7.6 The investor’s overall portfolio with borrowing opportunities 234
Figure 7.7 The investor’s overall portfolio with higher borrowing opportunities 235
Figure 7.8 The capital market line 235
Figure 8.1 Impact of correlation on portfolio risk 256
Figure 8.2 Impact of correlation on two-asset portfolio return and risk with
varying weights 256
Figure 8.3 The investor’s opportunity set with the CAL 261
Figure 8.4 The investor’s optimal risky and overall portfolios 263
Figure 8.5 The Markowitz efficient frontier 263
Figure 8.6 The capital market line and the efficient frontier 267
Figure 8.7 The security market line 270
Figure 8.8 Apple stock’s characteristic line 272
Figure 8.9 Security and portfolio characteristic lines 276
Figure 9.1 An example of market efficiency 297
Figure 9.2 New York Times’ stock price behavior, following company news 297
Figure 9.3 The three forms of market efficiency 299
Figure 9.4 Plot of Apple’s and DJIA’s stock returns 307
Figure 9.5 The S&P 500 index, 1970:1–2019:9 310
Figure 10.1 Top-down equity fundamental analysis 350
Figure 10.2 Macroeconomic equilibrium 353
Figure 10.3 Macroeconomic equilibriums 354
Figure 10.4 Equilibrium interest rate 355
Figure 10.5 The Fed’s dot plot 358
Figure 10.6 The business cycle and its phases 359
Figure 10.7 Leading indicator index for the United States, 1982−2019 362
Figure 10.8 The stages of industry life cycle 364
Figure 11.1 Expected and required return from a stock 375
Figure 11.2 Market clearing stock price 376
Figure 11.3 The S&P 500 index’s P/E ratio and earnings yield, 1990:1–2019:5 400
Figure 11.4 The S&P P/E multiple as a trading tool 403
Figure 12.1 The size of the global bond and equity markets, 2018 415
Figure 12.2 The components of the US bond market, 2000–2018 416
Figure 12.3 US corporate bond issuance, 2009–2018 427
Figure 12.4 Bond prices and yields 430
Figure 12.5 Path of bond prices over time 431
Figure 12.6 Bond price-yield relationship and tangent line 439
Figure 12.7 Four actual shapes and dates of the US yield curve 442
Figure 13.1 Yield curve twists 473
Figure 13.2 Butterfly types of and parallel shift of the yield curve 473
Figure 14.1 Payoff and profit/loss of a call option at expiration 496
Figure 14.2 Payoff and profit/loss of a call writer at expiration 497
Figure 14.3 Payoff and profit/loss of a put option at expiration 497
Figure 14.4 Payoff and profit/loss of a short put at expiration 497
Figure 14.5 A covered call strategy’s profit line 503
Figure 14.6 A protective put strategy’s profit line 505
Figure 14.7 A collar strategy’s profit line 507
Illustrations | xxv
Figure 14.8 A married put strategy’s profit line 509

Figure 14.9 Spread strategies 510
Figure 14.10 A multistate price tree 516
Figure 14.11 The Volatility (VIX) and S&P 500 indexes, 1990–2019 519
Figure 15.1 The clearinghouse and its traders 537
Figure 16.1 A credit default swap 574
Figure 16.2 A total return swap 576
Figure 16.3 An asset swap 577
Figure 16.4 Alternative investment asset classes 579
Figure 16.5 How a digital transaction works through blockchain 587
Figure 16.6 Aggressive versus conservative investment portfolios 593
Tables
Table 1.1 Selected balance sheet items of US households and nonprofit
organizations, 2019Q2 7
Table 1.2 Sources of financial and economic information 14
Table 1.3 Selected finance and accounting pays, 2018–19 23
Table 2.1 Average return of the S&P 500 index by decade, 1950–2018 33
Table 2.2 Dollar-cost averaging example 46
Table 3.1 Periodic cash flows of an asset 66
Table 3.2 Arithmetic and geometric means of US stocks, Treasury bonds,
and Treasury bills, 1928–2019 67
Table 3.3 Probability distribution of HPR of stock X 71
Table 3.4 Calculation of the variance of stock X 72
Table 3.5 Descriptive statistics of US stocks, T-bonds, and T-bills, 1928–2010 75
Table 3.6 Central banks’ key interest rates, September 2019 77
Table 4.1 Chronology of selected events at the NYSE 101
Table 4.2 Dow Jones Industrial Average components and statistics 108
Table 5.1 Selected money market instruments and rates 135
Table 5.2 Recent Treasury bill auction results, 1st week of October, 2019 137
Table 5.3 Currency assets and liabilities of non-US banks vis-à-vis all sectors 148
Table 5.4 Equivalent taxable yields and corresponding tax-exempt yields 152
Table 5.5 Average daily volume of issuance of bonds by various US entities,
2009−2019 154
Table 5.6 Bond ratings by S&P, Moody’s, and Fitch companies 154
Table 6.1 Some IPO pricings, filings, and withdrawals 175
Table 6.2 Performance of selected initial public offerings, September 2019 178
Table 6.3 Comparison of annual returns between two funds 190
Table 6.4 Rates of return of top ETFs, as of October 2019 196
Table 7.1 Portfolios and expected standard deviations of returns 214
Table 7.2 Economic scenarios and securities returns 218
Table 7.3 Economic scenarios and securities returns 226
Table 7.4 Summary of portfolios’ expected returns and risks 228
Table 8.1 Two-asset portfolio expected return and risk for three
correlation coefficients 256
Table 8.2 Correlation coefficients, diversification benefits, and portfolio risk 257
Table 8.3 Two-asset portfolio expected return and risk with short sales 258
Table 8.4 Correlations among selected financial assets and commodities, 2014–2019 260
Table 9.1 The prisoner’s dilemma 321
xxvi | Illustrations
Table 10.1 Apple’s stock quotations 340

Table 10.2 S&P 500 constituents and capitalization as of Sept 2019 344
Table 10.3 FOMC participants’ assessments of appropriate monetary policy 357
Table 10.4 NBER classification of recessions and contractions 360
Table 10.5 Components of economic indicators 361
Table 11.1 Stock price and returns decisions to buy or sell a stock 377
Table 11.2 Selected balance sheet items for IBM, December 30, 2018 378
Table 11.3 Selected financial information on IBM 379
Table 11.4 Selected data on IBM, 2016–2019 382
Table 11.5 Equity valuation models and predictions for IBM’s stock price 390
Table 12.1 Treasury bonds and notes 418
Table 12.2 How TIPS work 420
Table 12.3 Bond prices and yields 431
Table 12.4 Hypothetical bond portfolio characteristics 438
Table 13.1 A laddered bond portfolio example 461
Table 13.2 Example of a bond portfolio’s immunization 465
Table 13.3 A bond substitution swap example 470
Table 13.4 A bond yield swap example 471
Table 13.5 Active bond portfolio strategies and their risk levels 476
Table 13.6 Performance attribution analysis 480
Table 14.1 Selected call and put options on Hewlett-Packard 494
Table 14.2 Profit/loss outcomes of unhedged and hedged options portfolios 506
Table 14.3 Payoffs from a collar strategy 507
Table 14.4 Payoffs from a straddle strategy 508
Table 14.5 Profit/loss from a straddle strategy 508
Table 14.6 Options strategies and investor attitudes 510
Table 14.7 Factors affecting call and put options values 514
Table 14.8 Investor’s net position from put-call parity 523
Table 15.1 Brent crude oil futures contract specifications 536
Table 15.2 Profit/loss on a futures trade 537
Table 15.3 Changes in margin positions 538
Table 15.4 Reversing the trade 539
Table 15.5 Useful information and insights before trading in the futures market 543
Table 15.6 Some commodity futures and their characteristics 546
Table 15.7 10-year Treasury note futures characteristics 553
Table 15.8 Some tradable financial futures products 554
Table 15.9 An example of speculation 558
Table 16.1 Amounts outstanding of OTC global derivatives (in billions of US dollars) 573
Table 16.2 Example of an asset swap 577
Table 16.3 Top ten cryptocurrencies and exchanges, based on market cap 587
Boxes
Box 1.1 Ponzi scheme and Bernie Madoff 19
Box 1.2 CFA’s code of ethics and conduct 24
Box 2.1 The hedgehog bests the fox 39
Box 2.2 Example of a risk tolerance questionnaire 40
Box 3.1 Returns and risk aversion 77
Box 3.2 The St. Petersburg Paradox 81
Illustrations | xxvii
Box 4.1 A new world monetary authority? 98

Box 4.2 Some broker practices in the trade of securities 113
Box 4.3 The impact of margin calls on the equity market during the 2008
financial crisis 118
Box 5.1 The mechanics of purchasing Treasury bills 135
Box 5.2 Commercial paper situation during the credit crisis of 2008 140
Box 5.3 Lehman Brothers and the repo market 142
Box 6.1 Primary market activity in Europe 169
Box 6.2 Google’s road to Wall Street 178
Box 6.3 Investing in oil and gas UITs 183
Box 6.4 Creation and redemption mechanisms of ETFs and implications 195
Box 6.5 The Long-Term Capital Management hedge fund 201
Box 7.1 How diversified are US households? 215
Box 7.2 How to hedge in currency markets 219
Box 7.3 Asset allocation and academics 225
Box 7.4 Problems of insuring against risks 239
Box 8.1 The 2000 stock market crisis and the CAPM 273
Box 9.1 Fair value explained 301
Box 9.2 An example of a moving average 302
Box 9.3 The efficient market hypothesis and the crisis of 2008 306
Box 9.4 Some instances of return effects 309
Box 9.5 Revisiting the efficient market hypothesis 315
Box 9.6 Instances of irrational decisions 319
Box 10.1 Features of the S&P 500 index as a benchmark index 343
Box 10.2 Risks and benefits of investing in international equities 349
Box 10.3 The Consumer Confidence index 351
Box 11.1 Intrinsic value in practice 377
Box 11.2 Actual uses of the dividend discount model by firms 383
Box 11.3 Economic vs. accounting profit 397
Box 11.4 Determining when to buy and sell stocks 401
Box 12.1 Fannie and Freddie to the rescue 419
Box 12.2 TIPS in depth 421
Box 12.3 Duration measures 436
Box 12.4 The importance of bond convexity 440
Box 12.5 Factors that affect the shape of the yield curve and their implications 446
Box 13.1 Recent developments in marking-to-market rules 458
Box 13.2 Passive investment strategy and pension funds in the UK 459
Box 13.3 How PIMCO uses rebalancing in its global bond investment strategies 467
Box 13.4 Benchmark issues 478
Box 13.5 Bond and fixed-income exchange-traded funds 480
Box 14.1 NYSE’s new options trading floor 498
Box 14.2 Using the collar strategy to mitigate exchange rate exposure 507
Box 14.3 Time value and options value 513
Box 14.4 Black-Scholes-Merton or Binomial Model? 517
Box 15.1 The first futures contract 540
Box 15.2 CME Group’s financial reform efforts 540
Box 15.3 Organization of the Commodity Futures and Trading Commission 542
Box 15.4 The Financial Futures Association of Japan 544
Box 15.5 Interest rate futures in NYSE 553
Box 15.6 Program trading issues 559
xxviii | Illustrations
Box 16.1 Episodes of failed carry trades 571

Box 16.2 The European Union and the United States begin probes into the use
of credit default swaps 575
Box 16.3 The credit derivatives’ alphabet soup 578
Box 16.4 Long-short and market-neutral alternative funds 580
Box 16.5 Private equity and hedge funds deals in Brazil 583
Box 16.6 The future of alternative investments 585
Acknowledgments
The author wishes to thank the following people for their comments and suggestions to the second
edition.
My students at The American College of Greece: Foteini Rompora, Apostolos Pappas, Angelos
Thanos-Filis, Aspasia Romana, Walid Zorba, Konstandinos Kondylis, Christos Lamnidis, Zakari
Amin-Karkabi, Marianna Tsiouri, and Dimitrios Dritsas.
My colleagues whose criticisms improved the flow and focus of the second edition.
Anna Giannopoulou-Merika, Solon Molho, Panagiotis Asimakopoulos and Vassilios Sogiakas
from The American College of Greece, Greece. Eleftheria Kostika, The Bank of Greece, Greece.
Dimitrios Koutmos, Worcester Polytechnic Institute, MA, USA. Bansi Sawhney, and Daniel Ger-
lowski, University of Baltimore, MD, USA. Stefanos Papadamou, University of Thessaly, Greece.
Arav Ouandlous, Savannah State University, GA, USA. Anne Anderson, Middle Tennessee State
University, TN, USA. Nodas Katsikas, University of Kent, UK.
Preface to the second edition
To the student
Following up on the first edition, the revised version of the textbook continues presenting the
theories and strategies of investments from an intuitive, practical way in an effort to convey the
underlying stories behind the investments concepts. Using the economics point of view approach,
students appreciate their discipline, whichever this may be, because the interpretation of concepts
is emphasized rather than their mere memorization and mechanical application.
In the second edition of the textbook, some general new and innovative features are listed
below:
1. New boxes labeled “Market Flash” highlight the use of, or changes in current practices in, the
field, provide updates on strategies as applied by investment/portfolio professionals, offer
useful information for an investor, and give updates on regulations and more.
2. Current research, academic and/or professional, is included in each chapter, and is presented
in a concise fashion and abstracted from quantitative aspects so it can be useful to the
students.
3. Finally, the questions and problems at the end of each chapter are not mechanical and dry;
instead, they are ripped from the headlines and aim at soliciting the students’ critical thinking
and quantitative expertise to address real-life financial problems
Thus, the innovative features of the second edition of the textbook are its enhanced pedagogy
and the additional material in the text itself, where students will read how professionals deal with
real economic and financial problems and how policymakers set policies. Moreover, now each
chapter contains sections on investment strategies that novice investors can apply, and the pros and
cons of each strategy are discussed.
More specifically, each chapter has been updated and enhanced in discussion on both theories
and strategies as well as market insights.
New in this edition

All chapters have been updated and extended.
Chapter 1 contains further discussion on asymmetric information and a new section on envi-
ronmental, social, and corporate governance (ESG) issues.
Chapter 2 has been updated on topics like the long-term investing paradigm and the clash
between active and passive investment strategies.
Chapter 3 has an updated section on utility theory and has been expanded to include discus-
sion indifference curves and their use.
Chapter 4 discusses some new issues in securities trading, explains the impact of innovations
in the costs of trading, and includes some discussion on globalization and new regulatory issues for
global stock markets.
xxxii | Preface to the second edition
Chapter 5 has further analyses on the money market instruments and discusses some worries
the market has about the fed funds rate and LIBOR, and includes some new investment strategies,
which take into account climate change.
Chapter 6 presents the IPO process in greater detail, discusses the mutual fund companies
within the context of new regulations as well, and ends with some more advanced strategies in
mutual funds.
Chapter 7 has a more elaborate analysis of the steps in the investment process, and details the
asset allocation decision.
Chapter 8 includes a section on dynamic asset correlations and another on multifactor models
and their use in portfolio building.
Chapter 9 in general expands upon the discussions of market efficiency and behavioral finance.
Chapter 10 explains stock market quotations, expands upon the analysis of the management
of an equity portfolio (including a global equity portfolio), and includes some discussion on
some Federal Reserve monetary policies and their implications for investment strategies.
Chapter 11 includes more equity-valuation models, along with real-data applications, and a
section on the information content of dividends.
Chapter 12 updates the discussion on the global bond market and bond valuation, and includes
some analysis of strategies using the yield curve.
Chapter 13 now has a more detailed view of the bond investment management process, more
passive and active bond portfolio strategies, and a section on bond market efficiency and its conse-
quences on bond portfolio management.
Chapter 14 offers a clearer view of the mechanics of the options market and its participants,
and some more detailed analysis on selected options strategies.
Chapter 15 details the functions of the futures market and its organizational structure and
includes a section on risk arbitrage.
Chapter 16 has greatly expanded to include many more sections on alternative investments,
disruptive technologies such as cryptocurrencies, fintech, smart beta analytics and energy alterna-
tives, trends in investment management such as demographic shifts, cannabis equities, and inno-
vative pricing schemes.
New target audience

This book is intended for undergraduate students in finance, economics, and business-related dis-
ciplines as well as for MBA students taking a general investments course. Thus, students taking
finance courses, besides investments, such as financial markets and institutions, portfolio manage-
ment, and business finance, and economics courses such as money and capital markets, interna-
tional financial instruments, and the like. This textbook is global in the sense that it contains
material from the international financial markets, institutions, and instruments and discusses the
general, worldwide investment environment. Students should be able to appreciate the scope of the
international investment environment and confidently begin their investment endeavors, equipped
with the economic fundamentals and statistical tools and, at the same time, be aware of risks
involved.
Preface to the first edition
To the student
Congratulations for studying finance and welcome to the exciting field of investments! You will be
pleased to know that I decided to write this textbook in order to discuss and present the material
in a different way than what current textbooks do. My main objective in this textbook is to write
the material from an intuitive and practical way for you to understand. This means that the concepts
and applications will be presented from the economics point of view, that is, to tell the underlying story
behind the investments notions. I have always taught investments in this way and students seem to
appreciate it more than just learning and applying concepts in a dry, mechanical way. You will be
shown to think of investments (as well as finance) as a special branch (application) of economics
because many topics discussed in investments come from (micro and macro) economics but are
simply termed differently. Let me present some illustrative examples:
l When the interest rate (or the discount rate) is discussed in many investments textbooks, you
may not realize that the interest rate is nothing but an opportunity cost (of money) as you
have learned in your economics courses.
l When decisions involving investor selection among investment alternatives are discussed, you
may not see that what is really being applied is cost-benefit analysis or comparison between
marginal costs and marginal benefits.
l When discussing other investment topics, you may not be aware of sound economic analysis
that many market participants perform. For example, several financial organizations such as
the Securities and Exchange Commission and the New York Stock Exchange routinely make
economic decisions that you may not see in existing textbooks (because they are never explic-
itly exposed) but will see in this textbook.
l When the role of financial markets is discussed, you may not infer (or read in other textbooks)
that what is really meant concerns the efficiency with which resources are allocated in the
economy for a mutually beneficial exchange among participants.
l Finally, have you ever wondered how the equilibrium price of a share is determined? You
guessed it, from the interactions of demand for and supply of shares in the market.
Besides understanding the economics behind the actions of market participants, how else are
you going to learn about investments from this textbook? There are several other ways:
l Each chapter contains several boxes that enhance your understanding of the material and three
specific boxes labeled “Applying Economic Analysis”, “Lessons of Our Times” and “Interna-
tional Focus”, all found at the end of each chapter.
l In addition, some chapters contain appendices that show you how to apply several investment
techniques with real data, a financial calculator, and EXCEL. In some EXCEL cases, the equa-
tions are presented as cell information.
l Finally, each chapter contains thought-provoking questions and problems that require you to
think critically of the answers and display good skills in solving the problems, thus avoiding
tedious and useless memorization.
xxxiv | Preface to the first edition
So, let the challenge of learning the basics of investments begin and enjoy it!
To the instructor
What led me to write this textbook is my continuous quest to find a textbook in investments that
would present the concepts from the economics point of view so students can soundly interpret
these concepts relying on economic theory. Therefore, the concepts herein are presented in a sim-
ple-to-understand way and with the minimum required rigor so students grasp them without too
much effort. Thus, students will be able to put these investment concepts in perspective with the
economic knowledge they have from earlier classes. I have found this to be invaluable to my stu-
dents after teaching investments for more than a decade.
The chapters are shorter than those in the conventional textbooks in the sense that unnecessary
details on topics are not included. Only the important points on the subject will be presented and
discussed so students remain focused on the essence of the topic. For example, when presenting
topics such as stock exchanges, many textbooks present a lot of detail on how they operate but this
can be done by simply directing the student to the appropriate website for more information or
through a question/problem at the end of the chapter. Or, when discussing asset valuations, many
undergraduate textbooks go into the details of empirical research which could either be redundant,
if instructors omit it, or with no real value to the student, if instructors very briefly go over it. In
this textbook, current research is presented in a concise fashion and abstracted from quantitative
aspects so it can be useful to students. Furthermore, there are only 16 chapters in the textbook for
two reasons. First, the typical semester is about 14–15 weeks and thus instructors will be able to
finish their syllabus fully. Because textbooks typically have many more than 20 chapters, instructors
never get to all of them and thus may have to “cut corners”. This means that they either have to
skip entire chapters, or sections of chapters, or select sections that they deem necessary. Thus, with
the right number of chapters, instructors can avoid all of these forced decisions and simply concen-
trate on the delivery of material.
Finally, the small number of exercises at the end of each chapter are a mix of questions (for
thought and discussion) and problems. Questions are thought-provoking and problems will often
require knowledge of economics and statistics (which students typically have before taking the
course), not mechanical applications of formulas. The idea of such questions/problems is to enable
the student to continue learning the chapter material. As a result, the questions and problems come
from real-life experiences in the financial markets. Some sources include the Wall Street Journal, Finan-
cial Times, YahooFinance and the Economist. And since the chapters are short, you can present a chapter
per week, with some time left to go over some of the end-of-chapter problems in class for class
discussion.
Target audience
This textbook is intended for undergraduate students majoring in finance taking an investments
course at the 200 level and above in their field of study. The relevant course would be Introduction to
Investments, Principles of Investments, and Introduction to Finance. In addition to the majors, students minoring
in finance can use this textbook as well as students in economics who wish to take an elective course
in investments. Majors and non-majors (other than in economics) can also take the course as a
general business elective since it does not involve heavy quantitative analysis. In general, almost
every major discipline requires some knowledge of mathematics and statistics and thus the text-
book would be suitable for them.
Preface to the first edition | xxxv
Aims of the textbook

The aim of this textbook is to introduce the students to the fundamentals of investments in a simple,
intuitive, and practical manner. It will also enable the students to understand and intelligently
debate current financial and economic events, conduct basic yet rigorous financial evaluation of
investment issues, and prepare them for further study in the field of finance and investments. To
that end, the chapters are geared toward delivering an intuitive and a practical knowledge of invest-
ments and the end-of-chapter questions and problems necessitate critical thinking to be answered
or solved. Keep in mind that this textbook is not intended to make decisions for you or to assist you
in making money, as the opening page of Part I emphasizes. It will provide you with essential
information and sound guidance to make an intelligent investments decision.
Pedagogy
The innovative features of the text are its pedagogy and the additional boxes, where students can read
how professionals deal with real problems. Moreover, each chapter has a section on some strategies
that investors can apply in specific situations, as well as the pros and cons of each strategy.
Overall, the innovative features of this textbook are the following:
1. Presentation of material from the economics point of view stressing the interpretation of con-
cepts not the mere memorization and mechanical application of them.
2. Shorter chapters so instructors and students can focus on the main points of subjects rather
than wrestle with unnecessary details distracting them from the main issues.
3. Fewer chapters than in current textbooks so instructors can comfortably finish their syllabus
(or the entire textbook) within a semester.
4. Illustrations of current events through boxes which can be used to further the students’ knowl-
edge on the subject without having to follow the text’s flow.
5. Three types of special boxes appear in each chapter: boxes with “International Focus”, boxes
with “Applying Economic Analysis”, and boxes with ideas from well-known economists and
professionals on a given issue, labeled “Lessons of Our Times”.
6. Inclusion of a section on strategies in each chapter that investors can use and explanations of
their pros and cons.
7. A short list of thought-provoking questions and interpretive problems ripped from the head-
lines addressing real-life issues and dilemmas is at the end of each chapter.
Part I
Investment basics
What is an investment and why do people invest? Investment is the sacrifice of your resources (time,
money, and effort) today for the expectation of earning more resources tomorrow. What can you
do with your money? Spend it, save some of it, or invest it? If you choose the latter, where are you
going to invest it? There are many investment alternatives (like stocks and bonds), and the amount
of information on each one of them is staggering. What is your goal in investing? What are your
constraints and risks? Once you have defined these, what is the next step? Are you going to do the
investing on your own or are you going to hire a professional money manager? These are some of
the questions that you need to address as a (novice) investor, and we will deal with them in this
part of this textbook. In the remaining chapters, we will have more to say about the field of invest-
ments in general, the strategies that you can apply to achieve your goals, and the risks involved in
investing.
Chapter 1 examines the general investment framework by defining investments and the vari-
ous investment alternatives available in the market. It also presents the objectives and constraints of
individual and institutional investors, and the roles of the various financial intermediaries that assist
you in investing. Chapter 2 lays out the investment process (that is, the two main steps that you
need to take before investing) and presents some very basic and simple investment strategies.
Finally, Chapter 3 discusses in detail the basic elements of investments: risk and return. This chapter
also addresses the objective of investing, which is the maximization of your expected return, and
its constraint, which is (subject to) risk.
We end with a cautionary word. This textbook cannot make investment decisions for you! It
can only assist you in making informed decisions by providing you with valuable information so that
you can apply it to your particular investment situation.
Chapter 1
The investment framework
Chapter contents
1.1 Introduction 4
1.2 The general financial and economic environment 4
1.3 The objectives and constraints of investors 10
1.4 The investment management process 12
1.5 The role of investment information 13
1.6 Agency and ethical issues in investing 15
1.7 So why study investments? 22
1.9 The plan of the textbook 25
Key concepts 27
4 | INVESTMENT BASICS
Chapter objectives
After studying this chapter, you should be able to
l See what investment is and distinguish between real and financial assets
l Know the various classes of securities
l Understand the roles of the financial markets and financial intermediaries
l Know your investment objectives and constraints
l Evaluate the role of financial information on investments alternatives
l Understand some issues that arise in financial markets like agency theory, asymmetric infor-
mation, and ethical investment behavior
1.1 Introduction
This chapter deals with the general economic and financial environment in which market partici-
pants make investment decisions. Specifically, it discusses the securities an investor can invest in as
well as the financial markets that facilitate the trade of securities among investors. In this respect,
the functions of financial markets and financial intermediaries are explored. The chapter also
explains the investment management process and highlights the roles of investment or financial
information. Further, the objectives and constraints of investors, individual and institutional alike,
are listed and discussed. The latter deals with problems encountered among market participants
when engaging in mutual trades of securities and the occurrences of unethical investment behavior
in the marketplace. Next, we present some issues that arise in financial markets like agency theory,
asymmetric information, and ethical investment behavior. The chapter ends with the significance
of learning and practicing investments.
1.2 The general financial and economic environment

1.2.1 Definition of investments
To understand investments in general terms, let us start with a basic question. Why did you come
to college? Surely you could do other things with your money and time such as work, travel, and
so on. But because you chose to go to college means that you have some expectations later in life
(after you graduate). Perhaps you expect to earn a higher salary or to achieve a higher standard of
living or both. Therefore, you sacrifice money and other resources today for (hopefully) more
money (or wealth) tomorrow. In a broad sense, this sacrifice you currently make for future returns
is called investment. Stated differently, you are investing in your future by going to college today.
This definition of investment involves several elements worthy of special mention. First, you
are spending time and money (or resources in general). Your resources are scarce and thus valua-
ble. Investments deal with the efficient management of your money (or financial wealth) today in
hopes of receiving more money (or returns) in the future. This brings us to the next element of
investment: uncertainty of the future. In other words, the fact that you can only have an expectation
for higher returns in the future means that you are faced with risk. But why do people invest? Can’t
they just keep their money in the form of cash and stash it under their mattress or bury it in their
back yard? Well, you recall from economics that cash has an opportunity cost. Opportunity cost is
defined as the value of an activity that must be given up in order to engage in another activity.
Another insight from economics is that (disposable) income is either consumed, saved or both.
Saving means sacrificing consumption today for (the expectation of) greater consumption in the future.
THE INVESTMENT FRAMEWORK | 5
Investing also involves a similar sacrifice, as we saw above. However, there is a fundamental difference
between saving and investment. Saving does not entail risk (or, at most, very little) but investment
does. For example, if you put your money in a bank account like a certificate of deposit, you incur no
risk (of losing your money) because your savings up to $250,000 (at the time of writing) is insured
by the federal government (the Federal Deposit Insurance Corporation or FDIC). But, if you invest in the stock
market then you are faced with significant risk that you may lose all your invested capital. In general,
investment assets carry various amounts of risk ranging from none to very high risk.
1.2.2 The general investment environment

In a narrow sense, the investment environment refers to the various investment assets (or instru-
ments) that individuals and institutions can buy and sell as well as the markets in which these assets
are traded. The assets can be grouped into two major categories: real assets and financial assets. Real
assets are tangible and can be used to produce a good or a service. Examples of real assets are machin-
ery, factories, and land. Financial assets are intangible (or electronic entries) and represent claims on
the revenues generated from real assets or claims created by entities including the government.
Unlike real assets, financial assets do not produce a good or a service but indirectly help the pro-
duction of real assets. Examples of financial assets are the stocks or bonds that you own or a security
offered by the government.
How do financial assets help with the production of real assets? Well, if we buy shares of a car
company (in the primary market where securities are issued by the company and not from another
investor), the company uses the money to expand its productive capacity and sell more cars so it
can pay us back from the revenues generated from selling its cars. Similarly, if we buy a government
instrument then the government uses that money to finance its expenditures such as a highway or
a bridge. It is investments in financial assets that we will discuss in this book.
In a broader sense, the (global) investment environment refers to the world economic activity
and events as they are certain to affect the values, extent, and nature of financial markets (invest-
ments and portfolio construction) everywhere. For example, current (as of the third quarter of
2019) trade and geopolitical tensions between the US and some countries (and continents such as
Europe), corporate uncertainty and reduced capital spending, conflicting or uncoordinated mone-
tary policies (for instance, between the Federal Reserve and European Central Bank), and differen-
tial economic growth rates among countries have created a hugely uncertain (and risky) environment
for the global financial markets, players, and instruments. As a result, the approach or strategy for
portfolio construction will be different as greater emphasis on risk mitigation (or more conserva-
tivism) is likely to dominate the construction of global investment portfolios.
1.2.2.1 Securities
A generic term for a financial asset is security. A security is a legal claim on the revenue streams of
financial assets or real assets. Examples of securities with claims on a financial asset are bonds and
stocks. Although many securities have a specific collateral (or pledge) to back up the claim to a
revenue stream, others have not but simply represent a promise to pay. An example of a security
with a claim on a real asset with collateral is a mortgage bond (where the collateral is the actual
house). A share of stock is an example of a security without collateral and represents a promise to
pay wherever the corporation’s directors deems appropriate.
1.2.2.2 Classification of securities

Financial securities are classified in three major categories: equity, debt, and derivative securities.
We briefly explain each one below but will explore them in greater detail in Chapter 5.
Equity securities
Equity securities, or common stocks, represent ownership interest in a corporation. A common
stockholder is an investor who owns a share in a company and each share entitles the owner to one
vote in the corporation’s important financial matters. Common stockholders are the residual
claimants in the sense that if the corporation is liquidated they are the last in line among other
claimants (like creditors, the government and so on) to receive what is left. Many common stocks
pay dividends, which are cash payments made by many corporations to their common stockholders.
Preferred stock, although an equity security, also has the characteristics of a debt security. It resembles
an equity instrument because it pays dividends and a bond because those dividend payments are
fixed in amount and known in advance. Thus, sometimes preferred stock is known as a hybrid
security.
Debt securities
Debt securities are claims on some known, periodic stream of payments until the end of their life (the
maturity date). Debt securities are also known as fixed-income securities because they promise a fixed
stream of payments or pay a stream of payments on the basis of some formula. The most important
category of debt securities is a bond. A bond is a contractual obligation of the issuer (or seller) of the
bond to repay the holder (or buyer) of the bond a certain amount of interest on the loan in fixed
dates throughout its life plus the loan’s principal (or initial amount lent) at the maturity date. There
are other categories of bonds (or debt instruments) that do not pay interest periodically, sell at
discount and return their face value to the investor. These are known as (pure) discount bonds and
an example of them is the Treasury bill. In general, there are several categories of debt and other
fixed-income securities such as corporate bonds, government bonds, agency bonds, municipal
bonds, and international bonds (we will discuss them all in detail in Chapter 5).
Derivative securities
Derivative securities, also known as contingent claims, are securities whose values are derived from (or are
contingent upon) the underlying asset(s). The two most important types of such securities are
options and futures. In general, an option entitles (or gives the right, but not the obligation to) its
owner to buy (a call option) or sell (a put option) something on or before some specific point in time.
Options and futures have exploded in growth since the 1990s and have received wide use since
then as a means of hedging (or insuring against) risk. A futures contract obligates the traders to buy
or sell an asset at a pre-specified price at a specified time frame. For example, a buyer might be
committed to purchase the commodity in exchange for cash given to the seller upon delivery of the
commodity on the delivery date. The distinction between the right to do something and the obli-
gation to do something makes options more flexible instruments. However, this flexibility comes
with a price, called the premium, which is the compensation of the option purchaser to exercise the
option when there is a profitable opportunity.
1.2.2.3 Types of investors
Within an economy there are four types of security investors (or players or market participants),
namely households, businesses, the government, and the rest of the world. A further classification
of investor types is retail and institutional. In general, a retail or individual investor is one that has
a “small” amount of money to invest, whereas an institutional one invests millions of (or more)
dollars. Examples of individual investors are you and me (or households) and examples of institu-
tional investors are mutual funds, banks, insurance companies, and other financial institutions.
What are the differences and characteristics of each of these players? Let us start with households
first.
Households comprise consumers and individual (or retail) investors and they invest in securities
in order to earn higher returns (and accumulate wealth) to meet their future needs. Typically, they
are (net) savers and they are the ones supplying the funds to other market participants. Institutional
investors are entities dealing in financial assets and move billions of dollars around financial instru-
ments. These investors comprise mutual funds, investment banks, money managers, insurance
companies, and other financial institutions. They are net borrowers of funds (or in constant need
of receiving financing). Households invest in a wide variety of securities, just like institutional
investors, but differ in many ways. Specifically, retail investors cannot always enjoy all the benefits
of investing due to their unique financial circumstances, their limited budget, and tax liabilities
which may not be relevant for institutional investors. For example, households may be responsible
for paying taxes when receiving income from an investment but institutional investors may have
the (lawful) ability to pass their tax liabilities on to you, the investor (as we will see in Chapter 6).
Hence, institutional investors are much larger (in terms of portfolio size) than retail investors and
have a unique position within the financial system.
Table 1.1 shows the latest data (second quarter of 2019) on the balance sheet of households’
and nonprofit organizations in the United States. As you notice, household and nonprofit organi-
zations financial assets include not only stocks and bonds but items like bank accounts, pension,
and life insurance funds. Figure 1.1 illustrates the trend in ownership of assets, liabilities, and net
worth of both households and nonprofits roughly following the global financial crisis of 2008. As
Table 1.1 Selected balance sheet items of US households and nonprofits, 2019Q2
Assets Billions of $ Liabilities and Net Worth Billions of $
Real Assets Liabilities 16208.2

Real estate 32676.2 Home mortgages 10414.4
Households 29103.3 Consumer credit 4056.7
Nonprofits 3572.9 Bank and other loans 475.2
Nonfinancial assets 38981.5 Debt securities (munies) 214.2
Trade payables 406.8
Financial Assets 90689.2 Depository institution loans 334.6
Deposits (foreign + checks) 1371.8
Money market shares 1907.8
Time and savings deposits 9877.6
Debt securities 5638.0
Treasury sec’s 2016.5
Agency and GSE sec’s 593.6
Municipal sec’s 1892.6
Corporate & foreign bonds 1135.4
Loans 864.7
Mortgages 66.4
Corporate equities 18315.3
Mutual fund shares 9112.0
Life insurance reserves 1709.8
Pension fund reserves 27117.8
Other 1255.9
Total Assets 129670.6 Net Worth 113462.5
Source: Federal Reserve System, Board of Governors, Flow of Funds Accounts of the United States. Amounts outstanding end of
period, not seasonally adjusted. Assets and liabilities sides do not add up because of omitted items.
Figure 1.1 Assets, liabilities, and net worth of households and nonprofits.
is evident from the graph, we see a rapid change in assets and net worth with liabilities remaining
roughly constant. Specifically, asset growth was approximately 68% and net worth about 44%.
The government, in its three classifications, namely federal, state, and local, is another type of
market player. The government is also the regulator of many investment activities and sets the rules
of the game in the market. The government, at any point in time, can either be a net borrower of
funds or a net supplier of funds. By net borrower we mean that it runs a budget deficit, that is,
when its expenditures exceed its revenues and by budget surplus when the opposite is true. Most
of the time (except for a few years in the late 1990s) the US government ran (and still runs) budget
deficits and thus it continuously needs to borrow funds from the public.
Finally, it is important to realize that all above players can also be foreign entities, that is, a for-
eign individual (investor), a foreign corporation, or a foreign (sovereign) government. For exam-
ple, the multinational corporation is a foreign investor because it borrows funds from the global
financial markets to run its worldwide operations. It is through trade and investment (financial and
real) that foreign investors play an important role in any economy.
1.2.3 Financial markets and intermediaries

Financial markets exist to facilitate the flow of funds from one group of people, the savers or lenders,
to another group of people, the investors or borrowers. The economic function of the financial
markets is to increase the efficiency of a mutually beneficial exchange among people or institutions.
Financial intermediaries are institutions that bring together lenders and borrowers of funds. In other
words, they issue claims against themselves (by selling financial assets) in order to receive funds to
purchase other financial securities. Examples of financial intermediaries are banks, mutual funds,
and investment banks. The main economic function of financial intermediaries is to provide finan-
cial services to customers in an efficient manner.
1.2.3.1 The roles of financial markets

Let us begin with a simple question: which assets contribute to the wealth of an economy, real or
financial? The answer is real assets, such as land and plant and equipment, because they produce
goods and services. So, would it be possible for an economy to produce goods and services if there
were no financial markets to facilitate the flow of funds from those who have excess of funds, the
savers, to those in need, the investors? No, because it would not be possible to trade financial assets!
Therefore, the role of financial markets is to efficiently allocate financial resources among compet-
ing uses and ultimately contribute to the production of real assets in the economy. Real assets define
the wealth of an economy, while financial assets define the allocation of wealth among individuals.
By efficiency in financial markets we mean that it should not be possible for an investor to find
bargains in security markets. In other words, security markets (or assets) should incorporate all
relevant information quickly and efficiently regarding the value (price) of those securities so that
no investor has an advantage over them. This notion, referred to as the efficient market hypothesis, is
discussed in detail in Chapter 9.
It is important to note, at this point, that financial markets are not always efficient.1 There can
always be factors (exceptions) that will permit an astute investor to exploit the market (or an asset)
and earn a higher (abnormal) return but only temporarily and not on a consistent basis. We refer
to such factors as anomalies. One can ask then, “How efficient are financial markets?” We will learn
that there are three types of market efficiency. But even if the markets are mostly efficient, there
will always be people who will not believe that asset prices are fair (correct), will employ different
investment strategies, or have a need of a professional to manage their portfolios. In an efficient
market, asset prices would be fair, only one investment strategy would be the best, and investors
would invest on their own. Again, we discuss these situations and more in Chapter 9.
Another role of financial markets is to enable individuals to shift their consumption patterns
over their lifetime. When individuals do not wish to consume all of their income in the present,
they can save a portion of it for consumption or investment in later periods. Furthermore, they can
select among the vast diversity of financial instruments with varying degrees of risk to invest in.
If an investor wishes to purchase stock in a company, then he is taking on more risk than simply
“parking” the money in a safe bank account. So, financial markets permit investors to spread or
allocate risk in their investment holdings depending upon their tolerance for risk. This issue is
further taken up in Chapter 3. The box on International Focus discusses the causes that created the
global financial market crisis of 2008. The box on Lessons of our Times highlights the issues that
financial institutions faced and contributed to the global financial crisis and discusses the lessons
learned from such an experience.
In sum, financial markets allow individuals to achieve a higher level of utility in the future than
would be possible in their absence. More discussion on these and other functions of the global
financial markets is offered in Chapter 4. Please see the box Applying Economic Analysis for an
example of how financial markets maximize the utility of individuals.
1.2.3.2 The roles of financial intermediaries

As stated above, financial intermediaries bring together surplus funds units (savers) and deficit
funds units (investors). Under this capacity, financial intermediaries accept funds from savers and
lend funds to investors. In addition, some financial intermediaries issue their own securities to
finance purchases of other institutions’ securities. In general, financial intermediaries differ from
other companies in the sense that their business is in financial assets. For instance, if we compare
Ford Motor company (FORD) with a commercial bank, we will see that FORD has more real assets
(like plant and equipment) and fewer financial assets, whereas the opposite is true for the bank.
This is so because a commercial bank simply channels funds from households to the business sec-
tor. That is the social function of such intermediaries. Another example of a financial intermediary
is an investment company, commonly known as mutual fund. A mutual fund simply pools the
funds of small investors and invests the resulting big sum in a variety of financial assets on their
behalf. The ability to invest in such a great variety of instruments and the efficiency with which this
is done, at the same time achieving a low cost (per unit) of investing, is referred to as economies of
scale. The latter also generate huge advantages for small investors who obtain timely information on
their current and prospective investment choices.
1.3 The objectives and constraints of investors

Recall the general definition of economics: the study of how a society manages its scarce resources.
Society solves the management and allocation of resources when it employs its resources efficiently
so as to satisfy insatiable human wants. Let us adapt the definition to the study of investments.
Investors also have scarce resources like time and money, as we discussed earlier. In addition,
investors would like to maximize their reward to the highest extent possible, given their appetite
for risk (recall risky versus safe investment instruments). So, investors need to prioritize their
investment alternatives, just like consumers prioritize their wants (necessities and luxuries) and
select the ones that would give them greater utility (or satisfaction) sequentially. Therefore, inves-
tors must know their objectives, such as the maximization of reward, and their constraints, their
budgets for instance, before they begin investing.
To better understand the objectives of investors, individual and institutional, we need to
explain the term risk and the three attitudes (or appetites) they possess toward risk. Risk has a lot of
definitions. For example, it can be defined as the probability that there might be an unfavorable
fluctuation in the rate of return of a security. This means that the actual rate of return may be dif-
ferent from the expected one due the uncertainty of expected cash flows of the asset. Even in the
case of a safe investment, such as the Treasury bill, there is still the risk of receiving less in real terms
(due to inflation). The point is that there are several risks in investing but we will discuss them in
more detail in Chapter 3. The three attitudes toward risk are: risk loving, risk aversion, and risk
neutrality. A risk-loving investor is one that would take a fair game (a fair game is one where an equal
chance of winning/losing is present or that the expected payoff is zero). In other words, the utility
(or satisfaction) investors derive (from a bigger game) from winning exceeds the disutility (or
dissatisfaction) from losing. A risk-averse investor is one that is reluctant to accept risk. However, the
investor would take more risk if he expected to earn a higher return. Relative to a risk-lover, the
risk-averse investor would not take the fair gamble. Finally, a risk-neutral (or risk-indifferent) investor
is one who does not care much about risk. These attitudes toward risk are also known as the inves-
tor’s risk tolerance (or the opposite of the degree of risk aversion). Let us now specify the investors’
objectives with the two elements of investing, namely risk tolerance and return, in mind.
1.3.1 The objectives of investors

The starting point in this process for the individual investor is to determine the characteristics of
the various investments and then match them to his particular needs and preferences. All personal
investing is designed to achieve certain objectives, tangible such as family and large purchases, or
intangible (or financial) such as retirement and investments return. The individual’s objectives
regarding financial investments pertain to what he desires to achieve with his investment (financial)
portfolio. In general, objectives can be classified into return and risk objectives. For example, a risk
objective would entail the specification of an investor’s willingness (and ability) to assume more
risk (that is, be aggressive) or less risk (or be conservative) with his financial investments, while a
return objective would constitute specifying his desired or required return on his investment port-
folio. We will discuss these alternatives in detail in Chapter 3. The Market Flash box discusses if
investors realize their objectives.
MARKET FLASH
Are you realizing your objectives?
With student debt on the rise in the US, some young millennials (ages 22–28) are choosing to put off
four-year college and house purchases. Prospective students are considering other options, such as tak-
ing online classes and completing a two-year degree instead, and other millennials are delaying buying
homes because of high student debt.
Despite the 2018 market volatility, investors saving for retirement are not panicking but are stay-
ing focused on their long-term savings strategy. Other investment institutions report similar long-term
thinking and perspective among their customers in retirement accounts, suggesting a more disciplined
investment mindset.
Approximately half of Americans with children aged 18 or older have sacrificed or are sacrificing their
own retirement security in order to financially support their kids.
Institutional investors such as mutual funds, pension funds, endowment funds, insurance
companies, and banks, which provide investment services for a fee, also have objectives. For exam-
ple, mutual funds, which pool together individual investors’ funds and invest them on their behalf,
have specific objectives (called investment policies) for their business and are outlined in their
prospectuses. For example, an equity fund’s objective is to invest primarily in stocks and to provide
its customers with either high current income (or high dividend yields) and/or capital gains.
A bank’s objective is to maximize its earnings by earning a positive spread between lending and
borrowing rates. Finally, a life insurance company’s objective would be to earn sufficient funds to
meet future obligations for its policyholders.
Investors’ objectives vary among each group (retail and institutional) and can arise from
various factors. One factor, for the retail investor, is the investor’s age. Age can define an investor’s
objective by making him more aggressive or conservative in his investment choices. Simply put,
when individual investors are young, or at the early years of their productive and earning years,
they can tolerate taking some risks. The reason is that they have ample time ahead of them to not
only recoup any losses that would occur during their working life but also to increase their
expected rates of return. So, we can say that such investors have a high level of risk tolerance and
can be aggressive in their investment choices. At the other extreme, it is possible for a conserv-
ative investor to outlive his investment income because he was overly conservative! By contrast,
older individuals such as retired people cannot afford to assume much risk because they not only
have a smaller number of years left to live but also because they live on fixed incomes. So, for
these investors risk tolerance diminishes and they usually (tend to) invest in more conservative
securities.
Another factor is individual investor preferences. These include investments in human capital
(education and/or building up their earning power) or major purchases during the lifetime of the
investor. A great concern of individual investors during their prime working years is also protection
against risk (due to sickness or loss of employment). In this sense, individuals purchase insurance
as a hedge (or protection) against disability or death. Major purchases involve real assets, such as a
house, and financial assets, such as stocks and bonds. These investments are made possible by the
increase in the investor’s earning power over time and have become an essential element in an
investor’s portfolio. No wonder then that an entire financial industry (i.e., professional investors)
has emerged in order to assist these individuals with their investment choices by giving them advice
and/or managing investment accounts for them.
1.3.2 The constraints of investors

Individual and institutional investor constraints are either internally defined, that is, arising from
investors’ specific circumstances and needs, or externally imposed. For instance, age (as well), taxes
and regulation are obligatory, while liquidity and other special needs are investor-specific. In gen-
eral, constraints limit investment choices and, along with the objectives, they determine the inves-
tor’s appropriate investment mix. Let us briefly explain each of these constraints.
Taxes on investment returns usually have to be paid (unless the investment instrument is a
tax-exempt one, like a municipal security), and the correct rate of return on an investment should
be defined as the after-tax return. Both investor groups are concerned with tax-sheltering policies
or tax-deferred investments in an effort to meet their respective objectives. The regulatory environment
also limits investor actions. For example, institutional investors are bound by federal, state, and
local rules and regulations regarding their conduct of business. The prudent man law, for example,
refers to the fiduciary responsibility that professional investors have to serve the best interests of
their clients (or investors). Several agencies regulate the business of investing, such as the Securities
and Exchange Commission (SEC) and the Federal Reserve (Fed).
Liquidity constraints pertain to both investor groups and refer to the ability and the cost with
which an asset can be converted into cash. For example, if an investor has a specific need to set aside
an amount of money for a major purchase then this amount is considered a (liquidity) constraint.
An asset that can be exchanged for cash quickly and with little cost is a liquid asset. Money market
instruments, such as Treasury bills, are highly liquid, while capital market instruments such as
bonds are less liquid. Cash is the most liquid asset and real estate is the least liquid asset. These (and
more) market instruments are discussed in Chapter 5.
Age can also be a constraint because it defines the investor’s investment horizon. As explained above,
although the stage in the investor’s life shapes the investment objectives, it can also affect the choice
among assets. For example, if an investor knows that he will need a specific amount of money at
some future period, then investing in a bond whose maturity coincides with that period could be
the rational choice for that investor.
Finally, investors differ among themselves in their specific circumstances at different stages of
their life, if they are individual investors, or in their unique investment policies, if they are institu-
tional. For example, a married couple with children will naturally have to think about their chil-
dren’s education, while for a single individual this may not be a concern. An institutional investor,
say an endowment fund (which entails the management of portfolios for the benefit of nonprofit
institutions such as a university), usually applies a conservative investment policy, but such an
objective may change given a substantial change in the university’s circumstances. Finally, the
amount of initial capital might be a constraint for a novice investor, but this may not be a real
disadvantage if he chooses specific investment vehicles such as mutual funds (as we will see in
Chapter 6).
A written description of an investor’s return objectives and constraints along with his invest-
ment horizon and risk tolerance is known as the investor’s investment policy statement. Such a statement
serves as the foundation before the professional portfolio manager takes any investment action on
behalf of the investor (his client). The next step is to create the investor’s portfolio, execute it, and
then monitor and evaluate it. Let us now explain briefly the (portfolio) investment management
process.
1.4 The investment management process

Investment management refers to the professional management (investment) of a person’s money
(funds). Investment management is part of the financial services industry, which provides services to
individuals and companies in achieving their goals. We said above that once the client’s investment
policy statement is prepared, the next step is the construction of the actual portfolio (comprising
of the asset allocation and security selection steps) and finally an evaluation of the portfolio’s per-
formance. It is important to stress that the process does not stop there. Once the portfolio is built,
the manager (and the client) can’t just sit back and relax! Since investing is an ongoing process, the
portfolio must be continually monitored and adjusted, aligning it with the investor’s objectives and
constraints. This is a dynamic and systematic process that can be both simple and complex. We will
treat the investment (management) process in greater detail in Chapter 2.
What is the objective of the investment management process? First of all, recognize that pro-
fessional portfolio managers get paid for managing other people’s money and that their pay is
fee-based. This means that the more money a manager is handling, the greater the resulting fees
and the higher the manager’s salary. The objective of the portfolio manager is to use the inputs (i.e.,
funds, technology) as efficiently as possible in order to generate the greatest expected return pos-
sible for the client, given the constraints. The inputs are spelled out in the investor’s policy state-
ment and the constraints are the investor’s risk tolerance and preferences. Thus, the objective of
investment management is to maximize a client’s expected return given his risk constraints.
What could the future for investment management hold? Gary Brinson, a 35-year veteran
investment manager, argues that investment analysis and management will become more rigorous
in the future.2 In addition, the process of constructing global portfolios will change dramatically
becoming much more focused and specific. For example, country equity asset allocation will be
replaced by global sector or industry asset allocation. Furthermore, due to the fragmentation and
lumpiness of investment management, investment advisers (and their clients) need to be more
careful in recognizing the characteristics of the markets. He hopes that “investors will spend more
time on an organization’s investment philosophy, process and people than on past results and,
when analyzing past performance data, will apply statistically rigorous performance evaluation”.3
A recent book by R. Kahn on the future of investment management warns that the field is in a
state of flux, as active management is under pressure, with investors switching from active to index
funds; new financial products offer low-cost exposures to many active ideas; markets and regula-
tions have changed significantly over the past ten to 20 years; and data and technology are evolving
even more rapidly. He discusses various trends that have shaped the investment management field
including indexing, smart beta investing, and pure alpha investing that necessitate goals beyond
simple returns.4
1.5 The role of investment information

In order for an investor to achieve his objectives (given the constraints), it must be possible to
obtain adequate information on the available investment choices. Some of the desirable properties
of information are accuracy, timeliness, and relevance. Therefore, before making a final investment
selection, the investor needs to ask questions such as, what type of information do I need? How
and when can I use it?
Financial markets, as well as market participants such as brokerage firms, provide ample infor-
mation on financial and real assets and the economy in general. Investors use this information to
make rational choices among investment alternatives and meet their investment objectives. For
example, an individual who plans to buy a house will need to know the specifics of obtaining a
mortgage as well as the prevailing interest (or mortgage) rates. Similarly, another investor who
wishes to save part of his income will need to know the savings rates and other comparable interest
rates that banks in his neighborhood currently offer. Finally, asset prices and market interest rates
guide a firm’s management to appropriately select among investment projects and arrange for their
financing.
There are numerous sources of information for investors on practically all sorts of investment
alternatives. Investors can read newspapers, navigate the internet, watch television, listen to the
radio, go to the library, or simply consult a company. When investors wish to obtain comprehen-
sive and structured information, they may visit a brokerage firm (such as Schwab, Goldman Sachs,
JPMorgan Chase) and pay a service fee. The brokers who offer such information are known as
full-service firms, whereas those who do not provide information to their clients but only transact
on their behalf are known as discount brokers. We will discuss these brokers and the sources of
information in detail in Chapter 6. Table 1.2 contains some sources of financial and economic
information an investor typically uses.
Despite the abundance of information (even public information), information is not free but
comes with a cost. Economic intuition will help us understand why information is costly. Theoret-
ically, an investor can collect enormous amounts of information about a specific security before
making a decision. But the gathering of information is costly in terms of time, money, effort, etc.
In addition, the amount of information will surely contain conflicting notions about the security
in interest and the investor may not be able (or knowledgeable enough) to ignore this “noisy”
information. Here, we assume that all available information may not be embedded in the current
asset’s price, which is why the investor searches for additional information (this is an important
topic on informational efficiency and financial markets and will be discussed at length in Chapter 8).
So the investor needs to balance the extra (marginal) cost of obtaining information with the mar-
ginal benefit of using the information before making a decision on the asset (to purchase, buy, or
hold it), among other things.
Here is an example. On average and on a consistent basis, money (mutual) funds managers
have been unable to beat the stock market, that is, to earn a higher return than the aggregate
Table 1.2 Sources of financial and economic information
Newspapers Web address

Wall Street Journal online.wsj.com
Barron’s online.barrons.com
Investor’s Business Daily www.investors.com
Financial Times www.ft.com
Periodicals
The Economist www.economist.com
BusinessWeek www.businessweek.com
Forbes www.forbes.com
Fortune www.fortune.com
Web-based
Yahoo! Finance finance.yahoo.com
Bloomberg www.bloomberg.com
Standard & Poor’s www2.standardandpoors.com
Morningstar www.morningstar.com
Reuters/Eikon www.reuters.com
Government
Securities and Exchange Commission www.sec.gov
Federal Reserve System www.frb.org
Securities Investor Protection Corp. www.sipc.org
FINRA www.finra.og
SIMFA www.simfa.org
market. Any informational advantage they (thought they) possessed was quickly dissipated
through the (global) investment community and thus eliminated any excess gains to be made.
This is true given the widespread availability of information and the speed with which such infor-
mation is transmitted. So, any additional information that you might have collected or uncovered,
as an individual investor, might not work to your benefit. We will explore this situation in greater
detail in Chapter 9.
How do you feel about investing on your own? If you think that you are not knowledgeable,
you are afraid or you are hesitant, do not despair! A recent study reveals that while 60% of affluent
millennials do not feel knowledgeable about investing, those who learned about investing before
they were 15 years old are twice as likely to feel like they understand the topic compared to those
who did not.5 Investopedia and Chirp Research surveyed 1,405 affluent Americans online, including
844 millennials aged 23–38. While the median household income for millennials in the US is
$69,000 a year, the Investopedia study talked to millennials with a median household income of
$132,000. But while this generation (and you, perhaps) may fear the (global) financial markets,
the evolution of investment vehicles has made investing easier for millennials than it was for their
parents.
So, where would you go to learn about investing, besides reading this textbook (among oth-
ers) and taking relevant finance courses? We discussed the sources of information above, but mil-
lennials also learn about investing and keep up-to-date with financial information by talking to
professionals. The above survey found that almost two-thirds of millennials believe financial advi-
sors are the most trusted source of financial advice and information. More than half also trust
financial information from books (58%), television shows (54%) and newspapers (53%). How-
ever, since you are a serious finance learner, you should always be cautious about investment (or
any, for that matter) advice! We will learn of the various ways unscrupulous investment advisors
and portfolio managers act in order to extract value from your investment portfolio. Simply by
using your common sense and equipped with some knowledge, you should be able to navigate
these uncharted waters.
1.6 Agency and ethical issues in investing

We stated in the beginning of this chapter that the investment environment is composed of the
various securities and security markets as well as the various players in the economy. The players
in any economy are households, businesses, the government, and the rest of the world. These
players interact with one another on a daily basis and, because of this interaction, several problems
(issues) emerge. In this subsection, we discuss three conflicts that arise when financial markets are
not functioning efficiently. Conflicts arise among the firm’s stakeholders (a stakeholder is anyone who
has an interest, a stake, in the business such as owners, creditors, customers, the government, and
so on). These conflicts are asymmetry of information, the agency problem, and the crisis in corpo-
rate governance. In addition, we will take up the subject of ethics in investing, which is always a
current topic when people manage other people’s money.
1.6.1 Asymmetric information
The problem of asymmetric information arises when one party has more (or better) information than
the other party in a transaction. If the party with the additional information cannot reveal it to the
other party, then we have an inefficient allocation of resources. Consider a similar example of the
market for used cars, which highlighted George Akerlof’s award of the Nobel in Economics in 2001
and his famous paper titled “The Market for Lemons: Quality, Uncertainty, and the Market
Mechanisms”, published in 1970. The potential buyer of a used car cannot know how the car’s
previous owner drove it or its exact condition. In this case, the seller of the used car has more
information that the potential buyer. The alternative would be to buy a similar used car from a
dealer. The price of the dealer’s used car would be higher than the price of the private person’s used
car. Only if you knew with certainty that these two used cars were nearly identical might you be
indifferent between the two cars. In some cases, asymmetry of information is powerful enough to
distort a market or shut it down completely.
Why is asymmetric information so crucial to an understanding of financial markets? Perhaps
because it is related to people’s needs for financial assets in the first place. People who trade financial
assets have no intrinsic desire for the asset itself, they only care about how its value will change in
the future. That means that while information is important for many products, when it comes to
financial markets, information is the product.
Why should asymmetric information be of concern, particularly for investors? First, because
asymmetric information poses significant problems to a firm’s shareholders. For example, manag-
ers usually have better information than investors about the (uncertain) prospects of a proposed
project. If the firm does not have sufficient funds internally to finance this project, it may be forced
to raise those funds from new investors (new shareholders). A conflict may arise in this case
because existing shareholders will be unwilling to share their portion of ownership with new
investors as they will suffer a dilution (or spread) of earnings as a result. In addition, managers may
have to give up an investment project that would potentially raise the wealth of both current and
new shareholders. Foregoing a potentially profitable project because of such conflicts is economi-
cally wasteful and results in an inefficient allocation of resources.
Second, asymmetric information generates two equally important (and related) problems for
firms and their stakeholders. One is adverse selection, which emerges when one person is more
informed about the qualities of a commodity than another person and, as a result, the other less
informed person runs the risk of purchasing the lower-quality commodity. For example, people
who purchase health insurance know more about their personal health than their insurance com-
panies. Furthermore, if these people have serious health problems, they will tend to buy more
insurance compared to other people who are relatively healthy. So if insurance companies are to
stay in business, they must price the provision of health care higher than average to reflect the costs
of the sicker people, on average. This pricing policy, in turn, may discourage average healthy indi-
viduals from purchasing health insurance, which implies market failure.
The second problem of asymmetric information is moral hazard. Moral hazard is closely related
to the agent-principal problem we discuss next. It arises when one party cannot effectively monitor
the actions of another party who is hired to do a job (say, a manager in a corporation). As a result,
the hired person has an incentive to shirk and/or work to benefit himself much more than his
employer.
Can you exploit asymmetric information to your advantage, as an individual investor? Perhaps.
Consider this example. You are researching to find companies that you wish to invest in and thus
you spend time, money, and effort to select among the thousands of possibilities. In order to have
a chance at success, you should be able to uncover something that other investors have not found
or simply do not know about. For example, if you look at the companies near where you live, it is
possible to know a bit more about them (for instance, how they conduct business with the public,
whether they give to the community, what their relationships with employees and suppliers are,
and the like) than investors who live far away. Thus, you have an upper hand on the publicly avail-
able information because you know a bit more about the company that is not published anywhere,
especially if you deal with it as a customer. Thus, by looking at such companies, you lower the cost
of your search (for information) but increase your marginal benefit from the extra information you
have. Thus you might profitably exploit such information asymmetry to your benefit, meaning that
if you invest in the company you might be rewarded. See the Market Flash box.
MARKET FLASH
Reducing asymmetric information
Information asymmetry is adversely affecting all market agents and the competitive market in general,
and consumers have to make decisions based on partial and often biased information. But today, a grow-
ing number of companies arm consumers with the same information that businesses have long had. With
full information, consumers are able to see through marketing schemes, overpriced products, and inferior
goods and services, and they can then offer their business to the companies that offer the highest quality
offerings for the most reasonable price.
The auto industry is one such market in which buyers are increasingly gaining access to equal infor-
mation and being put on a more level playing field. With publications on the values of new and used cars
and appraisals services, consumers are now equipped to negotiate on more equal terms with the dealer.
The real estate market is another market in which consumers are gaining more access to information with
which to make more informed decisions. Realtors are now providing homebuyers with critical information
like average home prices by neighborhood, a property’s historic sale pricing, as well as details on similar
homes for comparison purposes.
Source: Huffpost.com
1.6.2 The agent-principal problem

In a corporation, which is a legal entity separate from its owners (i.e., the stockholders) or princi-
pals, an agent (manager) is hired to manage the business by the principals. A conflict arises when the
agent does not pursue actions in the best interests of the principals, as should be the ideal case. In fact,
if stockholders are unable to monitor the performance of the manager, the manager may very well
act in his own interest to the detriment of the stockholders. For instance, the manager may engage
in actions that promote his own well-being, and display extravagance in public, knowing that the
cost will be borne by stockholders. How do stockholders mitigate this problem? There are mecha-
nisms in place that tie the manager’s compensation to the realization of the objective of the corpo-
ration, which is the maximization of shareholder wealth. One such mechanism is stock options,
which increase in value when the company’s stock increases (which, naturally, is a result of prudent
manager actions). Another, more drastic mechanism to ensure the best performance from the the
manager is the threat of takeover by another company. When another firm acquires a firm that is
underperforming, the latter firm’s manager(s) are usually fired and replaced by officers from the
takeover firm. Read the Market Flash box on conflicts.
Another conflict arises when the interests of shareholders and creditors are different. For
example, consider the situation where the manager wants the corporation to engage in a risky
project, without selling more shares to raise the funds to finance it, but borrowing money from
creditors instead. The conflict arises because the stockholders know that if the project goes sour they
will lose, but the creditors will still be paid. If the project is successful both creditors and sharehold-
ers will share the potential reward. Also, the creditors have another incentive to push for this
investment, because they know that in the event of liquidation of the company, they will be first
in line to be compensated. Consider another example of this conflict. Assume that stockholders
persuade management to take on a venture that creditors find to be riskier than expected. The
higher risk causes the value of existing debt to go down and thus put creditors (who have supplied
additional capital to the firm) at risk. However, if the project goes well, all the rewards will accrue
exclusively to the stockholders because creditors get only a fixed return. On the other hand, if the
project fails bondholders may also have to share the loss. From the shareholders’ point of view, this
situation is a “heads I win, tails you lose” game, which may not be viewed well by creditors.
MARKET FLASH
Conflicts between managers and shareholders?
The Business Roundtable, an association of the most powerful chief executive officers (CEOs) in the US,
announced in August 2019 that the era of shareholder prevalence, the principals, is over. America’s cor-
porate leaders now believe that they can decide freely whom they serve. However, agents argue that
this decision is not for the principals to make. That American CEOs think they can choose their own mas-
ters attests not just to their own sense of entitlement, but also to the state of corporate America, which
has spread its power all over the globe. For example, JPMorgan’s Jamie Dimon, the chair of the Business
Roundtable’s own board of directors, served as both CEO and chair of the board of directors, in violation of
corporate-governance principles that recommend separating these two positions.
For CEOs, maximization of the share price is everything. Why, then, would CEOs come out against
a status quo that has allowed them to reign almost unchallenged, in favor of a stakeholder governance
model that puts employees and the environment on an equal footing with shareholders? The answer is
that share price primacy has ceased to protect CEOs in the way it once did and, most importantly, it has
become a threat. The emergence of powerful shareholder blocs has changed the corporate-governance
game as moving trillions of dollars of savings that need to be invested, institutional investors simply “rule”.
American CEOs seem to have concluded that best defense is a good offense. But if they are serious
about abandoning the shareholder-primacy model, they will need to engage in a variety of actions such
as public statements and legal reforms, particularly the measures needed to hold corporate directors and
officers accountable to the principals they serve.
Source: Katharina Pistor, Financial News, Aug 29, 2019, https://www.fnlondon.com/articles
1.6.3 Ethics in the marketplace

In addition to the problems discussed above, other kinds of behavior, by investment advisors or
professional investment managers, are typically found in the marketplace and particularly in the
investments area. This behavior might be motivated by the lax regulatory environment and by the
trust that unsophisticated and uninformed investors place in the professional managers who are
managing their money. Unethical or questionable behavior may also come from various market
participants such as investment advisers, accountants, or investment banks, and in various forms
like misrepresentation of a company’s financial strength, manipulation of financial/accounting
information, publishing misleading research, and so on. Specifically, within the institutional inves-
tor body there are state laws and “prudent man” laws (or prudent investor rules) that govern the pro-
fessional manager’s behavior and/or limit the allowable types of investments. In other words, such
professionals have the fiduciary responsibility to serve the interests of their clients as best as they can.
Unfortunately, some of them do not take that responsibility very seriously. Fortunately, however,
these people amount to just a small fraction of the profession.
Let us present some notable examples of such unethical behavior. In the early 2000s, Enron
corporation (a company dealing in energy) mis-stated its financial statements and used questiona-
ble accounting practices to convince investors that the company was healthy. The company hid its
huge debt and artificially inflated its earnings. The company went bankrupt in 2001 and its chief
financial officers and other managers were indicted and/or paid significant fines. WorldCom cor-
poration, the (then) number 2 long-distance telecommunications company in the US, declared
bankruptcy in 2002, when it was revealed that shady and fraudulent accounting methods were used
to cover the company’s declining financial condition and to increase its share price. The company’s
chief executive officer (CEO) and chief financial officer (CFO) were found guilty in 2005 and were
sentenced to jail. Parmalat, an Italian-based, multinational corporation dealing in dairy products,
claimed it had nonexistent accounts in US banks hiding its actual debt and transferring huge
amounts of money to the founder’s family business. The company’s CEO went to jail in Italy and
the company collapsed in 2004. In 2008, a wave of financial companies like Bear Stearns, Lehman
Brothers, and others filed for bankruptcy or were liquidated because they were involved in risky
securities in the housing industry and withheld those risks from their investors. These companies’
CEOs either were under federal investigation or indicted. A recent unethical behavior incident was
admitted by Wells Fargo’s CEO, John Stumpf, who in a congressional hearing in 2016 apologized
for the bank opening as many as 2 million bogus customer accounts that generated fees for the
lender. “I accept full responsibility for all unethical sales practices”, he said in the hearing. Finally,
another example of unethical behavior by one of Wall Street’s top brokers came to light in
2008/2009 which, as expected, burned many investors from a so-called Ponzi scheme. See Box 1.1
for details.
Other scandals involving a different kind of behavior rocked Wall Street in the 1990s. Account-
ing scandals involving the once-major accounting firm Arthur Andersen (in association with Enron
and other corporations), or investment banking scandals such as Credit Suisse First Boston and
Citigroup/Solomon Smith Barney banks. In Arthur Andersen’s case, the company was barred from
auditing companies’ books and was ultimately dissolved. Investment bankers assist a firm to go
public and launch a first-time stock offering called an initial public offering (more on that in Chap-
ter 6). The firms allocated shares to preferred clients as a quid pro quo for their investment banking
services. Several CEOs from these banks were indicted and sentenced to jail and/or required to pay
huge fines. A recent incident (as of October 2019) of unethical conduct involved the company
Infosys, where the US Securities and Exchange Commission cited anonymous whistleblowers (cur-
rent Infosys employees), who said they had evidence that senior executives oversaw irregular
accounting practices in order to boost the company’s short-term financial statements.
Box 1.1 Ponzi scheme and Bernie Madoff

The Madoff scandal
One of the most severe financial frauds in the history of the United States came to the fore in 2008, when
Bernard Madoff, a former NASDAQ chairman, was arrested by federal agents. The charge was that he ran,
for years, a $50 billion “Ponzi scheme” and deceived investors by operating a securities business that lost
money. Essentially, he was paying off some investors with the funds put up by other (new) investors in the
business – which is the basis of a Ponzi scheme. The Securities and Exchange Commission (SEC) defines a
Ponzi scheme as follows: “A Ponzi scheme is an investment fraud that involves the payment of purported
returns to existing investors from funds contributed by new investors.” Typically, such schemes tend to
collapse when inflows of new money dry up or when existing investors want to cash out.
See the SEC’s website http://www.sec.gov/answers/ponzi.htm
So what is being currently done to suppress future episodes of unethical behavior? Despite the
mechanisms already in place to deter such wrongdoings, such as being cast (forced) out, and the
increasing public outcry from consumers combined with the threat of activist investors, unscrupu-
lous people have always found (and, naturally, will continue to find) ways around the laws to
pursue their own self-interest. New laws have been enacted in recent years in response to these
waves of unethical board practices (now called crises in corporate governance) that have resulted in
severe financial crises, like the Sarbanes-Oxley Act of 2002, and the Securities and Exchange Com-
mission’s Fair Disclosure regulation put forth in 2000. The Sarbanes-Oxley Act created the Public
Company Accounting Oversight Board to oversee the auditing of companies, and it made CEOs
personally responsible for certifying their firms’ financial reports. The SEC’s regulation prohibits
the dissemination of relevant information to outsiders, such as analysts, before it is made public.
The rationale for this is to quell biased analysts’ research in exchange for other services by the
company. A securities investor has some extra protection coming from the Securities Investor Pro-
tection Corporation (SIPC). SIPC is a nonprofit corporation that insures customer accounts (for up
to $500,000) with brokerage member firms against failure. An investor can seek damages from a
brokerage firm (that is, a firm that buys/sells securities on his behalf), if he is not happy with its
advice and services. This is done via arbitration before a major stock exchange body (the National
Association of Securities Dealers, NASD, as we will see in later chapters).
Finally, another way to deter such practices by professional managers and advisers is for the
investor to shun such organizations. In other words, investors should reward institutions which
apply ethical behavior or social investing and “punish” those that do not. As an example, investors
might want to avoid investing in firms that pollute the environment irresponsibly. An actual exam-
ple can be drawn from the 1980s, when US multinational corporations and other investors avoided
investing (or doing business) in South Africa (because of apartheid).
1.6.4 Environmental, social, and governance

There is a new buzzword these days – Environmental-Social-Governance or ESG – comprising
issues such as environmental (climate) concerns, social responsibility by corporations including
socially-responsible investing efforts, and corporate governance. Let us briefly discuss each of them.
1.6.4.1 Social responsibility issues

An issue worthy of attention is social responsibility, which refers to the efforts that businesses make to
enhance society’s welfare. ESG grew out of a sense of social responsibility and now includes addi-
tional concerns, such as lower crop yields, defaulted loans, and political conflicts/instability. Some
relevant questions must be addressed regarding social responsibility. For example, should busi-
nesses act in the best interest of their shareholders (owners), or be responsible for the welfare of
all other stakeholders in general? Surely businesses have an ethical responsibility to provide a safe
product, safe environments for their workers, and so on. However, socially responsible actions
have costs, and if one firm acts in that manner and another does not, the former will be at a disad-
vantage in many respects. This, in turn, may make the firm less competitive, incur higher borrow-
ing costs, and cause its stock price to decline. Let us consider the following scenario to trace the
impact on investors. An investor is considering investing in two firms, one that behaves in a socially
responsible manner and another that does not. In all likelihood, most investors will ignore the
former firm for the following reason: why should the investor of one corporation subsidize society
to a greater extent than another corporation? But does all this mean that firms should not engage
in a socially responsible manner? No. Firms realize that socially responsible behavior is not only
good for society, but also a benefit for them in the long run. Hence social responsibility is desirable
and investors are very much cognizant of that.
In general today, several tenets make up social awareness. A company’s recruitment policy is
one, and this is becoming a key concern to investors worldwide. The broader the pool of talent
open to an employer, the greater is the chance of finding the optimum person for the job and thus
bringing greater value to the company. Another tenet covers human rights or the general health
and welfare of employees. One more element of social responsibility is consumer protection, as it
is increasingly recognized that consumers have a right to a degree of protection, evidenced by the
growth in damages.
A related issue is socially responsible investing (SRI), which encompasses additional socially con-
scious investment activities such as those that do not harm the environment, that protect human
rights and that generally promote (and maximize) the social good. Investors concerned with SRI
are urged to avoid companies that pollute the environment, apply unfair labor practices, or engage
in unethical business practices. In general, socially conscious investors use three investment strate-
gies to maximize both their return and the social good: they remove their investment portfolios
from abuser firms (called screening), they take an active role in discussing general societal or busi-
ness-governance concerns (called shareholder activism), and they direct their investment activities
toward less-advantaged communities (known as community investing). According to the 2019
Report on Socially Responsible Investing Trends, “total US-domiciled assets under management using SRI
strategies grew from $8.7 trillion at the start of 2016 to $12.0 trillion at the start of 2018, an
increase of 38 percent. This represents 26 percent of the $46.6 trillion in total US assets under
professional management”.6
1.6.4.2 Environmental issues

The threat of climate change and the growing depletion of resources are pressing issues today.
Global investors realize that they need to factor sustainability issues into their investment choices,
since such issues generate negative (and elusive) externalities, such as influences on the functioning
and revenues of the company that affect the revenue streams and supply chains of companies. In
general, every area of the debate from the depletion of resources to the future of industries depend-
ent upon diminishing raw materials, to the question of the obsolescence of a company’s product
or service is becoming central to the value attributed to that company.
1.6.4.3 Corporate governance issues

Corporate governance comprises the mechanisms, processes, and relations by which corporations are
controlled and operated to alleviate the problem of agency relationships. In essence, it outlines the
distribution of rights and responsibilities among the stakeholders of the corporation (such as the
board of directors, managers, shareholders, creditors, auditors, regulators, and others). Corporate
governance practices can be seen as attempts to align the interests of stakeholders. Another reason
for the impetus in the corporate governance practices of modern corporations, particularly in rela-
tion to accountability, was the high-profile collapses of a number of big corporations in the early
2000s (most of which involved accounting fraud) and the recent global financial crisis. As a result,
since then a large (and growing) number of corporations have included in their websites a section
on corporate governance (and responsibility).
A number of academic and professional studies have clearly demonstrated a positive relation-
ship between high performance on relevant ESG issues and superior (corporate) financial perfor-
mance. A study by Harvard Business School’s Eccles, Ioannou and Serafeim (2014) found that
companies that developed organizational processes to measure, manage, and communicate perfor-
mance on ESG issues in the early 1990s outperformed a carefully matched control group over the
next 18 years.7 In a different but related study on corporate sustainability, Khan, Serafeim and Yoon
(2016) demonstrated the positive relationship between high performance on relevant ESG issues
and superior financial performance.8
In 2017, environmental-social-governance (ESG) investments grew 25% from 2015, account-
ing for about one-quarter of all professionally managed investments globally.9 A 2017 study by
Nordea Equity Research reported that from 2012 to 2015, the companies with the highest ESG ratings
outperformed the lowest-rated firms by as much as 40%. In 2018, Bank of America Merrill Lynch
found that firms with a better ESG record than their peers produced higher three-year returns, were
more likely to become high-quality stocks, were less likely to have large price declines, and were
less likely to go bankrupt.10 ESG issues are a “hot topic” as money managers and other institutional
investors worldwide realize the value of these three items (environment, social conditions, and
corporate governance) for their clients and companies alike. It is no wonder that universities and
companies have dedicated vast resources to studying the trends in these items.
Overall, responsible investing is widely understood as the integration of ESG factors into
investment processes and decision making. ESG factors cover issues that traditionally are not part
of financial analysis and hence they need to be included in the decision-making process. This might
include how corporations respond to climate change, how effective their safety policies are in the
protection against accidents, how they manage their supply chains, how they treat their workers,
and whether they have a corporate culture that builds trust and fosters innovation.
1.7 So why study investments?

We end this chapter with an important question: why did you enter in the field of finance (and
its subcategory, investments) as a college student? Well, in order to answer this question – and,
of course, answers will vary among students (but not much!) – let us recall why people invest.
People invest for reasons such as earning a higher income on top of their normal income, enjoying
potential capital appreciation from their investments, securing (to the extent possible) a better
retirement, or even for the thrill of the act itself. Investing is practical and is a means to an end.
Therefore, for all the above reasons you have decided to enter this exciting field, or perhaps
because you have heard that employment opportunities in the areas of finance and investments
are growing and are highly rewarding, or because you simply wished to follow your parents’
careers.
In general, finance is divided into three related areas of study: investments, financial markets
and institutions, and corporate finance. Obviously, the area of investments involves the decisions
made by individuals, companies, and institutions when forming investment portfolios. As men-
tioned earlier, the greater investments area also includes investment management or the services
provided by professional retail and institutional agents to individual investors and companies. The
area of financial markets and institutions (or money and capital markets or money and banking) deals with the
various financial markets, institutions, and instruments that interact with the four players in
the economy. Specifically, financial markets supply the means by which households, businesses,
and governments obtain financing. Financial institutions are the intermediaries in the financial
markets because they create the financial instruments that enable the above players to achieve their
functions (and goals). Global financial markets (or the global financial environment) are explored
in detail in Chapter 4. Finally, corporate finance (or financial management) deals with the operation
(running or management) of the firm itself. This includes managerial functions like investment and
financing decisions, planning and forecasting, and dealing with the financial markets.
So, you have ample choices to start a professional career in the fields of accounting, finance
and investments, in particular. According to the United States’ Bureau of Labor Statistics, the national
mean wage for financial analysts (with a Bachelor’s degree) in 2018 was $85,660. Table 1.3 shows
other types of jobs and their pays for the Accounting and Finance fields, both in the US and UK. As
you see, the pays are hefty and vary across types of jobs in both countries. In sum, a major in finance
opens up many rewarding careers in the field itself and related fields such as economics, manage-
ment, accounting, law, academia, etc.
But even if you entered the field of (finance and) investments without necessarily seeking a
job there (perhaps you wish to be a lawyer or an academic economist), you would still need to
understand finance, in general, and investments, in particular, in order to make simple everyday
decisions. For example, you should know how to compare investment alternatives offered by your
bank, or to determine which is a better deal when obtaining a mortgage or refinancing an existing
Table 1.3 Selected finance and accounting pays, 2018–19
United States
Corporate acct Public acct Financial services

Chief Financial Officer $192,500 $200,000
Treasurer $185,000
Vice President, Finance $176,500
Director of Finance $145,500
Controller $115,000 $125,000
Divisional Controller $140,000
Assistant Controller $103,500
Accountant (3 to 5 Years) $70,000
Accountant (1 to 3 Years) $60,000
Financial Planning & Analysis (3 to 5 Years) $75,000
Financial Planning & Analysis (1 to 3 Years) $65,000
Internal Auditor (3 to 5 Years) $85,000
Internal Auditor (1 to 3 Years) $68,000
Regulatory Reporting (3 to 5 Years) $75,000
Regulatory Reporting (1 to 3 Years) $57,750
Financial Analyst $75,000
Tax Accountant $65,000
United Kingdom
Hedge fund, entry level $150–325k (£145–237k)

Private equity analyst $114.1k (£91k)
Investment banking division, analyst $150k (£91k)
Sales and trading, investment bank $125–135k (£60k–80k)
Quantitative risk analyst $80–100k (£65–85k)
Regulatory reporting accountant, newly-qualified $92k (£74k)
Internal auditor, financial services $87k (£70k)
Private banking relationship manager, Singapore S$52–94k (£30–54k)
Sources: https://corporatefinanceinstitute.com/resources/careers/compensation/finance-salary-guide/ https://news.efinan-

cialcareers.com/uk-en/181008/nine-best-high-paying-entry-level-jobs-finance
one. Therefore the study of investments is a highly rewarding one for all practical purposes, ena-
bling you personally to feel good about making wise lifetime decisions.
1.8 Chapter summary

In this chapter, the investment environment and the way an investor should begin making invest-
ment choices were addressed. The idea is to carefully define the specific objectives and balance them
against the constraints in order to make the best decision. This is a daunting task for not only indi-
vidual investors but also for professional (or institutional) investors. The investment environment
is vast and complex; unless the investor is cognizant of its way of functioning and caveats, he might
not be able to effectively realize or achieve his goals. Although individual investors always have the
option of seeking professional advice on investment alternatives, they can also seek investment
education from a nonprofit institution called the Chartered Financial Analyst (CFA) Institute. Its
mission includes the establishment of a code of ethics and professional conduct, in which the guidelines for
appropriate professional investment behavior are outlined. Box 1.2 describes this organization’s
mission.
Next, the various sources of obtaining information on various investment instruments (vehi-
cles) as well as on the various financial institutions so as to compare among instruments and select
the ones that would (or should) offer you the best risk-return combination were discussed. Some
issues that arise because of the nature of a corporation such as asymmetric information, adverse
selection, and agency conflicts were also presented. The sources of asymmetry and its consequences
(and benefits) were explored. The discussion also involved the reasons why conflicts might arise
between managers and shareholders and between shareholders and creditors. The chapter con-
cluded with the question “Why should you study finance and investments?” We arrived at the
conclusion that such knowledge is not only useful for practitioners in the areas of investments,
capital markets, and corporate finance – the three interrelated areas of finance – but also for making
decisions in everyday life.
Box 1.2 CFA’s code of ethics and conduct

The CFA Institute Code of Ethics and Standards of Professional Conduct (Code and Standards) are fun-
damental to the values of the CFA Institute and essential to achieving its mission to lead the investment
profession globally by setting high standards of education, integrity, and professional excellence. High
ethical standards are critical to maintaining the public’s trust in financial markets and in the investment
profession.
The Code of Ethics

ll Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other par-
ticipants in the global capital markets.
ll Place the integrity of the investment profession and the interests of clients above their own per-
sonal interests.
ll Use reasonable care and exercise independent professional judgment when conducting invest-
ment analysis, making investment recommendations, taking investment actions, and engaging in
other professional activities.
ll Practice and encourage others to practice in a professional and ethical manner that will reflect
credit on themselves and the profession.
ll Promote the integrity of, and uphold the rules governing, capital markets.
ll Maintain and improve their professional competence and strive to maintain and improve the com-
petence of other investment professionals.
Standards of Professional Conduct

ll Professionalism
ll Integrity of capital markets
ll Duties to clients
ll Duties to employers
ll Investment analysis, recommendations and action
ll Conflicts of interest
ll Responsibilities as a CFA institute member or CFA candidate
Source: CFA Institute

1.9 The plan of the textbook

The textbook consists of six parts, comprising the following chapters:
Part I (Investment Basics) contains Chapter 1, on the investment framework; Chapter 2, on the
investment process and strategies; and Chapter 3, on risk and return.
Part II (Financial Markets, Intermediaries, and Instruments) consists of Chapter 4, on the
global financial environment; Chapter 5, on the money and capital markets; and Chapter 6, which
details the functions of investment bankers and investment companies.
Part III (Portfolio Theory) has three chapters: Chapter 7, on diversification and asset allocation;
Chapter 8, on efficient diversification and capital market theory; and Chapter 9, on stock market
efficiency and behavioral finance.
Part IV (Equity Portfolio Management) contains two chapters: Chapter 10, on equity and fun-
damental analysis, and Chapter 11, on equity valuation and relevant investment strategies.
Part V (Debt Securities) includes chapter 12, on bond fundamentals and valuation, and
Chapter 13, on bond portfolio management and performance evaluation.
Finally, Part VI (Derivative Markets and Other Investments) has three chapters: Chapter 14, on
option markets and valuation models, Chapter 15, on futures markets and strategies, and Chapter 16,
which briefly discusses some current issues in investments including credit derivatives and alternative
investments.
Applying economic analysis

Utility and efficiency
One of the central propositions in economics is that people obtain a higher utility (satisfaction) by engag-
ing in a mutually beneficial exchange. This utility, however, is made possible by the presence and the
efficient functioning of financial markets. Let us illustrate with a simple example. Assume that there are
two people in an economy, Mr. Nick and Mr. Haris. Assume also that Mr. Nick wishes to spend less than his
current income and Mr. Haris more than his current income (assume for simplicity the rates are the same
for both individuals). Hence, Mr. Nick would be a lender (saver) and Mr. Haris a borrower (an investor). This
also means that if Mr. Nick agreed to finance Mr. Haris’ excess spending (consumption) then both parties
would engage in a mutually beneficial exchange. They would be able to do that by having an intermedi-
ary create a contract (financial claim). Therefore, one of the functions of the financial markets would be
to facilitate such exchanges and allocate the resources efficiently. A variation of the above would be for
the economy to allocate the saved resources (money here) into other uses such as capital goods (or real
assets) like plant and equipment instead of consumer goods. In this way, both individuals would have the
ability to enjoy more goods and services in the future thanks to the accumulation and use of (more) factors
of production. Again, financial markets are at the heart of transferring funds from Mr. Nick to Mr. Haris,
who could own such factors of production. In sum, the role of financial markets would be to enhance the
utilities of both individuals and reduce, at the same time, the cost of providing the opportunity to enjoy
goods and services. In other words, if one person’s utility is increased without reducing another person’s
utility, then economic efficiency is achieved.
International focus
Causes and consequences of the financial crisis of 2008
The financial (credit) crisis of 2007/8 began in the US housing market; experts say that it started as a bub-
ble. This was because the real estate market in the US peaked in 2006, ending up with a sharp decline in
the values of the underlying securities. Therefore, the owners of such securities – the mortgage-backed
securities and the collateralized debt obligations – who are scattered throughout the world, suffered
severe losses. In addition, the financial institutions that originated the mortgage loans and those who
owned such securities were equally damaged. Major US and European financial giants – like Lehman
Brothers, American International Group, Merrill Lynch, Freddie Mac – who owned such securities ended
up collapsing or being “taken over” by the government. The impact was immediately felt in the stock
markets worldwide which ended up collapsing. Investor trust in the global financial system was shattered.
Naturally the declines in equity markets impacted the real economy, as it hampered the ability of financial
institutions to extend further lending (financing) to economic agents (like households, businesses, and
the government), which slowed down economic activity and raised unemployment. Defaults by home-
owners and foreclosures on their properties rose to unprecedented highs in the US and spread through-
out Europe and Asia.
The International Monetary Fund (IMF) estimated that banks in the US and Europe lost more than
$1 billion on such assets (termed “toxic assets”) from 2007 to mid-2009. According to IMF estimates, US
bank losses amounted to 60% and Eurozone (and British) to about 40%. Finally, many world political lead-
ers started massive efforts to shore up their financial markets in an effort to abate the crisis’s impact and
save their nations from default. However, some nations (like Greece) were forced to seek IMF assistance in
order to survive through this truly global financial crisis.
In general the financial crisis has brought into question national financial architectures as regards
systemic financial institutions and the evaluation of risks and vulnerabilities. The global nature of the
financial crisis has made it clear that integrated financial markets have benefits and risks, with huge global
economic consequences.
Lessons of our times

Lessons of the global financial crisis
The crisis has forced anew the debate on whether macroeconomic policy should be concerned with high
asset price increases and leverage. It has also underscored the deficiencies in national financial regula-
tion and supervision. Several voices in both academia and world organizations have voiced their concern
about the way the global financial system functions and proposed various ways to fix the system and
avoid future financial crises of that magnitude. Specifically, they propose the following reform agendas.
1. Macroeconomic Policy Lessons

These lessons involve the objectives and implementation of monetary and fiscal policies as well as the
regulatory environment.
2. Redesigning Prudential Regulation and Supervision

It is accepted that one cause of the global financial crisis was the deficiencies or shortcomings in the coun-
tries’ financial regulatory environment. Suggestions include better and prudential supervision of financial
institutions, capital regulation, and liquidity issues. The consequences of financial activities need to be
better understood so that improved information disclosure, corporate governance practices, and greater
coordination within and across countries can be implemented.
3. Reform of the International Financial Architecture

Better surveillance of financial risks and vulnerabilities is needed, which can be achieved by closer cooper-
ation among international agencies. Better information is essential in order to understand risk assessment.
Source: Adapted from S. Claessens, G. Dell’Ariccia, D. Igan and L. Laeven, Lessons and Policy Implications from the Global
Financial Crisis, IMF Working Paper, February 2010.
Key concepts
Investment is the sacrifice you currently make for the expectation of higher future returns
Opportunity cost is defined as the value of an activity that must be given up in order to engage in
another activity
Saving means sacrificing consumption today for greater consumption in the future
Real assets are tangible and can be used to produce a good or a service
Financial assets are intangible (or electronic entries) and represent claims on the revenues generated
from real assets or claims created by the government
A security is a legal claim on the revenue streams of financial assets or real assets
A common stockholder is an investor who owns a share in a company and each share entitles the owner
to one vote in the corporation’s important financial matters
Preferred stock, although an equity security, also has the characteristics of a debt security
Debt securities, or fixed-income securities, promise a known, fixed stream of payments periodically
until the end of their life (or maturity date)
Derivative securities, also known as contingent claims, are securities whose value is derived from (or
contingent upon) the underlying asset(s)
In general, an option entitles (or gives the right, but not the obligation to) its owner to buy (a call
option) or sell (a put option) something
A futures contract obliges the traders to buy or sell an asset at a prespecified price at a specified time
frame
A retail or individual investor is one that has a “small” amount of money to invest, whereas an
institutional is one who invests millions of dollars (or more)
Financial intermediaries are institutions that bring together lenders and borrowers of funds
Risk is defined as the probability that an adverse event is going to take place, or in the case of inves-
tors, that there could be an unexpected fluctuation in the rate of return of a security
A risk-loving investor is one who would take on a fair game (a fair game is one whose expected
payoff is zero)
A risk-averse investor is one who is reluctant to accept risk
A risk-neutral (or indifferent) investor is one who does not care much about risk
Individual and institutional investor constraints are either internally defined, that is, arising from
investors’ specific circumstances and needs, or are externally imposed
Taxes, the regulatory environment, liquidity, age, and the investor’s investment horizon are examples of
constraints
In order for an investor to achieve his or her objectives (given the constraints), it must be possible
to obtain adequate information on the available investment choices
The problem of asymmetric information arises when one party has more (or better) information than
the other party in a transaction
A principal-agent conflict arises when the agent does not pursue actions in the best interests of the
owners, as should be the ideal case
Adverse selection emerges when one person is more informed about the qualities of a commodity than
another person and, as a result, the other less informed person runs the risk of purchasing the
lower-quality commodity
Moral hazard is another problem of the principal-agent problem
Unethical kinds of behavior by professional managers are typically found in the marketplace and
particularly in investments
Social responsibility refers to the efforts that businesses make in enhancing society’s welfare
Questions and problems

1. As a potential investor, what would be your objective(s) and constraints? What major trade-offs
do you face?
2. Why is it inappropriate to say “I want to make as much money on my investments as possi-
ble”? What are you ignoring?
3. Take a look at the cafeteria in your college campus. You and most of the other students go there
on a daily basis for food and drinks. If the male person working there to serve you is always
shirking his work responsibilities, how would you advise him to help him keep his job?
4. We discussed the conflicts that arise between a company’s manager and its stakeholders. Can
you suggest some other ways to align a manager’s goals to those of the firm’s owners? You
might want to scour the Wall Street Journal to find some relevant articles.
5. Consider the following scenario. Suppose your parents ask their neighbor (who consistently
pays attention to the stock market because he is an active investor) for advice on a particular
stock. Your parents want to decide if it makes sense to buy the stock. If the neighbor’s opinion
on the stock is favorable and he says that the company will do fine in the future, is it unethical
to make such a statement? Answer the question assuming that your parents thought that your
neighbor’s opinion was based on a good knowledge of the company.
6. We discussed the conflicts that arise between existing and new stockholders when manage-
ment wishes to undertake new projects financed by equity. Now, consider the following
scenario. The management of the firm has no other means of financing a new risky project but
to sell bonds. If bondholders knew of the project’s riskiness (which might be greater than they
would be willing to bear), they would refuse outright to provide the funds. Explain the out-
come of such behavior by the bondholders. Do we have an instance of market failure? What
if the bondholders did not know of the project’s risk? What impact would that have on the
bondholders’ wealth (relative to that of the stockholders)?
7. We discussed social responsibility in the text. Can you advance an argument for the mandatory
and for the nonvoluntary requirement of such behavior for firms by government law?
8. Would you be willing to accept more risk if you expected to earn a higher return? If so, which
attitude toward risk would you have?
9. How do you understand the term efficiency when applied to the financial markets?
10. Classify the following assets as real or financial: factory, stock, option, pencil, knowledge,
education.
11. Which business has more or less financial and/or real assets, a bank or IBM? What is each
business’s social function?
12. What are the social functions of financial intermediaries? Can you give some examples?
13. What is the objective of the investment management process?
14. Which actions currently exist to suppress future episodes of unethical behavior?
Notes
1 See Justin Fox, The Myth of Rational Markets, HarperCollins Publishers, 2009.
2 Gary P. Brinson, The future of investment management, Financial Analysts Journal 61(4), July–August, 2005,
24–28.
3 Ibid., p. 28.
4 Ronald N. Kahn, The Future of Investment Management, CFA Institute Research Foundation, 2018.
5 Joetta Gobell, Affluent millennials are economically optimistic, but afraid to invest, Investopedia, October 2,
2019. Joanna Campione, Most rich millennials don’t feel knowledgeable about investing, Yahoo!Finance,
October 6, 2019.
6 https://www.ussif.org/files/Trends/Trends%202018%20executive%20summary%20FINAL.pdf
7 Robert G. Eccles, Ioannis Ioannou and George Serafeim, The impact of corporate sustainability on organi-
zational processes and performance, Management Science 60(11), 2013, 2835–2857.
8 Mozaffar Khan, George Serafeim and Aaron Yoon, Corporate sustainability: first evidence on materiality,
The Accounting Review 91(6), 2016, 1697–1724.
9 https://www.bloomberg.com/professional/blog/global-sustainable-investments-grow-25-23-trillion/
10 https://hbr.org/2019/05/the-investor-revolution
Notes
1 John C. Bogle, Bogle on Mutual Funds, Irwin Publishing Company, 1994, p. 235.
2 http://www.sec.gov/investor/pubs/assetallocation.htm
3 B. Graham, The Intelligent Investor, Collins Publishing, 2005.
4 Benjamin Graham and Jason Zweig, The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical
Counsel, HarperCollins, 2008 edition.
https://jasonzweig.com/lessons-and-ideas-from-benjamin-graham-2/
5 John Reese, Warren Buffett’s investing formula revealed, Forbes.com, Oct 11, 2011.
6 B. Graham, The Intelligent Investor, Collins Publishing, 2005, p. 13.
7 B. Graham, The Intelligent Investor, Collins Publishing, 2005, pp. 18–20.
8 See D. Kahneman and A. Tversky, Subjective probability: a judgment of representativeness, Cognitive Psychol-
ogy 3(3), 1972, 430–454; A. Tversky and D. Kahneman, Availability: a heuristic for judging frequency and
probability, Cognitive Psychology 5(2), 1973, 207–232; W.F.M. DeBondt and R.H. Thaler, Do security analysts
overreact?, American Economic Review 80, 1990, 52–57; B.M. Barber and T. Odean, Trading is hazardous to
your wealth: the common stock investment performance of individual investors, Journal of Finance 55(2),
2000, 773–806; K.L. Fisher and M. Statman, Investment advice from mutual fund companies, Journal of
Portfolio Management 24(1), 1997, 9–25.
9 See Barron’s, The truth about timing, Nov 5, 2001.
10 It’s a good time to be in the market, R.M. Leary & Company, Dec 3, 2001 (press release).
11 Eric C. Chang, and Wilbur G. Lewellen, Market timing and mutual fund performance, Journal of Business
57(1), 1984, 57–72. Roy D. Henriksson, Market timing and mutual fund performance: an empirical
investigation, Journal of Business, 57(1), 1984, 73–96.
12 Burton Malkiel, The case for index funds, Mutual Funds Magazine, February 1999, p. 72.
13 For the combined approach, see Jack Treynor, Index funds and active portfolio management, Financial Ana-
lysts Journal, May–June 1974, 18.
14 Technically, you would need to invest for four weeks to earn that amount in one week using the average price.
15 Paul S. Marshall, A statistical comparison of value averaging vs. dollar cost averaging and random Invest-
ment techniques, Journal of Financial and Strategic Decisions 13(1), 1–13. P.S. Marshall and E.J. Baldwin, A statis-
tical comparison of dollar-cost averaging and purely random investing techniques, Journal of Financial &
Strategic Decision Making 7(2), 1994.
16 Karyl B. Leggio, and Donald Lien, An empirical examination of the effectiveness of dollar-cost averaging
using downside risk performance measures, Journal of Economics and Finance 27(2), Summer 2003, 211–223.
17 Michael, J. Brennan, Li Feifei and Walter N. Torous, Dollar cost averaging, Review of Finance 9(4), 2005,
509–535.
18 https://www.fidelity.com/learning-center/trading-investing/trading/avoiding-margin-account-trading-
violations
1 Caution is called for when we refer to the “total return” on an asset because we are ignoring several other
components that we will discuss in Part IV.
2 We will also encounter the term yield in the chapters on equities and debt where, for the latter, we offer a
slightly different definition.
3 Here we make an implicit assumption that the price in calculating HPY includes some additional compo-
nents such as accrued interest, but we will deal with that in the chapter on bonds.
4 There is one more very important metric, known as the Sharpe ratio, to judge the risk-return trade-off but
we will discuss it in a later chapter.
5 Ben S. Bernanke, Monitoring the financial system, Speech at the 49th Annual Conference on Bank Structure
and Competition, Federal Reserve Bank of Chicago, 2013. Jeremy Stein, Remarks at the Restoring House-
hold Financial Stability after the Great Recession Research Symposium, Federal Reserve Bank of St. Louis,
2013. Larry Fink, Chairman’s letter, Blackrock 2015 Annual Report, 2016.
6 Douglas W. Diamond and Raghuram G. Rajan, Illiquid banks, financial stability, and interest rate policy,
Journal of Political Economy 120, 2012, 552–591. Itamar Drechsler, Alexi Savov, and Philipp Schnabl, A model
of monetary policy and risk premia, Journal of Finance 73, 2018, 317–373.
7 Jaewon Choi and Mathias Kronlund, Reaching for yield by corporate bond mutual funds, Working Paper,
2016. Marco Di Maggio and Marcin T. Kacperczyk, The unintended consequences of the zero lower bound
policy, Journal of Financial Economics 123, 2017, 59–80. Aleksandar Andonov, Rob M.M.J. Bauer, and K.J.
Martijn Cremers, Pension fund asset allocation and liability discount rates, Review of Financial Studies 30, 2017,
2555–2595.
8 Lian Chen, Yueran Ma and Carmen Wang, Low interest rates and risk taking: evidence from individual
investment decisions, Working Paper, MIT, 2018.
9 Albert Ando and Franco Modigliani, The life-cycle hypothesis of saving: aggregate implications and tests,
American Economic Review 53(1), 1963, 55–84.
10 James Tobin, Liquidity preference as behavior towards risk, Review of Economic Studies, 25, 1958, 65–86.
1 https://us.etrade.com/what-we-offer/pricing-and-rates
2 https://www.wsj.com/articles/dark-pools-draw-more-trading-amid-low-volatility-11556886916
3 https://www.finra.org/about/what-we-do
1 If you insert the price for a 4-week bill into equation (1) and change n to 61 days, you will find the yield
of 1.569%.
2 See, Bankers’ acceptances: yesterday’s instrument to restart today’s credit markets?, Economic Synopses No. 5,
Federal Reserve Bank of St. Louis, 2009.
3 Mark Carlson and Burcu Duygan-Bump, The tools and transmission of Federal Reserve monetary policy in
the 1920s, FEDS Notes 2016-11-22, Board of Governors of the Federal Reserve System (US).
4 Late in 2010, the Fed proposed offering interest on such (short-term) bank deposits. The rationale was that
the Fed would be better able to control the federal funds rate and entice banks to restrict loans in times of
inflationary pressures.
1 Katherine, D. Spiess and John Affleck-Graves, Underperformance in long-run stock returns following sea-
soned equity offerings, Journal of Financial Economics 38(3), 1995, 243–267.
2 Tim Loughran and Jay R. Ritter, The operating performance of firms conducting seasoned equity offerings,
Journal of Finance 52(5), 2012, 1823–1850. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.
1997.tb02743.x
3 For a complete list of such dealers, see https://www.newyorkfed.org/markets/primarydealers
4 https://corporatefinanceinstitute.com/resources/knowledge/finance/ipo-process/
5 https://www.nyse.com/publicdocs/nyse/listing/nyse_ipo_guide.pdf
6 MMTec, Inc., through its operating entity, Gujia (Beijing) Technology Co., Ltd., provides comprehensive,
Internet-based technology services and solutions to the Chinese language-speaking hedge funds, mutual
funds, registered investment advisors, proprietary trading groups, and brokerage firms engaging in secu-
rities market transactions and settlements globally.
7 https://www.prnewswire.com/news-releases/mmtec-inc-announces-pricing-of-a-1-8-million-share-
firm-commitment-initial-public-offering-300775204.html
8 This example was from Vanguard’s Global Minimum Volatility Fund Summary Prospectus, Feb. 2019.
9 https://www.ipohub.org/costs-going-public/https://www.pwc.com/us/en/services/deals/library/
cost-of-an-ipo.html
10 https://www.forbes.com/sites/jayritter/2014/06/19/why-is-going-public-so-costly/#2c96bb9c4ff0
11 https://www.theguardian.com/business/2019/feb/28/aston-martin-sets-aside-30m-for-brexit-
as-revenues-rise
12 Jean Eaglesham and Eliot Brown, WeWork investors turned off by ‘sloppy’ IPO filings and information gaps,
Barrons.com, October 7, 2019.
13 IPO SYNDICATE vs SHORT SELLER: Just one day after a short seller slammed SmileDirectClub, all 10 banks
on its IPO rate it a buy, MarketWatch.com, October 8, 2019.
14 https://www.reuters.com/article/us-stocks-classaction/a-lawsuit-a-day-u-s-securities-class-actions-
soar-idUSKBN1FI2FM
15 https://www.icifactbook.org/ch3/19_fb_ch3
16 https://www.cefa.com/Learn/Content/CEF-Highlights-September-2019.fs
17 https://www.icifactbook.org/ch3/19_fb_ch3#equity
18 See SEC’s website, Mutual fund classes, www.sec.gov
19 FINRA’s website, Understanding mutual fund classes, www.finra.org
20 To get this value, first subtract the expense percentages from the growth rate: 0.08–0.0025 = 0.075. Then,
add 1 to it and raise it in the power of 45: (1+0.075)^45, which equals 28.7592. Finally, multiply this
value by $100,000 to get the ending value. Verify the value in the text with the 0.80% expense ratio.
21 Another tax issue is a wash sale. A wash sale is the repurchase of securities within a month after their prior
sale. For instance, if you own shares in a mutual fund whose value depreciated, you incur a paper loss (no
tax implication). But if you sold the shares you would realize a capital loss and thus you would reduce your
tax liability. So the purpose of a wash sale is to forbid the investor from converting a paper loss into a
realized loss by selling shares, reducing his tax liability, and them immediately repurchasing the shares.
22 Michael Jensen, The performance of mutual funds in the period 1945–1964, Journal of Finance 23(2), 389–
416, 1968.
23 Burton Malkiel, Returns from investing in equity mutual funds 1971–1991, Journal of Finance 50(2), June
1995.
24 M. Grinblatt and Sheridan Titman, Mutual fund performance: an analysis of quarterly portfolio holdings,
Journal of Business 62, 1989, 393–416.
25 William F. Sharpe, Mutual fund performance, Journal of Business 39(1 part 2), supplement 1966, 119–138.
26 Mark Gilbert, Sometimes investors should just run for the hills, Bloomberg, October 17, 2019.
27 Wall Street Journal, Monday, February 1, 2010, p. R1
28 Hailey Lynch, Sébastien Page, Robert A. Panariello, James A. Tzitzouris Jr. and David Giroux, The revenge
of the stock pickers, Financial Analysts Journal 75(2), 2019, 34–43. Itzhak Ben-David, Francesco A. Franzoni
and Rabih Moussawi, Do ETFs increase volatility? Journal of Finance 73(6), 2018, 2471–2535.
29 Andrea Riquier, Welcome to the adult table: SEC sets new ETF rules, Marketwatch, October 9, 2019.
30 Saqib I. Ahmed, SEC adopts new rules to level playing field for ETF providers, Reuters, September 26, 2019.
31 Jason Zweig, When funds lend stock, who gains?, Wall Street Journal, Sat.–Sun., 1–2 October, 2011.
1 Actually, others say that it was Mark Twain who first expressed that advice, but this is irrelevant to our
discussion.
2 Meir Statman, How many stocks make a diversified portfolio?, Journal of Financial and Quantitative Analysis 22,
September 1987, 355.
3 Bruno Solnik, Why not diversify internationally rather than domestically? Financial Analysts Journal, July 1974,
48–54.
4 The graph was generated in EXCEL using hypothetical data on a 60-asset portfolio with a standard deviation
of 30% and a correlation coefficient of 40%; then the same number of securities were used assuming that
they had a standard deviation of 25% and a correlation coefficient of 20% (to simulate the international
portfolio).
5 Nikiforos T. Laopodis, Portfolio diversification benefits within Europe: implications for a US investor,
International Review of Financial Analysis 14, 2005, 455–476.
6 See http://www.vanguard.com/pdf/icrieid.pdf
7 Harry M. Markowitz, Portfolio selection, Journal of Finance 7(1), 1952, 77–91.
8 Sébastien Page and Robert A. Panariello, When diversification fails, Financial Analysts Journal 74(3), 2018,
19–32.
9 D.B. Chua, M. Kritzman and S. Page, The myth of diversification, Journal of Portfolio Management 36(1), 2009,
26–35.
10 M.L. Leibowitz and A. Bova, Diversification performance and stress-betas, Journal of Portfolio Management 35(3),
2009, 41–47.
11 Please read Appendix A to this chapter for a review of regression analysis, which differs from correlation
analysis, and which will be useful in later chapters.
12 M. Cardinale, M. Navone and A. Pioch, The power of dynamic asset allocation, Journal of Portfolio Management
40(301), Spring 2014.
13 See Zvi Bodie, Alex Kane and Allan J. Markus, Essentials of Investments, McGraw-Hill, 2007, p. 134 for this
analysis of A.
14 Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, Determinants of portfolio performance,
Financial Analysts Journal 42(4), July/August, 1986, 39–48; and Determinants of portfolio performance II: an
update, Financial Analysts Journal 47(3), May/June, 1991, 40–48.
15 Roger G. Ibbotson and Paul D. Kaplan, Does asset allocation policy explain 40, 90, or 100 percent of per-
formance?, Financial Analysts Journal 56(1), Jan/Feb, 2000, 26–33.
16 Roger G. Ibbotson, The importance of asset allocation, Financial Analysts Journal 66(2), 2010, 18–20.
17 William Jahnke, The importance of asset allocation, Journal of Investing 9(1), Spring 2000, 61–64.
18 Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, Determinants of portfolio performance,
Financial Analysts Journal 42(4), July/August 1986, 39–48.
19 The variance of this portfolio, and its square root or its standard deviation, is found by substituting z and (1-z)
in lieu of the w’s (wH and wN weights) in equation (3) in Chapter 8, and recalling that the standard deviation
of the risk-free rate is zero and noting that its covariance with the risky asset (or portfolio) is also zero.
20 Paul A. Samuelson, Risk and uncertainty: a fallacy of large numbers, in The Collected Scientific Papers of Paul A.
Samuelson, ed. Joseph E. Stiglitz, MIT Press, 1966, 153–158.
21 If your version of EXCEL does not have Data Analysis in the Tools main menu, do the following: from Tools,
click Add-ins and select the Analysis Toolpaks-VBA. Then, return to Tools and you will see Data Analysis toward the
end of the drop-down menu.
1 We discuss behavioral finance extensively in the next chapter.
2 See E.S. Browning, The herd instinct takes over, Wall Street Journal, July 12, 2010.
3 This concept is related to Fisher’s separation theorem according to which an investor’s (consumer) decision
process takes place with production opportunities and capital market exchange opportunities and occurs
in two separate and different steps: first, the optimal production decision by taking on projects until the
marginal rate of return on investment equals the objective market rate is selected, and second, the optimal
consumption pattern by borrowing or lending along the capital market line to equate your subjective time
preference with the market rate of return is chosen. The underlying assumption is perfect and complete
capital markets. James Tobin, Liquidity preference as behavior towards risk, Review of Economic Studies 25(1),
1958, 65–86.
4 William F. Sharpe, Capital asset prices: a theory of market equilibrium under conditions of risk, Journal of
Finance (September 1964), 425–552. This seminal article awarded Sharpe the Nobel Prize in Economics in
1990.
5 Richard Roll, A critique of the capital asset theory tests: Part I: on the past and potential testability of the
theory, Journal of Financial Economics 4, 1977, 129–176.
6 Eugene Fama and Kenneth French, The cross-section of expected stock returns, Journal of Finance 47, June
1992, 427–465.
7 Eugene Fama and Kenneth French, Multifactor explanations of asset pricing anomalies, Journal of Finance 51,
1996, 55–84.
8 Stephen A. Ross, Return, risk and arbitrage, in Risk and Return in Finance, I Friend and J. Bicksler, eds, Ballinger
Press, 1976.
9 Michael C. Jensen, Fischer Black and Myron Scholes, The capital asset pricing model: some empirical tests,
in Studies in the Theory of Capital Markets, Michael C. Jensen, ed., Praeger, 1972. Sanjoy Basu, Investment perfor-
mance of common stocks in relation to their price-earnings ratios: a test of the efficient market hypothesis,
Journal of Finance 32, 1977, 663–682. Marc R. Reinganum, Misspecification of the capital asset pricing:
empirical anomalies based on earning yield and market value’, Journal of Financial Economics 9, 1981, 19–46.
Eugene F. Fama and Kenneth R. French, The cross-section of expected stock returns, Journal of Finance 47,
1992, 427–465. Eugene F. Fama and Kenneth R. French, Common risk factors in the returns on bonds and
stocks, Journal of Financial Economics 33, 1993, 3–56.
10 Richard Roll and Stephen A. Ross, An empirical investigation of the arbitrage pricing theory, Journal of Finance
35, December 1980, 1073–1103.
11 Nai-Fu Chen, Richard Roll and Stephen A. Ross, Economic forces and the stock market: testing the APT and
alternative asset pricing theories, Journal of Business 59(3), July 1986, 383–403.
12 Phoebe Dhrymes, Irwin Friend and Mustafa Gultekin, A critical reexamination of the empirical evidence
on the arbitrage pricing theory, Journal of Finance 39(2), June 1984, 323–346.
13 Eugene F. Fama and Kenneth R. French, The cross-section of expected stock returns, Journal of Finance 47(2),
1992, 427–465.
14 Mark M. Carhart, On persistence in mutual fund performance, Journal of Finance 52(1), 1997, 57–82.
15 Eugene F. Fama and Kenneth R. French, A five-factor asset pricing model, September 2014. Fama-Miller
Working Paper. Available at SSRN: https://ssrn.com/abstract=2287202 or http://dx.doi.org/10.2139/
ssrn.2287202
16 William F. Sharpe, Mutual fund performance, Journal of Business 39(S1), 1966, 119–138. Jack L. Treynor,
How to rate management of investment funds, Harvard Business Review 43(1), 1965, 63–75. Michael C.
Jensen, The performance of mutual funds in the period 1945–1964, Journal of Finance 23(2), 1968,
389–416.
17 Fischer Black, Capital market equilibrium with restricted borrowing, Journal of Business 45, July 1972,
444–455.
18 Wayne Ferson, Investment performance evaluation, Federal Reserve Bank of Atlanta, CenFis Working Paper
10–01, January 2010. Veronique LeSourd, Performance measurement for traditional investment: literature
survey, EDHEC Business School, France, January 2007.
19 Edwin Burmeister, Richard Roll and Stephen A. Ross. Using macroeconomic factors to control portfolio
risk, Working Paper, 2003.
20 Roger M. Edelen, Alan J. Marcus and Hassan Tehranian, Relative sentiment and stock returns, Financial Ana-
lysts Journal 66(4), 2010, 20–32.
1 Sanford J. Grossman and Joseph E. Stiglitz, On the impossibility of informationally efficient markets, Amer-
ican Economic Review 70, June 1980, 405.
2 The formula used to compute returns was the continuously compounded return, log(Current price/Previ-
ous price) x 100.
3 Richard Roll, R2, Journal of Finance 43, 1988, 541–566. David M. Cutler, James M. Poterba and Laurence H.
Summers, What moves stock prices, Journal of Portfolio Management 15, 1989, 4–12.
4 Steven L. Heston, Robert A. Korajczyk, Ronnie Sadka and Lewis D. Thorson, Are you trading predictably?,
Financial Analysts Journal 67(2), 2011, 36–44.
5 Mark Haug and Mark Hirschey, The January effect: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=
935154
6 Donald B. Keim, Size-related anomalies and stock return seasonality: some further evidence, Journal of Finan-
cial Economics 12, June 1983, 12–32.
7 Mustafa N. Gultekin and Bukent N. Gultekin, Stock market seasonality: international evidence, Journal of
Financial Economics 12, December 1983, 469–481. Lawrence D. Brown and Liyu Luo, The January barometer:
further evidence, Journal of Investing, Spring 2006, 25–31.
8 Gaert Rouwenhorst, International momentum strategies, Journal of Finance 53(1), 1998, 267–284.
9 Robert Shiller, Irrational Exuberance, Princeton University Press, 2nd edition, 2005.
10 William F.M. DeBondt, and Richard H. Thaler, Does the stock market overreact?, Journal of Finance 40, 1985,
793–805.
11 Robert Shiller, Do stock prices move too much to be justified by subsequent changes in dividends?, American
Economic Review 71, June 1981, 421–436.
12 Sanjoy Basu, Investment performance of common stocks in relation to price/earnings ratios: a test of the
efficient market hypothesis, Journal of Finance 32(3), June 1977, 663–682.
13 Marc R. Reinganum, Misspecification of the capital asset pricing: empirical anomalies based on earnings
yields and market values, Journal of Financial Economics 12, 1981, 89–104.
14 William Brock, Joseph Lakonishok and B. LeBaron, Simple technical trading rules and the stochastic prop-
erties of stock returns, Journal of Finance XLVII(5), 1992, 1731–1764. Robert Hudson, Michael Dempsey and
Kevin Keasey, A note on the weak form efficiency of capital markets: the application of simple technical
trading rules to UK stock prices – 1935 to 1994, Journal of Banking and Finance 20, 1996, 1121–1132.
15 Kuntara Pukthuanthong-Le, and Lee R. Thomas III, Weak-form efficiency in currency markets, Financial
Analysts Journal 64(3), May/June 2008, 31–52.
16 Tarun Chordia, Richard Roll and Avanidhar Subramanyam, Evidence on the speed of convergence to mar-
ket efficiency, Journal of Financial Economics 72, 2004, 485–518.
17 Nejar H. Seyhun, Insiders’ profits, costs of trading and market efficiency, Journal of Financial Economics 16,
1996, 189–212.
18 John C. Bogle and Rodney N. Sullivan, Markets in crisis, Financial Analysts Journal 65(1), Jan/Feb 2009, 17–24.
19 Eugene F. Fama and Kenneth French, Common risk factors in the returns of stocks and bonds, Journal of
Financial Economics 33, 1993, 3–56. Joseph Lakonishok, Andrei Shleifer and R. Vishny, Contrarian invest-
ment, extrapolation, and risk, Journal of Finance 50, 1995, 1541–1578.
20 Eugene F. Fama, Efficient capital markets: II, Journal of Finance XLVI(5), Dec 1991, 1575–1617.
21 Nicholas Barberis and Richard Thaler, A survey of behavioral finance, in Handbook of the Economics of Finance,
Volume 1, Part B, 2003, 1053–1112.
22 Daniel Kahneman and Amos Tversky, On the psychology of prediction, Psychological Review 80, 1973,
237–251. Daniel Kahneman and Amos Tversky, Choices, values, and frames, American Psychologist 39, 1984,
341–350.
23 William E.F. DeBond and Richard Thaler, Do security analysts overreact?, American Economic Review 80, 1990,
52–57.
24 Terrance Odean, Volume, volatility, price, and profit when all traders are above average, Journal of Finance 53,
1998, 1887–1934. Albert F. Wang, Overconfidence, investor sentiment and evolution, Journal of Financial
Intermediation 10, 2001, 138–170.
25 Hersh Shefrin and Meir Statman, The disposition to sell winners too early and ride losses too long, Journal
of Finance 40, July 1985, 777–790.
26 Jason Zweig, Investing experts urge “Do as I say, not as I do”, Wall Street Journal, January 3, 2009.
27 Robert J. Shiller, Stock prices and social dynamics, Brookings Papers on Economic Activity 2, 1984, 457–498.
Robert J. Shiller, Market Volatility, MIT Press, 1991.
28 Laurence H. Summers, Does the stock market rationally reflect fundamental values?, Journal of Finance 41,
1986, 591–601.
29 Jason Zweig, Investing experts urge “Do as I say, not as I do”, Wall Street Journal, January 3, 2009.
30 Alistair Byrne and Stephen P. Utkus, Behavioural Finance, Vanguard. Hamish Douglas, 10 cognitive biases that
can lead to investment mistakes, Magellan, July 2019.
31 N. Jegadeesh, and S. Titman, Returns to buying winners and selling losers: implications for stock market
efficiency. Journal of Finance 48(1), 1993, 65–91. N. Jegadeesh, Evidence of predictable behavior of security
returns, Journal of Finance 45(3), 1990, 881–898. W. DeBondt and R. Thaler, Does the market overreact?
Journal of Finance 40(3), 1985, 793–805.
1 Google 10-K report, Feb. 2010.
2 Joseph Lakonishok and Baruch Lev, Stock splits and stock dividends: why, who, and when, Journal of Finance 62,
1987, 913–932. Paul Schultz, Stock splits, tick size and sponsorship, Journal of Finance 55, 2000, 429–450.
3 Frank J. Fabozzi and Pamela Paterson Drake, Capital Markets, Financial Management, and Investment Management, John
Wiley & Sons, 2009.
4 E. F. Fama and K. R. French, Common risk factors on stocks and bonds, Journal of Financial Economics 33(1),
1993, 3–56.
5 J. A. Christopherson and C. N. Williams, Equity style: what it is and why it matters, in The Handbook of Equity
Style Management, 2nd edn, T. Daniel Coggin, Frank J. Fabozzi and Robert D. Arnott, eds., John Wiley & Sons,
1997, 9–10.
6 Ronald Q. Doeswijk, Trevin Lam and Laurens Swinkels, The global multi-asset market portfolio 1959–
2012, Financial Analysts Journal, 2014. Available at SSRN: https://ssrn.com/abstract=2352932
7 Cullen Roche, Is the global financial asset portfolio the perfect indexing strategy?, SeekingAlpha, Aug. 20,
2014. Cullen Roche, This is how the 2018 version of an efficient global investment portfolio looks,
MarketWatch, Jan. 4, 2018.
8 Michael Porter, Competitive Strategy, Free Press, 1980.
1 James Tobin, A general equilibrium approach to monetary theory, Journal of Money Credit and Banking 1(1),
1969, 15–29.
2 Another free, online source is Reuters (Reuters.com).
3 Of course, we could estimate it using actual data but we need to think how many years to go back and
whether to use weekly, daily, or monthly data. Different inputs yield different results.
4 Eric H. Sorensen and David A. Williamson, Some evidence on the value of dividend discount models,
Financial Analysts Journal 41(6), 1985, 60–69.
5 To obtain ROE from the survey, find the item referred to as Return on Shareholder Equity and to obtain the
dividend payout ratio find the item referred to as All dividends to Net Profits.
6 Franco Modigliani and Merton Miller, The cost of capital, corporation finance, and the theory of invest-
ment, American Economic Review 48, 1958, 261–297. Merton Miller and Franco Modigliani, Dividend policy,
growth and the valuation of shares, Journal of Business 34, 1961, 411–433.
7 Lal C. Chugh and Joseph W. Meador, The stock valuation process: the analysts’ view, Financial Analysts Journal
40(6), 1984, 41–48.
8 Glen D. Moyes, Brahim Saadounib, John Simon and Patricia A. Williams, A comparison of factors affecting
UK and US analyst forecast revisions, The International Journal of Accounting 36(1), 2001, 47–63.
9 S. Basu, Investment performance of common stocks in relation to their price-earnings ratios: a test of the
efficient market hypothesis, Journal of Finance 32(3), 1977, 663–682.
10 H. Levy and Z. Lerman, Testing P/E filters by stochastic dominance rules, Journal of Portfolio Management 11(2),
1985, 31–40.
11 S. A. Sharpe, Stock prices, expected returns, and inflation, Finance and Economics Discussion Series, 1999–02, 1999, 1.
12 Eugene F. Fama and William G. Schwert, Asset returns and inflation, Journal of Financial Economics, Nov. 1977,
129.
13 John Lintner, Distribution of incomes of corporations among dividends, retained earnings and taxes, Amer-
ican Economic Review 46(2), 1956, 97–113.
14 Merton Miller and Kevin Rock, Dividend policy under asymmetric information, Journal of Finance 40 (4),
1985, 1030–1051. Schlomo Benartzi, Roni Michaely and Richard Thaler, Do dividends signal the future
or the past?, Journal of Finance 52(3), 1997, 1007–1034. Gustavo Grullon, Roni Michaely and B. Swamina-
than, Are dividend changes a sign of firm maturity?’, Journal of Business 75(3), 2002, 387–424.
15 Eugene F. Fama and Kenneth R. French, Disappearing dividends: changing firm characteristics or lower
propensity to pay?, Journal of Financial Economics 60, 2001, 3–44. Gustavo Grullon and Roni Michaely, Divi-
dends, share repurchase and the substitution hypothesis, Journal of Finance 57, 2002, 1649–1684.
16 https://www.cnbc.com/market-strategist-survey-cnbc/
17 Michael Kamstra, Pricing firms on the basis of fundamentals, Federal Reserve Bank of Atlanta, Economic
Review, First Quarter 2003. Burton G. Malkiel, The efficient market hypothesis and its critics, Journal of Eco-
nomic Perspectives 17(1), Winter 2003, 59–82.
18 www2.standardandpoors.com
1 https://www.oecd.org/finance/Sovereign-Borrowing-Outlook-in-OECD-Countries-2019.pdf
2 J.Y. Campbell, R. Shiller and L.M. Viciera, Understanding inflation-indexed bond markets, Working Paper
available at http://kuznets.fas.harvard.edu/~campbell/papers/CampbellShillerViceira_20090503.pdf
3 M. Fleckenstein, F.A. Longstaff and H. Lustig, Why does the Treasury issue TIPS? The TIPS-Treasury bond
puzzle, NBER Working Paper number 16358, September 2010.
4 https://www.spglobal.com/en/research-insights/articles/u-s-corporate-debt-market-the-state-of-play-
in-2019
5 Ibid.
6 It is still possible for the investor to pay taxes (at all levels of government) on the imputed or not actually
received interest that accrues each year.
7 https://www.dealogic.com/insight/dcm-highlights-full-year-2018/
8 Ibid.
9 Antonio Velandia and Rodrigo Cabral, Why are more sovereigns issuing in euros?, The World Bank Group,
December 2017.
10 Read again the Appendix in Chapter 3 on Present/Future Value calculations.
11 For those students who want to be more mathematically savvy, here are the mathematical expressions for
PVIFA and PVIF: 1/r[1–1/(1+r)T] and 1/(1+r)T, respectively.
12 You can also find expanded tables either on the internet by doing a search or in any finance textbook.
13 You can also compute a bond’s price using EXCEL. The relevant EXCEL function is PRICE. Inserting the
above values along with the frequency input of 1 (for yearly payments or 2 for semiannual payments) you
can obtain the same number(s) above.
14 The easiest approach is to use EXCEL and its function of YIELD. Thus, for the example above type in the cells
1/1/2000 for settlement, 1/1/2009 for maturity, 10% for rate, 112.47 for price, 100 for redemption, 1 for frequency
(to denote yearly payments) and leave blank the basis input. Click OK to obtain 8%.
15 As with YTM, you can compute the YTC using the same EXCEL function substituting price for the call price.
16 F. Fabozzi, Bond Markets, Analysis and Strategies, Prentice Hall, 4th edition.
17 Ibid.
18 A. Estrella and Mary R. Tubin, The yield curve as a leading indicator: some practical issues, Current Issues in
Economics and Finance 12(5), Federal Reserve of New York, August 2006.
1 Christopher Blake, Edwin Elton and Martin Gruber, The performance of bond mutual funds, Journal of Business
56(3), 1993, 371–403. Vladyslav Sushko and Grant Turner, The implications of passive investing for
securities markets, BIS Quarterly Review, March 2018.
2 Frank Fabozzi, Bond Markets, Analysis and Strategies, 4th edition, Prentice Hall, 2000, p. 489.
3 M.J. Patterson, The biggest cause of tracking error in corporate ETFs, SeekingAlpha.com, March 4, 2011.
4 https://www2.investinginbonds.com/learnmore.asp?catid=6&id=390
5 Martin L. Leibowitz, Horizon analysis for managed bond portfolios, Journal of Portfolio Management 1(3), 1975,
23–43.
6 Martin L. Leibowitz and Alfred Weinberger, Contingent immunization–Part I: risk control procedures,
Financial Analysts Journal 38(6), Nov.–Dec. 1982, 17–32.
7 Note that as you directly type geomean in the function bar, do not forget to add the equal (=) sign before
the word.
8 Adrian W. Throop, Interest rate forecasts and market efficiency, Federal Reserve Bank of San Francisco
Economic Review, Spring 1981, 29–43.
9 Steven Katz, The price adjustment process of bonds to ratings reclassifications: a test of bond market effi-
ciency, Journal of Finance 29(2), May 1974, 551–559.
10 Steven G. Hall and David K. Miles, Measuring efficiency and risk in the major bond markets, Oxford Economic
Papers 44, 1992, 599–625. D. Cutler, J. Poterba and L. Summers, Speculative dynamics, NBER. Working
Paper No. 3242, Cambridge, Mass., January, 1989. R. I. Shiller, Market Volatility, MIT Press, 1989.
11 International Capital Market Association, Bond Market Transparency Standard–amended. Jan. 14, 2009.
12 Christopher Blake, Edwin J. Elton and Martin J. Gruber, The performance of bond mutual funds, Journal of
Business 56(3), 1993, 371–403.
1 www.cboe.com
2 The Options Institute.
3 Note that just like the daily absolute yield changes, the logs of the daily yield changes have a slight bias
toward lower yields.
4 John C. Cox, Stephen A. Ross and Mark Rubinstein, Option pricing: a simplified approach, Journal of Financial
Economics 7, 1979, 229–263.
5 Fischer Black and Myron Scholes, The pricing of options and corporate liabilities, Journal of Political Economy
81(2), May–June 1973, 637–654. Robert C. Merton, Theory of rational option pricing, Bell Journal of Eco-
nomics and Management Science 4(1), 1973, 141–183.
6 You can find these values in two ways: either look at the cumulative normal distribution tables (found in
all statistics textbooks) or seek the NORMDIST function in Excel. When using the tables, you may need to
interpolate (for accuracy). However, with the Excel function, just enter the exact number in X box, then
enter 0 for mean, 1 for standard deviation and type “true” in the cumulative box. Hit “OK” and you will
get the above values.
7 CBOE’s site (http://www.cboe.com/tradtool/ivolmain.aspx) offers a free service (calculator) for calculat-
ing the implied volatility of options.
8 Eric Ghysels, Andrew Harvey and Eric Renault, Stochastic volatility, in Statistical Methods in Finance, C. Rao and
G. Maddala (eds), Elsevier Science, North-Holland Series in Statistics and Probability, 1996.
1 www.nyse.com
2 www.tfx.co.jp/en/about_tfx/index_shtml
3 The Nodal Exchange is a US derivatives exchange providing price, credit, and liquidity risk management
to participants in the North American commodity markets. The Exchange has introduced the world’s larg-
est set of electric power locational futures contracts, as well as environmental contracts. Nodal Exchange
currently offers over 1,000 power and gas contracts on hundreds of unique locations, providing the most
effective basis risk management available to its energy market participants.
4 https://www.japantimes.co.jp/news/2019/09/18/business/financial-markets/electricity-futures-trad-
ing-japan-tokyo-commodity-exchange/#.Xef3spMzbIU
5 https://www.ft.com/content/f888af02-7c88-11e9-81d2-f785092ab560
6 As of 8:53 am and using the CNNMoney site.
7 To convert the dividends into points, you do the following: obtain the S&P 500 dividend yield, here
1.0345%, and multiply it by the S&P 500 spot index value, here 1,160. Obtain the value of 12 points. Then,
multiply these points by the days to expiration year adjustment (75/360) to derive the final dividend
conversion into points, or 2.5 points.
1 Daniel L. Thornton, Tests of covered interest rate parity, Federal Reserve Bank of St. Louis, July/August 1989.
2 James R. Lothian and Liuren Wu, Uncovered interest rate parity over the past two centuries, Journal of Inter-
national Money and Finance 30(2), April 2011, 448–473.
3 B. Protess, Banks increase their holdings in derivatives, New York Times, Sept. 23, 2011.
4 International Monetary Fund, Global Stability Report, 2006.
5 D. Mengle, Credit derivatives: an overview, Federal Reserve Bank of Atlanta Economic Review, fourth quarter
2007, 17.
6 H. Sender, Greenlight founder calls for CDS ban, Financial Times, Nov. 9, 2007.
7 P. Davies, Synthetic CDO equity investments, FT.com, July 31, 2006.
8 SEC report cites flaws at credit rating agencies, Yahoo!Finance, Oct. 2, 2011.
9 The REIT Story, REIT.com, Feb. 2011.
10 Jeffery R. Kosnett, Growing risk in REITs, Kiplinger.com, March 5, 2010.
11 Terry Pristin, A closer, and skeptical, look at nontraded REITS, New York Times, July 19, 2011.
12 F. Goltz and D. Schroeder, Hedge fund transparency: where do we stand?, Journal of Alternative Investments
12(4), Spring 2010, 20–37.
13 https://www.investor.gov/introduction-investing/basics/investment-products/hedge-funds
14 S. Bond and L. Johnson, Alternative asset pricing: momentum and the hedge fund puzzle, Journal of Alternative
Investments 13(1), Summer 2010, 55–71.
15 https://www.bloomberg.com/news/articles/2019-10-07/hedge-funds-post-the-best-performance-
this-year-since-2013
16 https://www.evidenceinvestor.com/third-quarter-2019-hedge-fund-performance-update/
17 https://www.wsj.com/articles/hedge-fund-performance-goes-from-bad-to-less-bad-11570413901
18 B. Protess, Think globally, deal locally, New York Times, Sept. 28, 2011.
19 Ibid.
20 Alternative Investments in Perspective, RREEF Research, A member of the Deutsche Bank Group, Sep. 2007.
21 https://www.eib.org/en/products/equity/infra-environment-funds/infrastructure-equity-funds.
htm?q=&sortColumn=_g_fundsInformation_vintageYear&sortDir=desc&pageNumber=0&itemPer
Page=25&pageable=true&language=EN&defaultLanguage=EN&_g_fundsInformations_fundType=infra
structure-equity-funds&or_g_fundsInformations_fundType=true&yearFrom=&yearTo=&orCountries=
true&orCountries.region=true
22 Rommel C. Gavieta, The global financial crisis, vulture funds, and Chinese official development assistance:
impact on Philippine infrastructure development, Journal of Structured Finance 16(2), 2010, 62–76.
23 M. Kassem and A. Shahine, Leveraging the Nile, Bloomberg Markets, Dec. 2010, 112–118.
24 C.A. Taylor and M. King, Investing in a vineyard? Beware grapes of wrath, The Guardian, Saturday April 23,
2011.
25 Christine Senior, The art of alternative investment, FTMandate.com, October 2010.
26 https://www.barrons.com/articles/art-funds-draw-few-investors-but-some-are-worth-a-look-
01556034302
27 Elan Weisz, Driving a tough bargain in the vintage car market, CNBC.com, Oct. 20, 2010.
28 Jack Shamash, Stamps do not always deliver top investment returns, Guardian.co.uk, August 6, 2010.
29 Barbara, Kollmeyer, From stamps to betting on life spans, Marketwatch.com, June 18, 2009.
30 https://hbr.org/2015/12/what-is-disruptive-innovation
31 https://www.reuters.com/article/us-usa-cryptocurrency-bill/u-s-proposes-barring-big-tech-companies-
from-offering-financial-services-digital-currencies-idUSKCN1U90NL
32 Jim Cunha and Colm Murphy, Are cryptocurrencies a good investment? Journal of Investing 28(3), 2019,
45–56.
33 E. Kostika and N. Laopodis, Dynamic linkages among cryptocurrencies, exchange rates and global equity
markets, Studies in Economics and Finance, 2019; https://www.emerald.com/insight/content/doi/10.1108/
SEF-01-2019-0032/full/html
34 Shaen Corbet, Andrew Meegan, Charles Larkin, Brian Lucye and Larisa Yarovaya, Exploring the dynamic
relationships between cryptocurrencies and other financial assets, Economics Letters 165, 2018, 28–34.
35 Dimitrios Koutmos, Return and volatility spillovers among cryptocurrencies, Economics Letters 173, 2018,
122–127.
36 https://www.cfainstitute.org/-/media/documents/support/programs/cfa/cfa-program-level-iii-fintech-
in-investment-management.ashx
37 https://www.cnbc.com/2016/01/19/10-things-investors-need-to-know-about-smart-beta.html
38 https://www.ubs.com/global/en/wealth-management/chief-investment-office/investment-opportunities/
longer-term-investments/2019/demographic-change-investment-opportunities.html
39 https://www.mckinsey.com/~/media/McKinsey/Industries/Financial%20Services/Our%20Insights/
The%20new%20Great%20Game%20in%20North%20American%20asset%20management/North-Amer
ican-asset-management-2018-vf.ashx
40 Robin Wigglesworth, Fidelity’s search for the technology of tomorrow, FT.com, Oct 20, 2019.
41 https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/financial-services/ch-fs-en-innovation-
in-private-banking-and-wealth-management.pdf
42 https://www.pwc.com/gx/en/asset-management/asset-management-insights/assets/pwc-awm-revolution-
pressure-on-profitability.pdf
43 The “Know thyself” maxim comes from ancient Greek meaning “know yourself” or do not think that you
know everything or are better than others. It was inscribed on the entrance of the Apollo Temple in Delphi,
Greece.
44 Sean D. Campbell and Francis X. Diebold, Weather forecasting for weather derivatives, Journal of the American
Statistical Association 100(469), 2000, 6–16.
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First edition published by Routledge 2013

British Library Cataloguing-in-Publication Data

Library of Congress Cataloging-in-Publication Data

ISBN: 978-0-367-46168-3 (hbk)

Visit the eResources: www.routledge.com/9780367461904

Part I Investment basics 1

Part II Financial markets, intermediaries, and instruments 93

Part III Portfolio theory 209

Part IV Equity portfolio management 331

Part V Debt securities 411

Part VI Derivative markets and other investments 489

List of illustrations xxiii

Part I Investment basics 1

2 The investment decision process and investment strategies 31

3 Fundamentals of risk and return 63

3.3.6 Utility and wealth 80

Part II Financial markets, intermediaries, and instruments 93

5 Money and capital market instruments and strategies 131

6 Investment bankers and investment companies 167

6.3.3 IPO documents 174

Part III Portfolio theory 209

7.4.3 The capital allocation line 231

8 Efficient diversification and capital market theory 251

9 Market efficiency and behavioral finance 295

Part IV Equity portfolio management 331

MARKET FLASH Dual-class common stock 337

11 Equity valuation and investment strategies 373

MARKET FLASH Is the P/E ratio dead? 394

Part V Debt securities 411

Lessons of our times: Downgrading US debt 449

13 Bond portfolio management and performance evaluation 455

Part VI Derivative markets and other investments 489

14.2.1 Basic option concepts 493

15 Futures markets and strategies 533

MARKET FLASH China’s overhaul of its futures market 545

16 Other investment topics and themes in investment management 567

16.5 Disruptive technologies 586

Figure 7.1 Portfolio risk and number of securities 215

Figure 14.8 A married put strategy’s profit line 509

Table 10.1 Apple’s stock quotations 340

Box 4.1 A new world monetary authority? 98

Box 16.1 Episodes of failed carry trades 571

New in this edition

New target audience

Aims of the textbook

The investment framework

1.2 The general financial and economic environment

1.2.2 The general investment environment

1.2.2.2 Classification of securities

Assets Billions of $ Liabilities and Net Worth Billions of $

Part I Investment basics 1

Part II Financial markets, intermediaries, and instruments 93

Part III Portfolio theory 209

Part IV Equity portfolio management 331

Part V Debt securities 411

Part VI Derivative markets and other investments 489

List of illustrations xxiii

Part I Investment basics 1

2 The investment decision process and investment strategies 31

3 Fundamentals of risk and return 63

3.3.6 Utility and wealth 80

Part II Financial markets, intermediaries, and instruments 93

5 Money and capital market instruments and strategies 131

6 Investment bankers and investment companies 167

6.3.3 IPO documents 174

Part III Portfolio theory 209

7.4.3 The capital allocation line 231

8 Efficient diversification and capital market theory 251

9 Market efficiency and behavioral finance 295

Part IV Equity portfolio management 331

MARKET FLASH Dual-class common stock 337

11 Equity valuation and investment strategies 373

MARKET FLASH Is the P/E ratio dead? 394

Part V Debt securities 411

Lessons of our times: Downgrading US debt 449

13 Bond portfolio management and performance evaluation 455

Part VI Derivative markets and other investments 489

14.2.1 Basic option concepts 493

15 Futures markets and strategies 533

MARKET FLASH China’s overhaul of its futures market 545

16 Other investment topics and themes in investment management 567

16.5 Disruptive technologies 586

Figure 7.1 Portfolio risk and number of securities 215

Figure 14.8 A married put strategy’s profit line 509

Table 10.1 Apple’s stock quotations 340

Box 4.1 A new world monetary authority? 98

Box 16.1 Episodes of failed carry trades 571