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fundamentals of investments

VALUATION AND MANAGEMENT

fifth edition

Bradford D. Jordan | Thomas W. Miller, Jr.

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Fundamentals of Investments

VALUATION AND MANAGEMENT

The McGraw-Hill/Irwin Series in Finance,
Insurance and Real Estate

Stephen A. Ross
Franco Modigliani Professor of Finance and Economics
Sloan School of Management
Massachusetts Institute of Technology
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Fifth Edition

Fundamentals of Investments

VALUATION AND MANAGEMENT

Bradford D. Jordan Thomas W. Miller Jr.

University of Kentucky Saint Louis University

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis
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FUNDAMENTALS OF INVESTMENTS

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Library of Congress Cataloging-in-Publication Data
Jordan, Bradford D.

Fundamentals of investments : valuation and management / Bradford D. Jordan,
Thomas W. Miller. -- 5th ed.

p. cm. -- (The McGraw-Hill/Irwin series in finance, insurance and real estate)
Includes index.
ISBN-13: 978-0-07-338235-7 (alk. paper)
ISBN-10: 0-07-338235-3 (alk. paper)
1. Investments. I. Miller, Thomas W. II. Title.
HG4521.C66 2009
332.6--dc22

2008023316

www.mhhe.com

To my late father, S. Kelly Jordan Sr.,
a great stock picker.
BDJ

To my parents, Tom and Kathy Miller,
my wife Carolyn, and #21
—Thomas W. Miller III.
TWM Jr.

About the Authors

Bradford D. Jordan

Gatton College of Business and Economics, University of Kentucky
Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst
Endowed Chair in Finance at the University of Kentucky. He has a long-standing interest in
both applied and theoretical issues in investments, and he has extensive experience teach-
ing all levels of investments. Professor Jordan has published numerous research articles on
issues such as valuation of fixed-income securities, tax effects in investments analysis, the
behavior of security prices, IPO valuation, and pricing of exotic options. He is co-author
of Fundamentals of Corporate Finance and Essentials of Corporate Finance, two of the
most widely used finance textbooks in the world.

Thomas W. Miller Jr.

John Cook School of Business, Saint Louis University
Tom Miller is the Senior Associate Dean for Academic Programs and Professor of Finance
at the John Cook School of Business at Saint Louis University. Professor Miller has a long-
standing interest in derivative securities and investments and has published numerous articles
on various topics in these areas. Professor Miller has been honored with many research and
teaching awards. Professor Miller is a co-author (with David Dubofsky) of Derivatives:
Valuation and Risk Management (Oxford University Press). Professor Miller’s interests
include golf, skiing, and American saddlebred horses.

vi

Preface

So why did we write this book?
As we toiled away, we asked ourselves this question many times, and the answer was

always the same: Our students made us.
Traditionally, investments textbooks tend to fall into one of two camps. The first type

has a greater focus on portfolio management and covers a significant amount of portfolio
theory. The second type is more concerned with security analysis and generally contains
fairly detailed coverage of fundamental analysis as a tool for equity valuation. Today, most
texts try to cover all the bases by including some chapters drawn from one camp and some
from another.

The result of trying to cover everything is either a very long book or one that forces the
instructor to bounce back and forth between chapters. This frequently leads to a noticeable
lack of consistency in treatment. Different chapters have completely different approaches:
Some are computational, some are theoretical, and some are descriptive. Some do macroeco-
nomic forecasting, some do mean-variance portfolio theory and beta estimation, and some
do financial statements analysis. Options and futures are often essentially tacked on the back
to round out this disconnected assortment.

The goal of these books is different from the goal of our students. Our students told us
they come into an investments course wanting to learn how to make investment decisions.
As time went by, we found ourselves supplying more and more supplemental materials to
the texts we were using and constantly varying chapter sequences while chasing this elusive
goal. We finally came to realize that the financial world had changed tremendously, and
investments textbooks had fallen far behind in content and relevance.

What we really wanted, and what our students really needed, was a book that would do
several key things:

• Focus on the students as investment managers by giving them information they can
act on instead of concentrating on theories and research without the proper context.

• Offer strong, consistent pedagogy, including a balanced, unified treatment of the
main types of financial investments as mirrored in the investment world.

• Organize topics in a way that would make them easy to apply—whether to a portfo-
lio simulation or to real life—and support these topics with hands-on activities.

We made these three goals the guiding principles in writing this book. The next several
sections explain our approach to each and why we think they are so important.

Who Is This Book For?

This book is aimed at introductory investments classes with students who have relatively
little familiarity with investments. A typical student may have taken a principles of finance
class and had some exposure to stocks and bonds, but not much beyond the basics. The
introductory investments class is often a required course for finance majors, but students
from other areas often take it as an elective. One fact of which we are acutely aware is that
this may be the only investments class many students will ever take.

We intentionally wrote this book in a relaxed, informal style that engages the student
and treats him or her as an active participant rather than a passive information absorber. We
think the world of investments is exciting and fascinating, and we hope to share our consid-
erable enthusiasm for investing with the student. We appeal to intuition and basic principles

vii

whenever possible because we have found that this approach effectively promotes under-
standing. We also make extensive use of examples throughout, drawing on material from
the world around us and using familiar companies wherever appropriate.

By design, the text is not encyclopedic. As the table of contents indicates, we have a total
of 20 chapters. Chapter length is about 30 to 40 pages, so the text is aimed at a single-term
course; most of the book can be covered in a typical quarter or semester.

Aiming the book at a one-semester course necessarily means some picking and choosing,
with regard to both topics and depth of coverage. Throughout, we strike a balance by intro-
ducing and covering the essentials while leaving some of the details to follow-up courses in
security analysis, portfolio management, and options and futures.

How Does the Fifth Edition of This Book Expand upon
the Goals Described Above?

Based on user feedback, we have made numerous improvements and refinements in the fifth
edition of Fundamentals of Investments: Valuation and Management. We have included an
appendix containing useful formulas. We updated every chapter to reflect current market
practices and conditions, and we significantly expanded and improved the end-of-chapter
material. Also, our chapters devoted to market efficiency and to behavioral finance continue
to rate highly among readers.

To give some examples of our additional new content:

• Chapter 2 contains a greatly expanded section on investment fraud and the Security
Investors Protection Corporation (SIPC). In addition, a new section has been added
to show students one way to form an investment portfolio.

• Chapter 4 contains a new section on the advantages and drawbacks of mutual fund
investing and a greatly expanded section on exchange-traded funds, which includes
exchange-traded notes (ETNs).

• Chapter 5 includes a greatly expanded section on private equity versus selling securi-
ties to the public. In addition, discussion of the current structure of the NYSE and the
NASDAQ is enhanced with new material.

• Chapter 6 contains a section on how we get the formula for constant perpetual growth.
Also, a detailed discussion of the two-stage dividend growth model is presented.

• Chapter 7 contains new material on an event study using actual events surrounding
Advanced Medical Optics.

• Chapter 10 contains a greatly revamped section on dedicated portfolios and reinvest-
ment risk.

• Chapter 14 now includes a detailed example of how to hedge an inventory using
futures contracts.

• Chapter 15 contains an expanded discussion of the Options Clearing Corporation
(OCC). In addition, the chapter has been extensively reorganized so that it naturally
culminates in the put-call parity condition.

• Chapter 16 has been extensively reworked. It now contains sections on a simple
way to value options; the one-period binomial option pricing model; the two-period
option pricing model; the binomial option pricing model with many periods; and the
Black-Scholes model. This chapter also describes employee stock options (ESOs)
and their valuation using a modified Black-Scholes-Merton model.

• Chapter 20 (Web site only) includes a discussion of reverse mortgages.

In addition, we have written a set of learning objectives for each chapter. We have exten-
sively reworked our chapter summaries to reflect the chapter’s learning objectives.

For the fifth edition, we significantly expanded and improved the end-of-chapter material.
We added new problems throughout, and we increased the number of CFA questions. We
created new questions that test understanding of concepts with no calculations involved. In
addition, our What’s on the Web? questions give students assignments to perform based on

viii Preface

information they retrieve from various Web sites. Our S&P Problems require the use of the
educational version of Market Insight, which provides access to S&P’s well-known Com-
pustat database, and they provide instructors with an easy way to incorporate current, real-
world data. Finally, in selected chapters, we have created spreadsheet assignments, which
ask students to create certain types of spreadsheets to solve problems.

We continue to emphasize the use of the Web in investments analysis, and we integrate
Web-based content in several ways. First, wherever appropriate, we provide a commented
link in the margin. These links send readers to selected, particularly relevant Web sites. Sec-
ond, our Work the Web feature, expanded and completely updated for this edition, appears in
most chapters. These boxed readings use screen shots to show students how to access, use,
and interpret various types of key financial and market data. Finally, as previously noted,
new end-of-chapter problems rely on data retrieved from the Web.

We continue to provide Spreadsheet Analysis exhibits, which we have enhanced for this
edition. These exhibits illustrate directly how to use spreadsheets to do certain types of
important problems, including such computationally intensive tasks as calculating Macaulay
duration, finding Black-Scholes option prices, and determining optimal portfolios based on
Sharpe ratios. We also continue to provide, where relevant, readings from The Wall Street
Journal, which have been thoroughly updated for this edition.

Assurance-of-Learning Ready

Many educational institutions today are focused on the notion of assurance of learning, an
important element of some accreditation standards. This edition is designed specifically to
support your assurance-of-learning initiatives with a simple, yet powerful, solution. Listed
below are the learning objectives for each chapter.

Each test bank question for this book maps to a specific chapter learning objective listed
in the text. You can use the test bank software to easily query for learning outcomes and
objectives that directly relate to the learning objectives for your course. You can then use the
reporting features of the software to aggregate student results in similar fashion, making the
collection and presentation of assurance-of-learning data simple and easy.

Chapter Learning Objectives

Chapter 1: A Brief History of Risk and Return
To become a wise investor (maybe even one with too much money), you need to know:

1. How to calculate the return on an investment using different methods.
2. The historical returns on various important types of investments.
3. The historical risks on various important types of investments.
4. The relationship between risk and return.

Chapter 2: Buying and Selling Securities
Don’t sell yourself short. Instead, learn about these key investment subjects:

1. The various types of securities brokers and brokerage accounts.
2. How to calculate initial and maintenance margin.
3. The workings of short sales.
4. The importance of investor objectives, constraints, and strategies.

Chapter 3: Overview of Security Types
Price quotes for all types of investments are easy to find, but what do they mean? Learn
the answer for:

1. Various types of interest-bearing assets.
2. Equity securities.
3. Futures contracts.
4. Option contracts.

Preface ix

Chapter 4: Mutual Funds
You’re probably going to be a mutual fund investor very soon, so you should definitely
know the following:

1. The different types of mutual funds.
2. How mutual funds operate.
3. How to find information about how mutual funds have performed.
4. The workings of exchange-traded funds.

Chapter 5: The Stock Market
Take stock in yourself. Make sure you have a good understanding of:

1. The difference between primary and secondary stock markets.
2. The workings of the New York Stock Exchange.
3. How NASDAQ operates.
4. How to calculate index returns.

Chapter 6: Common Stock Valuation
Separate yourself from the commoners by having a good understanding of these security
valuation methods:

1. The basic dividend discount model.
2. The two-stage dividend growth model.
3. The residual income model.
4. Price ratio analysis.

Chapter 7: Stock Price Behavior and Market Efficiency
You should strive to have your investment knowledge fully reflect:

1. The foundations of market efficiency.
2. The implications of the forms of market efficiency.
3. Market efficiency and the performance of professional money managers.
4. What stock market anomalies, bubbles, and crashes mean for market efficiency.

Chapter 8: Behavioral Finance and the Psychology of Investing
Psych yourself up and get to know something about:

1. Prospect theory.
2. The implications of investor overconfidence and misperceptions of randomness.
3. Sentiment-based risk and limits to arbitrage.
4. The wide array of technical analysis methods used by investors.

Chapter 9: Interest Rates
It will be worth your time to increase your rate of interest in these topics:

1. Money market prices and rates.
2. Rates and yields on fixed-income securities.
3. Treasury STRIPS and the term structure of interest rates.
4. Nominal versus real interest rates.

Chapter 10: Bond Prices and Yields
Singing “The Bonds Song” will help you learn:

1. How to calculate bond prices and yields.
2. The importance of yield to maturity.
3. Interest rate risk and Malkiel’s theorems.
4. How to measure the impact of interest rate changes on bond prices.

x Preface

Chapter 11: Diversification and Risky Asset Allocation
To get the most out of this chapter, spread your study time across:

1. How to calculate expected returns and variances for a security.
2. How to calculate expected returns and variances for a portfolio.
3. The importance of portfolio diversification.
4. The efficient frontier and importance of asset allocation.

Chapter 12: Return, Risk, and the Security Market Line
Studying some topics will yield an expected reward. For example, make sure you
know:

1. The difference between expected and unexpected returns.
2. The difference between systematic risk and unsystematic risk.
3. The security market line and the capital asset pricing model.
4. The importance of beta.

Chapter 13: Performance Evaluation and Risk Management
To get a high evaluation of your performance, make sure you know:

1. How to calculate the three best-known portfolio evaluation measures.
2. The strengths and weaknesses of these three portfolio evaluation measures.
3. How to calculate a Sharpe-optimal portfolio.
4. How to calculate and interpret Value-at-Risk.

Chapter 14: Futures Contracts
You will derive many future benefits if you have a good understanding of:

1. The basics of futures markets and how to obtain price quotes for futures
contracts.

2. The risks involved in futures market speculation.
3. How cash prices and futures prices are linked.
4. How futures contracts can be used to transfer price risk.

Chapter 15: Stock Options
Give yourself some in-the-money academic and professional options by understanding:

1. The basics of option contracts and how to obtain price quotes.
2. The difference between option payoffs and option profits.
3. The workings of some basic option trading strategies.
4. The logic behind the put-call parity condition.

Chapter 16: Option Valuation
Make sure the price is right by making sure that you have a good understanding of:

1. How to price options using the one-period and two-period binomial model.
2. How to price options using the Black-Scholes model.
3. How to hedge a stock portfolio using options.
4. The workings of employee stock options.

Chapter 17: Projecting Cash Flow and Earnings
Help yourself grow as a stock analyst by knowing:

1. How to obtain financial information about companies.
2. How to read basic financial statements.
3. How to use performance and price ratios.
4. How to use the percentage of sales method in financial forecasting.

Preface xi

Chapter 18: Corporate Bonds
Conform to your fixed-income knowledge covenants by learning:

1. The basic types of corporate bonds.
2. How callable bonds function.
3. The workings of convertible bonds.
4. The basics of bond ratings.

Chapter 19: Government Bonds
Before you loan money to Uncle Sam (and his relatives), you should know:

1. The basics of U.S. Treasury securities and how they are sold.
2. The workings of the STRIPS program and pricing Treasury bonds.
3. How federal agencies borrow money.
4. How municipalities borrow money.

Chapter 20 (Web site only): Mortgage-Backed Securities
Before you mortgage your future, you should know:

1. The workings of a fixed-rate mortgage.
2. Government’s role in the secondary market for home mortgages.
3. The impact of mortgage prepayments.
4. How collateralized mortgage obligations are created and divided.

How Is This Book Relevant to the Student?

Fundamental changes in the investments universe drive our attention to relevance. The first
major change is that individuals are being asked to make investment decisions for their
own portfolios more often than ever before. There is, thankfully, a growing recognition that
traditional “savings account” approaches to investing are decidedly inferior. At the same
time, the use of employer-sponsored “investment accounts” has expanded enormously. The
second major change is that the investments universe has exploded with an ever-increasing
number of investment vehicles available to individual investors. As a result, investors must
choose from an array of products, many of which are very complex, and they must strive to
choose wisely.

Beyond this, students are more interested in subjects that affect them directly (as are we
all). By taking the point of view of the student as an investor, we are better able to illustrate
and emphasize the relevance and importance of the material.

Our approach is evident in the table of contents. Our first chapter is motivational;
we have found that this material effectively “hooks” students and even motivates a
semester-long discourse on risk and return. Our second chapter answers the student’s next
natural question: “How do I get started investing and how do I buy and sell securities?”
The third chapter surveys the different types of investments available. After only three
chapters, very early in the term, students have learned something about the risks and
rewards from investing, how to get started investing, and what investment choices are
available.

We close the first part of the text with a detailed examination of mutual funds. Without a
doubt, mutual funds have become the most popular investment vehicles for individual inves-
tors. There are now more mutual funds than there are stocks on the NYSE! Given the size
and enormous growth in the mutual fund industry, this material is important for investors.
Even so, investments texts typically cover mutual funds in a cursory way, often banishing
the material to a back chapter under the obscure (and obsolete) heading of “investment com-
panies.” Our early placement lets students quickly explore a topic they have heard a lot about
and are typically interested in learning more about.

xii Preface

How Does This Book Allow Students to Apply
the Investments Knowledge They Learn?

After studying this text, students will have the basic knowledge needed to move forward
and actually act on what they have learned. We have developed two features to encourage
students in making decisions as an investment manager. Learning to make good investment
decisions comes with experience, while experience (regrettably) comes from making bad
investment decisions. As much as possible, we press our students to get those bad decisions
out of their systems before they start managing real money!

Not surprisingly, most students don’t know how to get started in buying and selling se-
curities. We have learned that providing some structure, especially with a portfolio simula-
tion, greatly enhances the experience. Therefore, we have a series of Get Real! boxes. These
boxes (at the end of each chapter) usually describe actual trades for students to explore. The
intention is to show students how to gain real experience with the principles and instruments
covered in the chapter. The second feature is a series of Stock-Trak exercises that take stu-
dents through specific trading situations using Stock-Trak Portfolio Simulations, which can
be found in the book’s Web site, www.mhhe.com/jm5e.

Because we feel that portfolio simulations are so valuable, we have taken steps to assist
instructors who, like us, plan to integrate portfolio simulations into their courses. Beyond the
features mentioned above, we have organized the text so that the essential material needed
before participating in a simulation is covered at the front of the book. Most notably, with
every book, we have included a free subscription to Stock-Trak Portfolio Simulations. Stock-
Trak is the leading provider of investment simulation services to the academic community;
providing Stock-Trak free represents a significant cost savings to students. To our knowledge,
ours is the first (and only) investments text to directly offer a full-featured online brokerage
account simulation with the book at no incremental cost.

How Does This Book Maintain a Consistent,
Unified Treatment?

In most investments texts, depth of treatment and presentation vary dramatically from instru-
ment to instrument, which leaves the student without an overall framework for understand-
ing the many types of investments. We stress early on that there are essentially only four
basic types of financial investments—stocks, bonds, options, and futures. In parts 2 through
6, our simple goal is to take a closer look at each of these instruments. We take a unified ap-
proach to each by answering these basic questions:

1. What are the essential features of the instrument?

2. What are the possible rewards?

3. What are the risks?

4. What are the basic determinants of investment value?

5. For whom is the investment appropriate and under what circumstances?

6. How is the instrument bought and sold, and how does the market for the instrument
operate?

By covering investment instruments in this way, we teach the students what questions to
ask when looking at any potential investment.

Unlike other introductory investments texts, we devote several chapters beyond the basics
to the different types of fixed-income investments. Students are often surprised to learn that
the fixed-income markets are so much bigger than the equity markets and that money man-
agement opportunities are much more common in the fixed-income arena. Possibly the best
way to see this is to look at recent CFA exams and materials and note the extensive coverage
of fixed-income topics. We have placed these chapters toward the back of the text because
we recognize not everyone will want to cover all this material. We have also separated the
subject into several shorter chapters to make it more digestible for students and to allow
instructors more control over what is covered.

Preface xiii

Acknowledgments

We have received extensive feedback from reviewers at each step along the way, and we are
very grateful to the following dedicated scholars and teachers for their time and expertise:

Aaron Phillips, California State University - Bakersfield
Allan O’Bryan, Rochester Community & Technical College
Allan Zebedee, San Diego State University
Ann Hackert, Idaho State University
Carl R. Chen, University of Dayton
Carla Rich, Pensacola Junior College
Caroline Fulmer, University of Alabama
Charles Appeadu, University of Wisconsin–Madison
Christos Giannikos, Bernard M. Baruch College
David Dubofsky, University of Louisville
David Louton, Bryant College
David Loy, Illinois State University
David Peterson, Florida State University
David Stewart, Winston-Salem State University
Deborah Murphy, University of Tennessee–Knoxville
Donald Wort, California State University–East Bay
Dwight Giles, Jefferson State Community College
Edward Miller, University of New Orleans
Felix Ayadi, Fayetteville State University
Gay B. Hatfield, University of Mississippi
Gioia Bales, Hofstra University
Howard Van Auken, Iowa State University
Howard W. Bohnen, St. Cloud State University
It-Keong Chew, University of Kentucky
Jeff Edwards, Portland Community College
Jeff Manzi, Ohio University
Jennifer Morton, Ivy Technical Community College of Indiana
Ji Chen, University of Colorado
Jim Tipton, Baylor University
Joe Brocato, Tarleton State University
Joe Walker, University of Alabama–Birmingham
Johnny Chan, University of Dayton
John Bockino, Suffolk County Community College
John Clinebell, University of Northern Colorado
John Ledgerwood, Bethune-Cookman College
John Paul Broussard, Rutgers, The State University of New Jersey
John Romps, St. Anselm College
John Wingender, Creighton University
Jorge Omar R. Brusa, University of Arkansas
Karen Bonding, University of Virginia
Kerri McMillan, Clemson University
Lalatendu Misra, University of Texas at San Antonio
Linda Martin, Arizona State University
Lisa Schwartz, Wingate University

xiv Preface

M. J. Murray, Winona State University
Marc LeFebvre, Creighton University
Margo Kraft, Heidelberg College
Matthew Fung, Saint Peter’s College
Michael C. Ehrhardt, University of Tennessee–Knoxville
Michael Gordinier, Washington University
Michael Nugent, SUNY–Stony Brook
Nolan Lickey, Utah Valley State College
Nozar Hashemzadeh, Radford University
Patricia Clarke, Simmons College
Paul Bolster, Northeastern University
Percy S. Poon, University of Nevada, Las Vegas
Randall Wade, Rogue Community College
Richard Lee Kitchen, Tallahassee Community College
Richard W. Taylor, Arkansas State University
Robert Friederichs, Alexandria Technical College
Robert Kozub, University of Wisconsin—Milwaukee
Ronald Christner, Loyola University–New Orleans
Samira Hussein, Johnson County Community College
Sammie Root, Texas State University—San Marcos
Samuel H. Penkar, University of Houston
Scott Barnhart, Clemson University
Scott Beyer, University of Wisconsin–Oshkosh
Stephen Chambers, Johnson County Community College
Steven Lifland, High Point University
Stuart Michelson, University of Central Florida
Thomas M. Krueger, University of Wisconsin–La Crosse
Tim Samolis, Pittsburgh Technical Institute
Vernon Stauble, San Bernardino Valley College
Ward Hooker, Orangeburg-Calhoun Technical College
William Compton, University of North Carolina–Wilmington
William Elliott, Oklahoma State University
William Lepley, University of Wisconsin–Green Bay
Yvette Harman, Miami University of Ohio
Zekeriah Eser, Eastern Kentucky University

We’d like to thank Kay Johnson, Penn State University–Erie, for developing the Test Bank, Scott
Beyer, University of Wisconsin, Oshkosh, for his work on the Instructor’s Manual, and Lynn
Phillips Kugele, University of Mississippi, for creating the Student Narrated Power Point.

The following doctoral and MBA students did outstanding work on this text: Steve Hailey,
Jared Jones MD, and Brett Carney; to them fell the unenviable task of technical proofreading
and, in particular, careful checking of each calculation throughout the text and supplements.

We are deeply grateful to the select group of professionals who served as our development
team on this edition: Michele Janicek, Executive Editor; Elizabeth Hughes, Development
Editor; Ashley Smith, Marketing Manager; Bruce Gin, Project Manager; Matt Baldwin,
Designer; Gina Hangos, Production Supervisor, and Brian Nacik, Media Project Manager.

Bradford D. Jordan

Thomas W. Miller, Jr.

Preface xv

Coverage

This book was designed and developed explicitly for a first course in investments taken
by either finance majors or nonfinance majors. In terms of background or prerequisites,
the book is nearly self-contained, but some familiarity with basic algebra and account-
ing is assumed. The organization of the text has been designed to give instructors the
flexibility they need to teach a quarter-long or semester-long course.

To present an idea of the breadth of coverage in the fifth edition of Fundamentals
of Investments, the following grid is presented chapter by chapter. This grid contains
some of the most significant new features and a few selected chapter highlights. Of
course, for each chapter, features like opening vignettes, Work the Web, Spreadsheet
Analyses, Get Real, Investment Updates, and end-of-chapter material have been thor-
oughly reviewed and updated.

Chapters and Learning Selected Topics of Interest Learning Outcome/Comment
Outcomes

PART ONE Introduction

Chapter 1 Dollar returns and percentage returns. Average returns differ by asset class.
A Brief History of Risk and Return
Return variability and calculating variance Return variability also differs by asset class.
Chapter 2 and standard deviation.
Buying and Selling Securities
Arithmetic versus geometric returns. Geometric average tells you what you actually
earned per year, compounded annually.
Arithmetic returns tells you what you earned in
a typical year.

The risk-return trade-off. Historically, higher returns are associated with
higher risk.

Brokerage accounts and choosing a Discussion of the different types of brokers and
broker. accounts available to an individual investor.

Expanded Material: Investment Fraud “Insurance” for investment fraud does not exist
and the Security Investors Protection in the United States. The SIPC restores funds to
Corporation (SIPC). investors who have securities in the hands of
bankrupt brokerage firms.
Short sales.
Investor objectives, constraints, and Description of the process of short-selling stock.
strategies.
Presentation of issues like risk and return,
New Section: Forming an Investment resource constraints, market timing, and asset
Portfolio. allocation.

An investment portfolio must account for an
investor’s risk tolerance, objectives, constraints,
and strategies.

xvi

Chapters and Learning Selected Topics of Interest Learning Outcome/Comment
Outcomes

Chapter 3

Overview of Security Types Classifying securities. Interest-bearing, equity, and derivative
securities.

NASD’s new TRACE system and Up-to-date discussion of new developments in
transparency in the corporate bond fixed income with respect to price, volume, and
market. transactions reporting.

Equity securities Obtaining price quotes for equity securities.

Derivative securities: Obtaining futures Defining the types of derivative securities,

contract and option contract price quotes interpreting their price quotes, and calculating

using the Internet. gains and losses from these securities.

Chapter 4

Mutual Funds Investment companies and types of Covers concepts like open-end versus closed-end
funds. New Section: The Advantages and funds and net asset value.
Drawbacks of Mutual Fund Investing.

Mutual fund organization, creation, costs, Presents types of expenses and fees like front-

and fees. end loads, 12b-1 fees, management fees, and

turnover.

Short-term funds, long-term funds, and Discussion of money market mutual funds versus
fund performance. the variety of available stock and bond funds
and how to find their performance.

Special funds like closed-end funds, The closed-end fund discount mystery and a

exchange-traded funds (expanded discussion of exchange-traded funds (ETFs) and

material ), and hedge funds (expanded exchange-traded notes (ETNs).

material ). New Material: exchange traded

notes (ETNs).

PART TWO Stock Markets

Chapter 5

The Stock Market The primary stock market. Expanded The workings of an initial public offering (IPO),
Material: Seasoned equity offerings a seasoned equity offering (SEO), the role of
(SEOs). investment bankers, the role of the Securities
and Exchange Commission (SEC).

The secondary stock market. New The role of dealers and brokers, the operation
Material: The current structure of the of the New York Stock Exchange (NYSE),
NYSE and NASDAQ. NASDAQ market operations.

Stock indexes, including the Dow Jones The difference between price-weighted indexes
Industrial Average (DJIA) and the and value-weighted indexes.
Standard & Poor’s 500 Index (S&P 500).

Chapter 6

Common Stock Valuation The basic dividend discount model (DDM) Valuation using constant and nonconstant
and several of its variants. New Material: growth.
How we get the formula for constant
perpetual growth. New Material: The
two-stage dividend growth model.

Expanded Section: Residual Income Model Valuation of non-dividend-paying stocks.
(RIM).

Price ratio analysis. Valuation using price-earnings, price-cash flow.

New Material: Updated McGraw-Hill Using Value Line information to value a stock
valuation detailed example. using methods presented earlier in the chapter.

xvii

Chapters and Learning Selected Topics of Interest Learning Outcome/Comment
Outcomes
Forms of market efficiency. The effects of information on stock prices with
Chapter 7 respect to market efficiency.
New Material: Event studies using actual Explains how new information gets into stock
Stock Price Behavior and Market events surrounding Advanced Medical prices and how researchers measure it.
Efficiency Optics.
Informed traders, insider trading, and New Example: Martha Stewart and ImClone.
illegal insider trading.
Expanded Material: Market efficiency Discuss the performance of professional money
and the performance of professional managers versus static benchmarks.
money managers.
Expanded Material: Anomalies. Presentation of the day-of-the-week effect, the
amazing January effect, the turn-of-the-year
Bubbles and crashes. effect, and the turn-of-the-month effect.
Shows the extent of famous events like the
Chapter 8 Introduction to behavioral finance. crash of 1929, the crash of October 1987, the
Asian market crash, and the “dot-com” bubble
Behavioral Finance and the Prospect theory. and crash.
Psychology of Investing
Overconfidence, misperceiving The influence of reasoning errors on investor
randomness, and overreacting to chance decisions.
events. How investors tend to behave differently when
Sentiment-based risk and limits to faced with prospective gains and losses.
arbitrage. Examines the consequences of these serious
Expanded Material: Technical analysis. errors in judgment.

PART THREE Interest Rates and Bond Valuation New Examples: 3Com/Palm mispricing, the Royal
Dutch/Shell Price Ratio.
Chapter 9 Interest rate history and a quick review New Material: Elliott Waves, expanded
Interest Rates of the time value of money. discussions of charting, moving averages, MACD,
Money market rates and their prices. money flow, and Fibonacci numbers.

Chapter 10 Rates and yields on fixed-income A graphical presentation of the long-term
Bond Prices and Yields securities. history of interest rates.
Nominal versus real interest rates. Important money market concepts including
Determinants of nominal interest rates. pricing U.S. Treasury bills, bank discount yields
versus bond equivalent yields, annual percentage
Straight bond prices and yield to rates, and effective annual returns.
maturity (YTM). The Treasury yield curve, the term structure of
The concept of duration and bond risk interest rates, and Treasury STRIPS.
measures based on duration. The Fisher hypothesis.
Expanded Material: Dedicated portfolios Problems with traditional theories and modern
and reinvestment risk. term structure theory.
Immunization.
Calculate straight bond prices, calculate yield to
maturity.
Calculate and interpret a bond’s duration. The
dollar value of an “01,” yield value of a 32nd.
Learn how to create a dedicated portfolio and
show its exposure to reinvestment risk.
Minimize the uncertainty concerning the value
of a bond portfolio at its target date.

xviii

Chapters and Learning Selected Topics of Interest Learning Outcome/Comment
Outcomes

PART FOUR Portfolio Management

Chapter 11 Expected returns and variances. Calculating expected returns and variances
using equal and unequal probabilities.
Diversification and Risky Asset
Allocation

Portfolios and the effect of diversification Compute portfolio weights, expected returns,

on portfolio risk. variances, and why diversification works.

The importance of asset allocation. The effect of correlation on the risk-return
trade-off.

The Markowitz efficient frontier and Compute risk-return combinations using various
illustrating the importance of asset portfolio weights for three assets.
allocation using three securities.

Chapter 12 Diversification, systematic and Total risk is comprised of unsystematic and
Return, Risk, and the Security unsystematic risk. systematic risk and only unsystematic risk can be
Market Line Measuring systematic risk with beta. reduced through diversification.

Chapter 13 The security market line and the reward- The average beta is 1.00. Assets with a beta
Performance Evaluation and Risk to-risk ratio. greater than 1.00 have more than average
Management systematic risk.
The capital asset pricing model (CAPM).
The security market line describes how the
Extending CAPM. market rewards risk. All assets will have
the same reward-to-risk ratio in competitive
financial markets.

Expected return depends on the amount and
reward for bearing systematic risk as well as the
pure time value of money.

One of the most important extensions of the
CAPM is the Fama-French three-factor model.

Performance evaluation measures. Calculate and interpret the Sharpe ratio, the
Sharpe-optimal portfolios. Treynor ratio, and Jensen’s alpha.

Value-at-Risk (VaR) The portfolio with the highest possible Sharpe
Example showing how to calculate a ratio given the assets comprising the portfolio
Sharpe-optimal portfolio. is Sharpe optimal.

VaR is the evaluation of the probability of a
significant loss.

Combines the concepts of a Sharpe ratio, a
Sharpe-optimal portfolio, and VaR.

PART FIVE Futures and Options

Chapter 14 The basics of futures contracts and using Futures quotes from the Internet and financial
Futures Contracts them to hedge price risk. New Material: press, short and long hedging, futures accounts.
Hedging an inventory using futures
markets. Basis, cash markets, and cash-futures arbitrage.
Index arbitrage, speculating with stock index
Spot-futures parity. futures, and hedging stock market risk with
stock index futures.
Stock index futures. Expanded Example: Shows how to use portfolio duration when
Changing the beta of a stock portfolio deciding how many futures contracts to use to
using stock index futures. hedge a bond portfolio.

Hedging interest rate risk with futures.

xix

Chapters and Learning Selected Topics of Interest Learning Outcome/Comment
Outcomes

Chapter 15

Stock Options Option basics and option price quotes. The difference between call and put options,
European and American options, online option
price quotes, option chains.

Option payoffs and profits. Diagram long and short option payoffs and
profits for calls and puts.

Option strategies. New Material: Using Protective puts, covered calls, straddles.
options to manage risk. Enhanced
Material: Spreads and combinations.

Option intrinsic value. Know how to calculate this important aspect of
option prices.

Put-call parity. Shows how a call option price equals a put
option price, the price of an underlying share
of stock, and appropriate borrowing.

PART SIX Topics in Investments

Chapter 16

Option Valuation New Material: The one-period and two- How to compute option prices using this option
period binomial option pricing model. pricing model—by hand and by using an online
option calculator.

New Material: The Black-Scholes option How to compute option prices using this
pricing model. famous option pricing model—by hand and
by using an online option calculator.

Measuring the impact of changes in Computing call and put option deltas.
option inputs.

Hedging stock with stock options. Using option deltas to decide how many option
contracts are needed to protect a stock’s price
from feared declines in value.

Employee stock options (ESOs) and Features of ESOs, repricing ESOs, and ESO
their valuation. Enhanced Material: valuation.
Black-Scholes-Merton option pricing
model.

Chapter 17

Projecting Cash Flow and Earnings The basics of financial statements. Income statement, balance sheet, cash flow
statement, performance and price ratios.

Financial statement forecasting using the Preparing pro forma income statements and

percentage of sales approach. balance sheets to examine the potential

amount of external financing needed.

Updated Material: A detailed case study Using actual financial data to prepare
valuing Starbucks Corporation. pro forma income statements and balance
sheets using different sales growth
scenarios.

Chapter 18

Corporate Bonds Corporate bond basics and types of Become familiarized with the basics of the
corporate bonds. various types of corporate bonds.

Bond indentures and callable bonds. Bond seniority provisions, call provisions, and
Enhanced Material: Make-whole call make-whole call provisions.
provisions.

Corporate bond credit ratings. Enhanced Assessing the credit quality of the bond issue.
Material: Bond yield spreads.

xx

Chapters and Learning Selected Topics of Interest Learning Outcome/Comment
Outcomes
Chapter 19 Government bonds basics emphasizing Details of U.S. Treasury bills, notes, bonds, and
Government Bonds U.S. government debt. STRIPS.
U.S. savings bonds.
Chapter 20 (Web site only) Covers important changes to these investment
Mortgage-Backed Securities Municipal bonds and their credit ratings. vehicles.

Reviews important features of bonds issued by
municipal governments.

Fixed-rate mortgages and prepayment. Presents home mortgage principal and interest
calculations.
Secondary mortgage markets. New
Material: Reverse mortgages. The function of GNMA and its clones, the PSA
Collateralized mortgage obligations, mortgage prepayment model.
CMOs.
Describing how cash flows from mortgage pools
are carved up and distributed to investors.

xxi

Features

About the Authors

Pedagogical Features

From your feedback, we have included many pedagogical features in this text that will
be valuable learning tools for your students. This walkthrough highlights some of the
most important elements.

Chapter Openers CHAPTER 4

These one-paragraph introductions for each Mutual Funds
chapter present scenarios and common mis-
conceptions that may surprise you. An expla-
nation is more fully developed in the chapter.

“Take calculated risks. That is quite different from being rash.”
–George S. Patton

Learning Objectives With only $2,000 to invest, you can easily own shares in Microsoft, GM, McDonald’s,
IBM, Coke, and many more stocks through a mutual fund. Or, you can invest in a port-
You’re probably going folio of government bonds or other investments. Indeed, many thousands of different
to be a mutual fund mutual funds are available to investors. In fact, there are about as many mutual funds
investor very soon, so as there are different stocks traded on the NASDAQ and the New York Stock Exchange
you should definitely combined. There are funds for aggressive investors, conservative investors, short-term
know the following: investors, and long-term investors. There are bond funds, stock funds, international
funds, and you-name-it funds. Is there a right fund for you? This chapter will help you
1. The different types of find out. ■
mutual funds.
As we discussed in an earlier chapter, if you do not wish to actively buy and sell individual
2. How mutual funds securities on your own, you can invest in stocks, bonds, or other financial assets through a
operate. mutual fund. Mutual funds are simply a means of combining or pooling the funds of a large
group of investors. The buy and sell decisions for the resulting pool are then made by a fund
3. How to find manager, who is compensated for the service provided.
information about
how mutual funds Because mutual funds provide indirect access to financial markets for individual inves-
have performed. tors, they are a form of financial intermediary. In fact, mutual funds are now the largest
type of intermediary in the United States, followed by commercial banks and life insurance
4. The workings of companies.
Exchange-Traded
Funds.

jor82353_ch04.indd 96 8/9/08 10:38:23 AM

Check This! ✓ 4.4a What is the difference between a load fund and a no-load fund?
4.4b What are 12b-1 fees?
Every major section in each chapter ends CHECK THIS
with questions for review. This feature helps
students test their understanding of the ma-
terial before moving on to the next section.

money market mutual MONEY MARKET MUTUAL FUNDS Key Terms
fund
As the name suggests, money market mutual funds, or MMMFs, specialize in money Key terms are indicated in bold and defined
A mutual fund specializing in market instruments. As we describe elsewhere, these are short-term debt obligations issued in the margin. The running glossary in the
money market instruments. by governments and corporations. Money market funds were introduced in the early 1970s margin helps students quickly review the
and have grown tremendously. At the end of 2006, about 850 money market funds managed basic terminology for the chapter.
almost $2.3 trillion in assets. All money market funds are open-end funds.

Most money market funds invest in high-quality low-risk instruments with maturities

jor82353_ch04.indd 105 8/9/08 10:38:30 AM

Web Addresses www MONEY MARKET FUND ACCOUNTING A unique feature of money market funds is
Visit that their net asset values are always $1 per share. This is purely an accounting gimmick,
jor82353_ch04.indd W105 eb sites are called out in the margins, www.mfea.com however. A money market fund simply sets the number of shares equal to the fund’s assets.
along with a notation of how they relate to for info on thousands of In oth8e/9r/0w8 o1r0d:3s8:,30ifAMthe fund has $100 million in assets, then it has 100 million shares. As the
the chapter material. funds, including MMMFs. fund earns interest on its investments, the fund owners are simply given more shares.

The reason money market mutual funds always maintain a $1 net asset value is to
make them resemble bank accounts. As long as a money market fund invests in very safe,

jor82353_ch04.indd 105 8/9/08 10:38:30 AM

INVESTMENT UPDATES Investment Updates

GET A FRESH ANGLE ON YOUR FINANCES These boxed readings, reprinted from various
business press sources, provide additional real-
Not sure whether you’re saving enough or whether you high-quality corporate bonds, municipals, money-market world events and examples to illustrate the
have the right investment mix? To get a better handle on funds, and savings accounts. But don’t stop there. material in the chapter. Some articles from the
your portfolio, it sometimes helps to look at your finances past two years highlight very recent events,
from another angle. I would expand the list to include Social Security and others present events of more historical
retirement benefits, pension income, mortgage debt, significance.
1 How Much Do You Need in and any other loans you have. After all, you regularly
Conservative Investments to Feel Safe? receive income from Social Security and your pension,
just as you would from a bond. Meanwhile, your debts
Investment advisers and Wall Street firms constantly involve making regular payments to other folks.
exhort investors to consider their risk tolerance. For
instance, we are often prodded to fill out those irritating All these dealings affect your sense of financial secu-
questionnaires where we are asked whether our goal is rity, and they should influence how you structure your
“growth” or “capital preservation.” portfolio. For instance, if you expect a traditional com-
pany pension when you retire, you effectively have a
The answer, of course, is that we want both. Even huge position in bonds and thus you might want to load
retirees need growth from their portfolios. Even freshly up on stocks in your investment portfolio.
minted college graduates hanker after some stability.
On the other hand, if you have a heap of debts, your
My advice: Forget risk tolerance. Instead, divide your financial position is much more precarious and you may
portfolio into two parts Designate one portion for “get- want to take less risk with your investments. On that

id t hi h b bl i

xxiii

Work the Web WORK THE WEB

Various screenshots appear throughout the Here is a stock quote and an option chain for Starbucks Corp. (SBUX) from Yahoo! Finance (finance.yahoo.com).
text. These exercises illustrate how to ac-
cess specific features of selected Web sites
in order to expand students’ knowledge of
current investment topics.

EXAMPLE 10.1 Calculating Straight Bond Prices Numbered Examples

Suppose a bond has 20 years to maturity and a coupon rate of 8 percent. The bond’s Example boxes are integrated throughout the
yield to maturity is 7 percent. What’s the price?
chapters to reinforce the content and demonstrate
In this case, the coupon rate is 8 percent and the face value is $1,000, so the annual
coupon is $80. The bond’s price is calculated as follows:

1. Present value of semiannual coupons:

΄ ΅_$_8_0_ to students how to apply what they’ve learned.

.07
1 ؊ ____1____ ‫ ؍‬$854.20289
(1.035)40

2. Present value of $1,000 principal: Each example displays an intuitive or mathemati-

_$_1__,0_0__0_ ‫؍‬ $252.57247 cal application in a step-by-step format. There is
(1.035)40

The bond’s price is the sum of coupon and principal present values: enough detail in the explanations so that the stu-

Bond price ‫ ؍‬$854.20 ؉ $252.57 ‫ ؍‬$1,106.77

This bond sells for $1,106.77. dent doesn’t have to look elsewhere for additional
Straight bond prices may be calculated using a built-in spreadsheet function. An
information.
example of how to use an Excel™ spreadsheet to calculate a bond price is shown in
the nearby Spreadsheet Analysis box. 8/9/08 11:44:34 AM

jor82353_ch15.indd 470

Spreadsheet Analysis SPREADSHEET ANALYSIS

Self-contained spreadsheet examples show students 1 A B C D E F GH
how to set up spreadsheets to solve problems—a 2
vital part of every business student’s education. 3 Calculating the Price of a Coupon Bond
4
jor82353_ch10.indd 317 5 A Treasury bond traded on March 30, 2008 matures in 20 years on March 30, 2028.
6 Assuming an 8 percent coupon rate and a 7 percent yield to maturity, what is the
7 price of this bond?
8 Hint: Use the Excel function PRICE.
9
10 $110.6775 = PRICE("3/30/2008","3/30/2028",0.08,0.07,100,2,3)
11
12 For a bond with $1,000 face value, multiply the price by 10 to get $1,106.78.
13
14 This function uses the following arguments:
15
16 =PRICE("Now","Maturity", Coupon,Yield,100,2,3)
17
18 The 100 indicates redemption value as a percent of face value.
19 The 2 indicates semi-annual coupons.
20 The 3 specifies an actual day count with 365 days per year.
8/9/08 11:12:44 2AM1

xxiv

jor82353_ch10.indd 317 8/9/08 11:12:44 AM

Numbered Equations American put option price Ն MAX[K ؊ S, 0] (15.4)

Key equations are highlighted and numbered se- EUROPEAN CALLS Because European options cannot be exercised before expiration, we
quentially. For easy reference, a new appendix at cannot use the arbitrage strategies that we used to set lower bounds for American options.
the end of the book lists these key equations by We must use a different approach (which can be found in many textbooks that focus on op-
chapter. tions). It turns out that the lower bound for a European call option is greater than its intrinsic
value.

European call option price Ն MAX[S ؊ K/(1 ؉ r)T, 0] (15.5)

EUROPEAN PUTS The lower bound for a European put option price is less than its intrin-
sic value. In fact, in-the-money European puts will frequently sell for less than their intrinsic
value. How much less? Using an arbitrage strategy that accounts for the fact that European
put options cannot be exercised before expiration, the lower bound for a European put
option is:

European put option price Ն MAX[K/(1 ؉ r)T – S, 0] (15.6)

To give you some intuition, let’s look at an extreme case. Suppose the stock price falls to
zero before expiration and there is absolutely no chance that the stock price will recover
before expiration American put holders would immediately exercise their puts because it is

FIGURE 1.9 The Normal Distribution: Illustrated Returns Based on the Historical Figures and Tables
Return and Standard Deviation for a Portfolio of Large-Company
Common Stocks This text makes extensive use of real data and
presents them in various figures and tables.
Probability Explanations in the narrative, examples, and
end-of-chapter problems refer to many of these
68% exhibits.

95% Return on 8/9/08 11:44:52 AM
Ͼ99% large-company
common stocks
Ϫ3␴ Ϫ2␴ Ϫ1␴ 0 ϩ1␴ ϩ2␴ ϩ3␴

Ϫ48.0% Ϫ27.9% Ϫ7.8% 12.3% 32.4% 52.5% 72.6%

jor82353_ch15.indd 493

Summary and 3.6 Summary and Conclusions
Conclusions
In this chapter we examine the basic types of financial assets. We discuss three broad classes:
Each chapter ends with a summary that interest-bearing assets, equity securities, and derivative assets—futures and options. For
highlights the important points of the chap- each of the broad classes, we ask three questions. First, what is its basic nature and what
ter. This provides a handy checklist for stu- are its distinguishing characteristics? Second, what are the potential gains and losses from
dents when they review the chapter. owning it? Third, how are its prices quoted online and in the financial press? We cover many
aspects of these investments. We provide a brief description of these investments broken
jor82353_ch01.indd 21 down by the chapter’s important concepts.

1. Various types of interest-bearing assets.

A. Each of these major groups can be further subdivided. Interest-bearing assets include
money market instruments and fixed-income securities.

B. Money market instruments generally have the following two properties: (1) they are
essentially IOUs sold by large corporations or governments to borrow money; and
(2) they mature in less than one year from the time they are sold, meaning that the loan
must be repaid within one year.

C Fixed-income securities are securities that promise to make fixed payments according

xxv

8/9/08 10:24:07 AM

Get Real! GET REAL

For instructors looking to give their students This chapter added to your understanding of put and call options by covering the
a taste of what it means to be an invest- rights, obligations, and potential gains and losses involved in trading options. How
ment manager, this feature (at the end of should you put this information to work? You need to buy and sell options to experi-
each chapter) acts as a first step by explain- ence the gains and losses that options can provide. So, with a simulated brokerage
ing to students how to apply the material account (such as Stock-Trak), you should first execute each of the basic option trans-
they just learned. The Get Real boxes en- actions: buy a call, sell a call, buy a put, and sell a put.
courage students—whether for practice in a
trading simulation, or with real money—to For help getting started, you can find an enormous amount of information about-
make investment decisions, and they also options on the Internet. Useful places to start are the options exchanges: Chicago
give some helpful tips to keep in mind. Board Options Exchange (www.cboe.com), American Stock Exchange (www.amex.
com), Pacific Stock Exchange (www.pacificex.com), and Philadelphia Stock Exchange
(www.phlx.com). Excellent Web sites devoted to options education are the Options
Industry Council (www.optionscentral.com) and the Options Clearing Corporation
(www.optionsclearing.com). You might also look at the options section of Trading
Markets (www.tradingmarkets.com) or Investor Links (www.investorlinks.com).

For information on option trading strategies, try entering the strategy name into
an Internet search engine. For example, enter the search phrases “covered calls” or
“protective puts” for online information about those strategies. For more general
information, try the search phrase “options trading strategies” to find sites like Com-
modity World (www.commodityworld.com). For a sales pitch on writing covered calls,
check out Write Call (www.writecall.com).

If you’re having trouble understanding options ticker symbols, don’t feel alone be-
cause almost everyone has trouble at first. For help on the net, try the search phrases
“option symbols” or “options symbols” to find sites like www.optionscentral.com. Of
course, the options exchanges listed above also provide complete information on the
option ticker symbols they use.

jor82353_ch15.indd 499 8/9/08 11:44:56 AM

Chapter Review Problems and Self-Test Chapter Review Problems
and Self-Test
1. Call Option Payoffs You purchase 25 call option contracts on Blue Ox stock. The strike
price is $22, and the premium is $1. If the stock is selling for $24 per share at expiration, Students are provided with one to three
what are your call options worth? What is your net profit? What if the stock were selling practice problems per chapter with worked-
for $23? $22? out solutions to test their abilities in solving
key problems related to the content of the
2. Stock versus Options Stock in Bunyan Brewery is currently priced at $20 per share. A call chapter.
option with a $20 strike and 60 days to maturity is quoted at $2. Compare the percentage gains
and losses from a $2,000 investment in the stock versus the option in 60 days for stock prices
of $26, $20, and $18.

3. Put-Call Parity A call option sells for $8. It has a strike price of $80 and six months until
expiration. If the underlying stock sells for $60 per share, what is the price of a put option with
an $80 strike price and six months until expiration? The risk-free interest rate is 6 percent per
year.

Answers to Self-Test Problems

1. Blue Ox stock is selling for $24. You own 25 contracts, each of which gives you the right to
buy 100 shares at $22. Your options are thus worth $2 per share on 2,500 shares, or $5,000.
The option premium was $1, so you paid $100 per contract, or $2,500 total. Your net profit
is $2,500. If the stock is selling for $23, your options are worth $2,500, so your net profit is
exactly zero. If the stock is selling for $22, your options are worthless, and you lose the entire
$2,500 you paid.

2. Bunyan stock costs $20 per share, so if you invest $2,000, you’ll get 100 shares. The option
premium is $2, so an option contract costs $200. If you invest $2,000, you’ll get $2,000/$200 ϭ
10 contracts. If the stock is selling for $26 in 60 days, your profit on the stock is $6 per share, or
$600 total. The percentage gain is $600/$2,000 ϭ 30%.
In this case your options are worth $6 per share or $600 per contract You have 10 contracts

xxvi

Test Your IQ IQ Test Your Investment Quotient

An average of 15 multiple-choice questions For the remaining questions and problems, the circled numbers in the margin refer to the
are included for each chapter, many of corresponding learning objective in this chapter.
which are taken from past CFA exams. This 2 1. Balance Sheet Assets White Company assets as of December 31, 2007:
text is unique in that it is the only text that
presents CFA questions in multiple-choice Cash and cash equivalents $ 150
format—which is how they appear on the Operating assets $1,190
actual exam. Answers to these questions Property, plant, and equipment $1,460
appear in Appendix A. Total assets $2,800

White Co. experienced the following events in 2008:

Old equipment that cost $120 and that was fully depreciated was scrapped

Depreciation expense was $125

Cash payments for new equipment were $200

Based on the information above, what was White Co.’s net amount of property, plant, and
equipment at the end of 2008?

a. $1,415
b. $1,535
c. $1,655
d. $1,660

2 2. Cash Flow Cash flow per share is calculated as
a. Net cash flow/Shares outstanding.
b. Operating cash flow/Shares outstanding.
c. Investing cash flow/Shares outstanding.
d. Financing cash flow/Shares outstanding.

2 3 Cash Flow Which of the following is not an adjustment to net income used to obtain operat

Concept Questions Concept Questions

1 1. Money Market Instruments What are the distinguishing features of a money market instrument? At the end of every chapter are 10 to 15 concept
questions that further reinforce key concepts 8/9/08 11:51:55 AM
2 2. Preferred Stock Why is preferred stock “preferred”? jor82353_ch17.indd 573 found throughout the chapter.
3. WSJ Stock Quotes What is the PE ratio reported for stocks in The Wall Street Journal? In

2 particular, how is it computed?

1 4. Yields The current yield on a bond is the coupon rate divided by the price. Thus, it is very
similar to what number reported for common and preferred stocks?

Questions and Problems Questions and Problems

jor82353_ch03.indd 92 A variety of problems (average of 20 per chapter) are Core Q8/u9/e0s8tio1n0s:31:13 A2M 1. Stock Quotations You found the following stock quote for DRK Enterprises, Inc., at your
included in each chapter to test students’ understanding favorite Web site. You also find that the stock paid an annual dividend of $0.86, which resulted
of the conceptual and mathematical elements. Each prob- in a dividend yield of 1.30 percent. What was the closing price for this stock yesterday? How
lem is labeled with the subject and the level—core or many round lots of stock were traded yesterday?
intermediate. Selected answers appear in Appendix B, and
complete solutions are included in the Instructor Web site. DAILY YTD 52 WEEK

Company Symbol Vol Close Chg %Chg %Chg High Low %Chg
DRK Enterprises DRK
18,649,130 ?? 0.26 Ϫ0.39% 8.73% 78.19 51.74 27.4%

S&P Problems S&P Problems

www.mhhe.com/edumarketinsight Now included in the end-of-chapter mate-
1. Industry Comparison On the Market Insight Home Page, follow the “Industry” link to go to rial are problems directly incorporating the
the industry home page. The drop down menu allows you to select different industries. Answer Educational Version of Market Insight, a ser-
the following questions for these industries: Air Freight & Logistics, Apparel Retail, Department vice based on Standard & Poor’s renowned
Stores, Electric Utilities, Home Improvement Retail, Investment Banking & Brokerage, and Compustat database. These problems pro-
Regional Banks. vide an easy method of including current
a. How many companies are in each industry? real-world data in the course.
b. What are the total sales in each industry?
c. Do the industries with the largest total sales have the most companies in the industry? 8/9/08 10:31:14 AM
What does this tell you about competition in the various industries?

Chapter 1 ■ A Brief History of Risk and Return 35

jor82353_ch03.indd 93

jor82353_ch01.indd 35 8/9/08 10:24:19 AM xxvii

What’s on the Web? What’s on the Web?

These end-of-chapter activities show students 1. Ticker Symbols Go to finance.yahoo.com and look up the ticker symbols for the following
how to use and learn from the vast amount of companies: 3M Company, International Business Machines, Dell Computer, Advanced Micro
financial resources available on the Internet. Devices, American Standard Company, and Bed, Bath & Beyond.

2. Average Return and Standard Deviation Go to finance.yahoo.com and enter the ticker
symbol for your favorite stock. Now, look for the historical prices and find the monthly closing
stock price for the last six years. Calculate the annual arithmetic average return, the standard
deviation, and the geometric return for this period.

Stock-Trak Exercises Stock-Trak Exercises

To access the Stock-Trak Exercise for this chapter, please visit the book Web site at Unique to this text! This text is the only book
www.mhhe.com/jm5e and choose the corresponding chapter. that incorporates Stock-Trak Portfolio Simula-
tions® exercises. Stock-Trak is one of the most
jor82353_ch01.indd 36 successful trading simulations with over 30,000
college students having trading accounts each
semester (see Supplements for more informa-
tion). Go to the next level in teaching your
students about investments management by
encouraging your students to use this product.
Chapters with Stock-Trak Exercises will have the
logo and the URL for the book’s Web site. The
actual exercise and questions related to the
chapter will be presented in both the Student
and Instructor portions of the Web site. Instruc-
tors and Students must be registered for Stock-
Trak in order to make trades (see the Supple-
ment Section of the Preface or the insert card
for more information).

8/9/08 10:24:20 AM

8/9/08 10:24:20 AM

xxviii

Resources

Teaching and Learning Supplements

We have developed a number of supplements for both teaching and learning to accompany
this text. Each product has been significantly revised for the fifth edition.

For Instructors

Instructor’s Resource CD-ROM
ISBN 0-07-3363804
The Instructor’s Resource CD-ROM contains the following assets:

PowerPoint Presentation, prepared by Thomas W. Miller Jr., Saint Louis
University
This product, created by one of the authors, contains over 300 slides with lecture
outlines, examples, and images and tables from the text.
Instructor’s Manual, prepared by Scott Beyer, University of Wisconsin, Oshkosh
Developed to clearly outline the chapter material as well as provide extra teaching
support, the first section of the Instructor’s Manual includes an annotated outline of
each chapter with suggested Web sites, references to PowerPoint slides, teaching
tips, additional examples, and current events references.
Solutions Manual, Prepared by Joe Smolira, Belmont University
The Solutions Manual contains the complete worked-out solutions for the end-of-
chapter questions and problems.
Test Bank, prepared by Kay Johnson, Penn State University–Erie
With almost 1,500 questions, this Test Bank, in Microsoft Word, provides a variety
of question formats (true-false, multiple choice, fill-in-the-blank, and problems) and
levels of difficulty to meet any instructor’s testing needs.
Computerized Test Bank (Windows) This computerized version of the Test Bank
utilizes McGraw-Hill’s EZ Test testing software to quickly create customized exams.
This user-friendly program allows instructors to sort questions by format; edit exist-
ing questions or add new ones; and scramble questions for multiple versions of the
same test.
Videos ISBN 0-07-3363790 (DVD format)
The McGraw-Hill/Irwin series of finance videos are 10-minute case studies on topics
such as Financial Markets, Stocks, Bonds, Portfolio Management, Derivatives, and Going
Public.

Digital Solutions

Online Learning Center (OLC):
Online Support at www.mhhe.com/jm5e
The Online Learning Center (OLC) contains FREE access to additional Web-based study
and teaching aids created for this text, such as:

xxix

Student Support

New! Student-Narrated PowerPoints created by Lynn Phillips Kugele, The University
of Mississippi.

Students all learn differently and these chapter PowerPoints were created with that
rationale in mind. The interactive presentations provide detailed examples demonstrat-
ing how to solve key problems from the text. The slides are accompanied by an audio
narration. They can be purchased as part of the premium content package available for
$10 and then viewed online or uploaded onto an iPod.

Excel Templates

Corresponding to most end-of-chapter problems, each template allows the student to
work through the problem using Excel, reinforcing each concept. Each end-of-chapter
problem with a template is indicated by an Excel icon in the margin beside it.

Self-Study Chapter Quizzes

Quizzes consist of 10–15 multiple-choice questions on various chapter topics. They
reveal a score instantly and provide feedback to help students study.

Other Features

Be sure to check out the other helpful features found on the OLC including key-term
flashcards, helpful Web links, and more!

Teaching Support
Along with having access to all of the same material your students can view on the book’s
OLC, you also have password-protected access to the Instructor’s Manual, Solutions to end-
of-chapter problems, Instructor’s PowerPoint, Excel Template Solutions, Video clips, and
Video projects and questions.

OLCs can be delivered in multiple ways—through the textbook Web site (www.mhhe
.com/jm5e), through PageOut (see Packages below), or within a course management system
like Blackboard, WebCT, TopClass, or eCollege. Ask your campus representative for more
details.

PageOut at www.pageout.net
Free to adopters, this Web page generation software is designed to help you create your own
course Web site, without all of the hassle. In just a few minutes, even the most novice com-
puter user can have a functioning course Web site.

Simply type your material into the template provided and PageOut instantly converts it
to HTML. Next, choose your favorite of three easy-to-navigate designs and your class Web
home page is created, complete with online syllabus, lecture notes, and bookmarks. You can
even include a separate instructor page and an assignment page.

PageOut offers enhanced point-and-click features, including a Syllabus Page that applies
a real-world link to original text material, an automatic grade book, and a discussion board
where you and your students can exchange questions and post announcements. Ask your
campus representative to show you a demo.

Additional Resources Packaged with Your New Text

Stock-Trak Portfolio Simulation
Give your students investment management experience! McGraw-Hill/Irwin has partnered
with Stock-Trak and is providing a free subscription to the Stock-Trak Portfolio Simulation
for one semester with the purchase of every new copy of Fundamentals of Investments:
Valuation and Management, Fifth Edition by Jordan and Miller. Stock-Trak gives students
$500,000 and allows them to trade stocks, options, futures, bonds, mutual funds, and inter-
national stocks—no other simulation offers all these types of securities! More than 600 pro-
fessors have used this service, and around 30,000 college students each semester participate.
All trades are done on the Web at www.stocktrak.com/cj. See this site for more information
or use the Stock-Trak card bound into this text. Stock-Trak exercises are available on the
book Web site, www.mhhe.com/jm5e.

xxx

Standard & Poor’s Educational Version of Market Insight
McGraw-Hill/Irwin and the Institutional Market Services division of Standard & Poor’s
are pleased to announce an exclusive partnership that offers instructors and students free
access to the educational version of Standard & Poor’s Market Insight with each new
textbook. The Educational Version of Market Insight is a rich online resource that pro-
vides six years of fundamental financial data for more than 1,000 companies in the data-
base. S&P-specific problems can be found at the end of almost all chapters in this text. For
more details, please see the bound-in card inside the front cover of this text, or visit www
.mhhe.com/edumarketinsight.

xxxi

Brief Contents

PART ONE Introduction 1 12. Return, Risk, and the Security Market
Line 380
1. A Brief History of Risk and Return 1
2. Buying and Selling Securities 37 13. Performance Evaluation and Risk
3. Overview of Security Types 71 Management 413
4. Mutual Funds 96
PART FIVE Futures and Options 436

PART TWO Stock Markets 133 14. Futures Contracts 436
15. Stock Options 467
5. The Stock Market 133
6. Common Stock Valuation 166 PART SIX Topics in Investments 508
7. Stock Price Behavior and Market
16. Option Valuation 508
Efficiency 207 17. Projecting Cash Flow and Earnings 545
8. Behavioral Finance and the Psychology of 18. Corporate Bonds 581
19. Government Bonds 613
Investing 240 20. Mortgage-Backed Securities (Web site only )

PART THREE Interest Rates and Bond APPENDIXES
Valuation 277
A Answers to Test Your Investment Quotient
9. Interest Rates 277 Questions 643
10. Bond Prices and Yields 314
B Answers to Selected Questions and
PART FOUR Portfolio Problems 647
Management 349
C Key Equations 649
11. Diversification and Risky Asset
Allocation 349 Index 653

xxxii

Contents

PART ONE Introduction 1 Investor Protection 39
Broker–Customer Relations 40
1. A Brief History of Risk and Return 1 2.2 Brokerage Accounts 40
Cash Accounts 40
1.1 Returns 2 Margin Accounts 40
Annualizing Returns on a Margin
Dollar Returns 2 Purchase 45
Hypothecation and Street Name
Percentage Returns 4 Registration 45
Other Account Issues 46
A Note on Annualizing Returns 6 2.3 Short Sales 47
Basics of a Short Sale 47
1.2 The Historical Record 7 Short Sales: Some Details 48
2.4 Investor Objectives, Constraints,
A First Look 8 and Strategies 54
Risk and Return 54
A Longer Range Look 9 Investor Constraints 54
Strategies and Policies 56
A Closer Look 9 2.5 Forming an Investment Portfolio 61
Some Risk Tolerance Scores 61
1.3 Average Returns: The First Lesson 12 Risk and Return 61
Investor Constraints 62
Calculating Average Returns 12 Strategies and Policies 62
REITS 63
Average Returns: The Historical Record 14 2.6 Summary and Conclusions 63

Risk Premiums 16 Overview of Security Types 71
3.1 Classifying Securities 72
The First Lesson 16 3.2 Interest-Bearing Assets 72

1.4 Return Variability: The Second Lesson 17 Money Market Instruments 72
Fixed-Income Securities 73
Frequency Distributions and Variability 17 3.3 Equities 76
Common Stock 76
The Historical Variance and Standard Preferred Stock 76
Deviation 17 Common Stock Price Quotes 77
3.4 Derivatives 82
The Historical Record 19 Futures Contracts 82

Normal Distribution 20

The Second Lesson 21

1.5 More on Average Returns 24

Arithmetic versus Geometric Averages 24

Calculating Geometric Average Returns 24 3.

Arithmetic Average Return or Geometric
Average Return? 26

1.6 Risk and Return 27

The Risk-Return Trade-Off 27

A Look Ahead 28

1.7 Summary and Conclusions 28

2. Buying and Selling Securities 37
2.1 Getting Started 38
Choosing a Broker 38
Online Brokers 39

xxxiii

Futures Price Quotes 83 The Closed-End Fund Discount
Gains and Losses on Futures Contracts 84 Mystery 119
3.5 Option Contracts 85 Exchange-Traded Funds 120
Option Terminology 85 Hedge Funds 123
Options versus Futures 86 4.9 Summary and Conclusions 126

Option Price Quotes 86 PART TWO Stock Markets 133
Gains and Losses on Option Contracts 88

Investing in Stocks versus Options 88 5. The Stock Market 133
3.6 Summary and Conclusions 89 5.1 Private Equity Versus Selling Securities to

4. Mutual Funds 96 the Public 134
Private Equity 134
4.1 Advantages and Drawbacks of Mutual Fund Venture Capital 134
Investing 97

Advantages 97 Selling Securities to the Public 135

Drawbacks 97 The Primary Market for Common Stock 135

4.2 Investment Companies and Fund The Secondary Market for Common
Types 98 Stock 137

Open-End versus Closed-End Funds 98 Dealers and Brokers 139

Net Asset Value 99 5.2 The New York Stock Exchange 140

4.3 Mutual Fund Operations 100 NYSE Membership 140

Mutual Fund Organization and Types of NYSE Members 140

Creation 100 The NYSE Hybrid Market 141

Taxation of Investment Companies 101 NYSE-Listed Stocks 141

The Fund Prospectus and Annual 5.3 Operation of the New York Stock
Report 101 Exchange 142

4.4 Mutual Fund Costs and Fees 101 NYSE Floor Activity 142

Types of Expenses and Fees 101 Special Order Types 143

Expense Reporting 103 5.4 NASDAQ 147

Why Pay Loads and Fees? 105 NASDAQ Operations 147

4.5 Short-Term Funds 105 NASDAQ Participants 149

Money Market Mutual Funds 105 5.5 NYSE and NASDAQ Competitors 149

Money Market Deposit Accounts 106 5.6 Stock Market Information 150

4.6 Long-Term Funds 107 The Dow Jones Industrial Average 151

Stock Funds 107 Stock Market Indexes 152

Taxable and Municipal Bond Funds 109 More on Price-Weighted Indexes 156

Stock and Bond Funds 110 The Dow Jones Divisors 156

Mutual Fund Objectives: Recent More on Index Formation: Base-Year
Developments 111 Values 157

4.7 Mutual Fund Performance 113 5.7 Summary and Conclusions 158

Mutual Fund Performance Information 113 6. Common Stock Valuation 166
6.1 Security Analysis: Be Careful Out
How Useful Are Fund Performance
Ratings? 116 There 167
6.2 The Dividend Discount Model 167
Closed Funds 117
Constant Perpetual Growth 168
4.8 Closed-End Funds, Exchange-Traded Historical Growth Rates 170
Funds, and Hedge Funds 118 The Sustainable Growth Rate 172

Closed-End Funds Performance
Information 118

xxxiv Contents

6.3 The Two-Stage Dividend Growth 7.9 Market Efficiency and the Performance of
Model 175 Professional Money Managers 220

Nonconstant Growth in the First 7.10 Anomalies 223
Stage 178 The Day-of-the-Week Effect 223
Discount Rates for Dividend Discount The Amazing January Effect 223
Models 180 Turn-of-the-Year Effect 226
Observations on Dividend Discount Turn-of-the-Month Effect 226
Models 180 The Earnings Announcement Puzzle 227
6.4 The Residual Income Model 181 The Price-Earnings (P/E) Puzzle 227
Residual Income 181
The RIM versus the Constant Growth 7.11 Bubbles and Crashes 227
DDM 182 The Crash of 1929 227
6.5 Price Ratio Analysis 183 The Crash of October 1987 228
Price-Earnings Ratios 183 The Asian Crash 230
Price-Cash Flow Ratios 184 The “Dot-Com” Bubble and Crash 230
Price-Sales Ratios 187
7.12 Summary and Conclusions 232

Price-Book Ratios 187 8. Behavioral Finance and the Psychology of
Applications of Price Ratio Analysis 187 Investing 240
6.6 An Analysis of the McGraw-Hill 8.1 Introduction to Behavioral Finance 241
Company 188 8.2 Prospect Theory 241
Using the Dividend Discount Model 189 Frame Dependence 242
Using the Residual Income Model 189 Mental Accounts and Loss Aversion 242
Using Price Ratio Analysis 192 House Money 244
6.7 Summary and Conclusions 194 8.3 Overconfidence 245

7. Stock Price Behavior and Market Overconfidence and Trading
Efficiency 207 Frequency 245

7.1 Introduction to Market Efficiency 208 Overtrading and Gender: “It’s (Basically)
7.2 What Does “Beat the Market” a Guy Thing” 245
What Is a Diversified Portfolio to the
Mean? 208 Everyday Investor? 245
7.3 Foundations of Market Efficiency 208 8.4 Misperceiving Randomness and
7.4 Forms of Market Efficiency 209 Overreacting to Chance Events 246
7.5 Why Would a Market Be Efficient? 210 The “Hot-Hand” Fallacy 246
7.6 Some Implications of Market The Gambler’s Fallacy 249
8.5 Sentiment-Based Risk and Limits to
Efficiency 211 Arbitrage 251
Does Old Information Help Predict Future Limits to Arbitrage 251
Stock Prices? 211 The 3Com/Palm Mispricing 251
Random Walks and Stock Prices 211 The Royal Dutch/Shell Price Ratio 252
How Does New Information Get into Stock
Prices? 212

Event Studies 212 8.6 Technical Analysis 253

7.7 Informed Traders and Insider Trading 215 Why Does Technical Analysis Continue to
Informed Trading 215 Thrive? 253
Insider Trading 215 Dow Theory 254
Elliott Waves 255
7.8 How Efficient Are Markets? 217 Support and Resistance Levels 255
Are Financial Markets Efficient? 217 Technical Indicators 256
Some Implications of Market Relative Strength Charts 258
Efficiency 219

Contents xxxv

Charting 259 Coupon Rate and Current Yield 315
Fibonacci Numbers 264 10.2 Straight Bond Prices and Yield to
Other Technical Indicators 265
8.7 Summary and Conclusions 267 Maturity 316
Straight Bond Prices 316
PART THREE Interest Rates and Bond Premium and Discount Bonds 318
Valuation 277 Relationships among Yield Measures 319
A Note on Bond Price Quotes 320
9. Interest Rates 277 10.3 More on Yields 322
9.1 Interest Rate History and Money Market Calculating Yields 322
Rates 278 Yield to Call 323
Interest Rate History 278 10.4 Interest Rate Risk and Malkiel’s
Money Market Rates 280 Theorems 325
9.2 Money Market Prices and Rates 283 Promised Yield and Realized Yield 325
Bank Discount Rate Quotes 283 Interest Rate Risk and Maturity 325
Treasury Bill Quotes 284 Malkiel’s Theorems 326
Bank Discount Yields versus Bond 10.5 Duration 329
Equivalent Yields 286 Macaulay Duration 329
Bond Equivalent Yields, APRs, Modified Duration 329
and EARs 288 Calculating Macaulay Duration 330
9.3 Rates and Yields on Fixed-Income Properties of Duration 332
Securities 290 10.6 Bond Risk Measures Based on
The Treasury Yield Curve 290 Duration 333
Rates on Other Fixed-Income Dollar Value of an 01 333
Investments 290 Yield Value of a 32nd 333
9.4 The Term Structure of Interest Rates 294 10.7 Dedicated Portfolios and Reinvestment
Treasury STRIPS 294 Risk 334
Yields for U.S. Treasury STRIPS 296 Dedicated Portfolios 334
9.5 Nominal versus Real Interest Rates 297 Reinvestment Risk 335
Real Interest Rates 297 10.8 Immunization 337
The Fisher Hypothesis 297 Price Risk versus Reinvestment Rate
Inflation-Indexed Treasury Securities 298 Risk 337
9.6 Traditional Theories of the Term Immunization by Duration Matching 338
Structure 301 Dynamic Immunization 338
Expectations Theory 301 10.9 Summary and Conclusions 339
Maturity Preference Theory 302
Market Segmentation Theory 303 PART FOUR Portfolio
9.7 Determinants of Nominal Interest Rates: Management 349
A Modern Perspective 303
Problems with Traditional Theories 303 11. Diversification and Risky Asset
Modern Term Structure Theory 304 Allocation 349
Liquidity and Default Risk 305 11.1 Expected Returns and Variances 350
9.8 Summary and Conclusions 306 Expected Returns 350
Calculating the Variance of Expected
10. Bond Prices and Yields 314 Returns 352
10.1 Bond Basics 315 11.2 Portfolios 353
Straight Bonds 315 Portfolio Weights 353

xxxvi Contents

Portfolio Expected Returns 353 12.7 Extending CAPM 401

Portfolio Variance of Expected Returns 355 A (Very) Brief History of Testing
11.3 Diversification and Portfolio Risk 356 CAPM 401

The Effect of Diversification: Another The Fama-French Three-Factor
Lesson from Market History 356 Model 402
The Principle of Diversification 357
12.8 Summary and Conclusions 403

11.4 Correlation and Diversification 360 13. Performance Evaluation and Risk
Why Diversification Works 360 Management 413

Calculating Portfolio Risk 362 13.1 Performance Evaluation 414

The Importance of Asset Allocation, Performance Evaluation Measures 414
Part 1 363 The Sharpe Ratio 415
The Treynor Ratio 415
More on Correlation and the Risk-Return Jensen’s Alpha 416
Trade-Off 365 13.2 Comparing Performance Measures 417
Sharpe-Optimal Portfolios 419
11.5 The Markowitz Efficient Frontier 367

The Importance of Asset Allocation,
Part 2 367

11.6 Summary and Conclusions 370 13.3 Investment Risk Management 422

Value-at-Risk 423

12. Return, Risk, and the Security Market 13.4 More on Computing Value-at-Risk 426

Line 380 13.5 Summary and Conclusions 428

12.1 Announcements, Surprises, and Expected

Returns 381 PART FIVE Futures and Options 436

Expected and Unexpected Returns 381

Announcements and News 381 14. Futures Contracts 436

12.2 Risk: Systematic and Unsystematic 383 14.1 Futures Contracts Basics 437

Systematic and Unsystematic Risk 383 Modern History of Futures
Trading 437
Systematic and Unsystematic Components
of Return 384 Futures Contract Features 438

12.3 Diversification, Systematic Risk, and Futures Prices 439
Unsystematic Risk 385 14.2 Why Futures? 443
Diversification and Unsystematic
Risk 385 Speculating with Futures 443
Diversification and Systematic Risk 385 Hedging with Futures 444
14.3 Futures Trading Accounts 448
12.4 Systematic Risk and Beta 386 14.4 Cash Prices versus Futures Prices 450
The Systematic Risk Principle 386 Cash Prices 450
Measuring Systematic Risk 386 Cash-Futures Arbitrage 450
Portfolio Betas 388 Spot-Futures Parity 452
More on Spot-Futures Parity 453
12.5 The Security Market Line 389 14.5 Stock Index Futures 453
Beta and the Risk Premium 389 Basics of Stock Index Futures 453
The Reward-to-Risk Ratio 390 Index Arbitrage 454
The Basic Argument 390 Hedging Stock Market Risk with
The Fundamental Result 392 Futures 455
The Security Market Line 394 Hedging Interest Rate Risk with
Futures 456
12.6 More on Beta 396
A Closer Look at Beta 397

Where Do Betas Come From? 398 Futures Contract Delivery Options 457

Why Do Betas Differ? 400 14.6 Summary and Conclusions 458

Contents xxxvii

15. Stock Options 467 16.2 The One-Period Binomial Option Pricing
15.1 Options on Common Stocks 468 Model 510
Option Basics 468
Option Price Quotes 469 The One-Period Binomial Option Pricing
Stock Option Ticker Symbols 471 Model—The Assumptions 510
15.2 The Options Clearing Corporation 472
15.3 Why Options? 473 The One-Period Binomial Option Pricing
15.4 Stock Index Options 475 Model—The Setup 510
Index Options: Features and
Settlement 475 The One-Period Binomial Option Pricing
Index Option Price Quotes 476 Model—The Formula 511
15.5 Option “Moneyness” 478
15.6 Option Payoffs and Profits 479 What Is Delta? 513
Option Writing 479
Option Payoffs 479 16.3 The Two-Period Binomial Option Pricing
Option Payoff Diagrams 480 Model 513
Option Profit Diagrams 482
15.7 Using Options to Manage Risk 483 Step 1: Build a Price Tree for Stock Prices
The Protective Put Strategy 483 through Time 514
The Protective Put Strategy and Corporate
Risk Management 484 Step 2: Use the Intrinsic Value Formula
Using Call Options in Corporate Risk to Calculate the Possible Option Prices
Management 485 at Expiration 514
15.8 Option Trading Strategies 485
The Covered Call Strategy 486 Step 3: Calculate the Fractional Share
Spreads 486 Needed to Form Each Risk-Free Portfolio
Combinations 487 at the Next-to-Last Date 515
15.9 Option Intrinsic Value 489
15.10 Arbitrage and Option Pricing Step 4: Calculate All Possible Option Prices
Bounds 491 at the Next-to-Last Date 516
The Upper Bound for Call Option
Prices 491 Step 5: Repeat This Process by Working
The Upper Bound for Put Option Prices 491 Back to Today 516
The Lower Bounds for Call and Put
Option Prices 492 16.4 The Binomial Option Pricing Model with
15.11 Put-Call Parity 494 Many Periods 517
Put-Call Parity with Dividends 496
What Can We Do with Put-Call 16.5 The Black-Scholes Option Pricing
Parity? 496 Model 519
15.12 Summary and Conclusions 498
16.6 Varying the Option Price Input
PART SIX Topics in Investments 508 Values 522

16. Option Valuation 508 Varying the Underlying Stock Price 523

16.1 A Simple Model to Value Options before Varying the Option’s Strike Price 523
Expiration 509
Varying the Time Remaining until Option
Expiration 523

Varying the Volatility of the Stock Price 524

Varying the Interest Rate 524

16.7 Measuring the Impact of Stock Price
Changes on Option Prices 525

Interpreting Option Deltas 526

16.8 Hedging Stock with Stock Options 527

Hedging Using Call Options—The
Prediction 527

Hedging Using Call Options—The
Results 528

Hedging Using Put Options—The
Prediction 528

Hedging Using Put Options—The
Results 528

16.9 Hedging a Stock Portfolio with Stock Index
Options 529

xxxviii Contents

16.10 Implied Standard Deviations 531 Sinking Fund Provisions 594

CBOE Implied Volatilities for Stock Coupon Payment Provisions 594
Indexes 531 18.4 Protective Covenants 595
16.11 Employee Stock Options 532 18.5 Event Risk 596
ESO Features 533 18.6 Bonds without Indentures 598
ESO Repricing 533 18.7 Preferred Stock 598
ESOs at The Gap, Inc. 533 18.8 Adjustable-Rate Bonds 599
Valuing Employee Stock Options 534 18.9 Corporate Bond Credit Ratings 599
16.12 Summary and Conclusions 536
Why Bond Ratings Are Important 601

17. Projecting Cash Flow and Earnings 545 18.10 Junk Bonds 601
17.1 Sources of Financial Information 546 18.11 Bond Market Trading 604
17.2 Financial Statements 546 18.12 Summary and Conclusions 605
The Balance Sheet 547
19. Government Bonds 613

The Income Statement 549 19.1 Government Bond Basics 614

The Cash Flow Statement 550 19.2 U.S. Treasury Bills, Notes, Bonds, and
Performance Ratios and Price Ratios 551 STRIPS 614
17.3 Financial Statement Forecasting 553 Treasury Bond and Note Prices 618
The Percentage of Sales Approach 553 Treasury Inflation–Protected
The Pro Forma Income Statement 553 Securities 620
The Pro Forma Balance Sheet 555
Scenario One 556 19.3 U.S. Treasury Auctions 622
Scenario Two 558 19.4 U.S. Savings Bonds 623
Projected Profitability and Price Ratios 559
17.4 Starbucks Corporation Case Study 560 Series EE Savings Bonds 623
Pro Forma Income Statement 560 Series I Savings Bonds 624
Pro Forma Balance Sheet 562 19.5 Federal Government Agency Securities 624
Valuing Starbucks Using Ratio Analysis 568 19.6 Municipal Bonds 626
Valuing Starbucks Using a Two-Stage Municipal Bond Features 628
Residual Income Model 568 Types of Municipal Bonds 630
Valuing Starbucks: What Does the Market Municipal Bond Credit Ratings 631
Say? 570 Municipal Bond Insurance 632
19.7 Equivalent Taxable Yield 633
19.8 Taxable Municipal Bonds 634

17.5 Summary and Conclusions 570 19.9 Summary and Conclusions 635

18. Corporate Bonds 581 20. Mortgage-Backed Securities (Web site
18.1 Corporate Bond Basics 582 only) 20-1
18.2 Types of Corporate Bonds 583
18.3 Bond Indentures 584 20.1 A Brief History of Mortgage-Backed
Bond Seniority Provisions 586 Securities 20-2
Call Provisions 586
Put Provisions 589 20.2 Fixed-Rate Mortgages 20-2

Fixed-Rate Mortgage Amortization 20-3

Fixed-Rate Mortgage Prepayment and
Refinancing 20-6

Bond-to-Stock Conversion Provisions 589 20.3 Government National Mortgage
Association 20-10
Graphical Analysis of Convertible Bond
Prices 591 GNMA Clones 20-11

Bond Maturity and Principal Payment 20.4 Public Securities Association Mortgage
Provisions 593 Prepayment Model 20-11

Contents xxxix

20.5 Cash Flow Analysis of GNMA Fully APPENDIXES
Modified Mortgage Pools 20-13
A Answers to Test Your Investment Quotient
Macaulay Durations for GNMA Mortgage- Questions 643
Backed Bonds 20-15
B Answers to Selected Questions and
20.6 Collateralized Mortgage Obligations 20-17 Problems 647

Interest-Only and Principal-Only Mortgage C Key Equations 649
Strips 20-17
Index 653
Sequential Collateralized Mortgage
Obligations 20-19

Protected Amortization Class Bonds 20-21

20.7 Yields for Mortgage-Backed Securities and
Collateralized Mortgage Obligations 20-23

20.8 Summary and Conclusions 20-24

xl Contents

Fundamentals of Investments

VALUATION AND MANAGEMENT



CHAPTER 1

A Brief History of Risk
and Return

“All I ask is for the chance to prove that money can’t make me happy.“
–Spike Milligan

Learning Objectives Who wants to be a millionaire? Actually, anyone can retire as a millionaire. How?
Consider this: Suppose you, on your 25th birthday, invest $3,000. You have the disci-
To become a wise pline to invest $3,000 for the next 39 birthdays. You retire on your 65th birthday. How
investor (maybe even much will you have? The answer might surprise you. If you earn 10 percent per year,
one with too much you will have about $1.46 million. Are these numbers realistic? Based on the history
money), you need to of financial markets, the answer appears to be yes. For example, over the last 81 or so
know: years, the widely followed Standard & Poor’s index of large-company common stocks
has actually yielded about 12 percent per year. ■
1. How to calculate
the return on an The study of investments could begin in many places. After thinking it over, we decided that
investment using a brief history lesson is in order, so we start our discussion of risk and return by looking back
different methods. at what has happened to investors in U.S. financial markets since 1925. In 1931, for example,
the stock market lost 43 percent of its value. Just two years later, the market reversed itself and
2. The historical returns gained 54 percent. In more recent times, the stock market lost about 25 percent of its value on
on various important October 19, 1987, alone, and it gained almost 40 percent in 1995. Very recently, following nine
types of investments. years of consecutive gains, the stock market lost value in three straight years, 2000 through 2002.
From the end of 2002 through July of 2007, however, the market gained about 58 percent.
3. The historical risks
on various important So what should you, as a stock market investor, expect when you invest your own money?
types of investments. In this chapter, we study more than eight decades of market history to find out.

4. The relationship
between risk and
return.

In this chapter, we present the historical relation between risk and return. As you will
see, this chapter has a lot of very practical information for anyone thinking of investing in
financial assets such as stocks and bonds. For example, suppose you were to start investing
in stocks today. Do you think your money would grow at an average rate of 5 percent per
year? Or 10 percent? Or 20 percent? This chapter gives you an idea of what to expect (the
answer may surprise you). The chapter also shows how risky certain investments can be, and
it gives you the tools to think about risk in an objective way.

Our primary goal in this chapter is to see what financial market history can tell us
about risk and return. One of the most important things to get out of this discussion is
a perspective on the numbers. What is a high return? What is a low return? More gen-
erally, what returns should we expect from financial assets such as stocks and bonds,
and what are the risks from such investments? Beyond this, we hope that by studying
what did happen in the past, we will at least gain some insight into what can happen
in the future.

The history of risk and return is made day by day in global financial markets. The Internet
is an excellent source of information on financial markets. Visit our Web site (at www.mhhe.
com/jm5e) for suggestions on where to find information on recent financial market events.
We will suggest other sites later in the chapter.

Not everyone agrees on the value of studying history. On the one hand, there is philoso-
pher George Santayana’s famous comment, “Those who do not remember the past are con-
demned to repeat it.” On the other hand, there is industrialist Henry Ford’s equally famous
comment, “History is more or less bunk.” These extremes aside, perhaps everyone would
agree with Mark Twain, who observed, with remarkable foresight (and poor grammar), that
“October. This is one of the peculiarly dangerous months to speculate in stocks in. The oth-
ers are July, January, September, April, November, May, March, June, December, August,
and February.”

Two key observations emerge from a study of financial market history. First, there
is a reward for bearing risk, and, at least on average, that reward has been substantial.
That’s the good news. The bad news is that greater rewards are accompanied by greater
risks. The fact that risk and return go together is probably the single most important
fact to understand about investments, and it is a point to which we will return many
times.

1.1 Returns

We wish to discuss historical returns on different types of financial assets. First,
we need to know how to compute the return from an investment. We will consider
buying shares of stock in this section, but the basic calculations are the same for any
investment.

DOLLAR RETURNS
If you buy an asset of any type, your gain (or loss) from that investment is called the
return on your investment. This return will usually have two components. First, you may
receive some cash directly while you own the investment. Second, the value of the asset
you purchase may change. In this case, you have a capital gain or capital loss on your
investment.1

To illustrate, suppose you purchased 100 shares of stock in Harley-Davidson (ticker
symbol: HOG) on January 1. At that time, Harley was selling for $50 per share, so your
100 shares cost you $5,000. At the end of the year, you want to see how you did with your
investment.

1 As a practical matter, what is and what is not a capital gain (or loss) is determined by the Internal Revenue
Service. Even so, as is commonly done, we use these terms to refer to a change in value.

2 Part 1 ■ Introduction

The first thing to consider is that over the year, a company may pay cash dividends to its
shareholders. As a stockholder in Harley, you are a part owner of the company, and you are
entitled to a portion of any money distributed. So if Harley chooses to pay a dividend, you
will receive some cash for every share you own.

In addition to the dividend, the other part of your return is the capital gain or loss on the
stock. This part arises from changes in the value of your investment. For example, consider
these two cases:

www Ending Stock Price Case 1 Case 2
January 1 value $69.96 $39.78
Our favorite investments December 31 value $5,000 $5,000
Web site is Yahoo! Dividend income $6,996 $3,978
Finance at Capital gain or loss $ 81 $ 81
finance.yahoo.com $1,996 ؊$1,022

Visit this site and look
around!

total dollar return At the beginning of the year, on January 1, the stock is selling for $50 per share, and,
The return on an investment as we calculated above, your total outlay for 100 shares is $5,000. Over the year, Harley
measured in dollars that accounts pays dividends of $.81 per share. By the end of the year, then, you received dividend
for all cash flows and capital gains income of
or losses.
Dividend income ϭ $.81 ϫ 100 ϭ $81

In Case 1, suppose that as of December 31, Harley was selling for $69.96, meaning that the
value of your stock increased by $19.96 per share. Your 100 shares are now worth $6,996,
so you have a capital gain of

Capital gain ϭ ($69.96 Ϫ $50) ϫ 100 ϭ $1,996

On the other hand, if the price had dropped to, say, $39.78 (Case 2), you would have a capital
loss of

Capital loss ϭ ($39.78 Ϫ $50) ϫ 100 ϭ Ϫ$1,022

Notice that a capital loss is the same thing as a negative capital gain.
The total dollar return on your investment is the sum of the dividend and the capital

gain (or loss):

Total dollar return ϭ Dividend income ϩ Capital gain (or loss)

In Case 1, the total dollar return is thus given by

Total dollar return ϭ $81 ϩ $1,996 ϭ $2,077

Overall, between the dividends you received and the increase in the price of the stock, the
value of your investment increased from $5,000 to $5,000 ϩ $2,077 ϭ $7,077.

A common misconception often arises in this context. Suppose you hold on to your
Harley-Davidson stock and don’t sell it at the end of the year. Should you still consider the
capital gain as part of your return? Isn’t this only a “paper” gain and not really a cash gain
if you don’t sell it?

The answer to the first question is a strong yes, and the answer to the second is an
equally strong no. The capital gain is every bit as much a part of your return as the divi-
dend, and you should certainly count it as part of your return. The fact that you decide
to keep the stock and don’t sell (you don’t “realize” the gain) is irrelevant because you
could have converted it to cash if you had wanted to. Whether you choose to do so is up
to you.

Chapter 1 ■ A Brief History of Risk and Return 3

After all, if you insist on converting your gain to cash, you could always sell the stock
and immediately reinvest by buying the stock back. There is no difference between doing
this and just not selling (assuming, of course, that there are no transaction costs or tax con-
sequences from selling the stock). Again, the point is that whether you actually cash out and
buy pizzas (or whatever) or continue to hold the investment doesn’t affect the return you
actually earn.

PERCENTAGE RETURNS

It is usually more convenient to summarize information about returns in percentage terms
than in dollar terms, because that way your return doesn’t depend on how much you actually
invested. With percentage returns the question we want to answer is: How much do we get
for each dollar we invest?

To answer this question, let Pt be the price of the stock at the beginning of the year.
Let Dt ϩ 1 be the dividend paid on the stock during the year. The following cash flows are
the same as those shown earlier, except that we have now expressed everything on a per-
share basis:

January 1 stock price, Pt Case 1 Case 2
December 31 stock price, Pt ϩ 1 $50.00 $50.00
Dividend income, Dt ϩ 1 $69.96 $39.78
Capital gain or loss $ .81 $ .81
$19.96 ؊$10.22

dividend yield In our example, the price at the beginning of the year was $50 per share and the dividend
The annual stock dividend as a paid during the year on each share was $.81. If we divide the dividend by the beginning stock
percentage of the initial stock price, the result is the dividend yield:
price.
Dividend yield ‫ ؍‬Dt ؉ 1 ͞ Pt (1.1)
capital gains yield ‫ ؍‬$.81 ͞ $50 ‫ ؍‬.0162 ‫ ؍‬1.62%
The change in stock price as a
percentage of the initial stock This calculation says that for each dollar we invested we received 1.62 cents in dividends.
price. The second component of our percentage return is the capital gains yield. This yield is

total percent return calculated as the change in the price during the year (the capital gain) divided by the begin-
The return on an investment ning price. With the Case 1 ending price, we get:
measured as a percentage that
accounts for all cash flows and Capital gains yield ‫( ؍‬Pt ؉ 1 ؊ Pt ) ͞ Pt (1.2)
capital gains or losses. ‫( ؍‬$69.96 ؊ $50) ͞ $50

‫ ؍‬$19.96 ͞ $50 ‫ ؍‬.3992 ‫ ؍‬39.92%

This 39.92 percent yield means that for each dollar invested we got about 40 cents in capital
gains (HOG heaven).

Putting it all together, per dollar invested, we get 1.62 cents in dividends and 39.92 cents
in capital gains for a total of 41.54 cents. Our total percent return is 41.54 cents on the
dollar, or 41.54 percent. When a return is expressed on a percentage basis, we often refer
to it as the rate of return, or just “return,” on the investment. Notice that if we combine the
formulas for the dividend yield and capital gains yield, we get a single formula for the total
percentage return:

Percentage return ‫ ؍‬Dividend yield ؉ Capital gains yield (1.3)

‫ ؍‬Dt ϩ 1 ͞ Pt ؉ (Pt ϩ 1 ؊ Pt ) ͞ Pt
‫( ؍‬Dt ϩ 1 ؉ Pt ϩ 1 ؊ Pt) ͞ Pt

To check our calculations, notice that we invested $5,000 and ended up with $7,077.
By what percentage did our $5,000 increase? As we saw, our gain was $7,077 Ϫ $5,000 ϭ
$2,077. This is an increase of $2,077 ͞ $5,000, or 41.54 percent.

4 Part 1 ■ Introduction

WORK THE WEB

To look up information on common stocks using the Web, finance.yahoo.com. Here we have looked up (using the
you need to know the “ticker” symbol for the stocks in “Symbol Lookup” link) and entered ticker symbols for
which you are interested. You can look up ticker sym- some well-known “tech” stocks: Dell, Cisco, Intel, and
bols in many places, including one of our favorite sites, Microsoft.

Once we hit “Get Quotes,” this is what we got:

As you can see, we get the price for each stock, along (number of shares traded). You will find a lot of links to
with information about the change in price and volume hit and learn more, so have at it!

EXAMPLE 1.1 Calculating Percentage Returns

Suppose you buy some stock in Concannon Plastics for $35 per share. After one year,
the price is $49 per share. During the year, you received a $1.40 dividend per share.
What is the dividend yield? The capital gains yield? The percentage return? If your
total investment was $1,400, how much do you have at the end of the year?

Your $1.40 dividend per share works out to a dividend yield of

Dividend yield ‫ ؍‬Dt ؉ 1 ͞ Pt
‫ ؍‬$1.40 ͞ $35
‫ ؍‬4%

The per-share capital gain is $14, so the capital gains yield is

Capital gains yield ‫( ؍‬Pt ؉ 1 ؊ Pt) ͞ Pt
‫( ؍‬$49 ؊ $35) ͞ $35
‫ ؍‬$14 ͞ $35
‫ ؍‬40%

The total percentage return is thus 4% ϩ 40% ϭ 44%.
If you had invested $1,400, you would have $2,016 at the end of the year. To check

this, note that your $1,400 would have bought you $1,400 ͞ $35 ϭ 40 shares. Your
40 shares would then have paid you a total of 40 ϫ $1.40 ϭ $56 in cash dividends.
Your $14 per share gain would give you a total capital gain of $14 ϫ 40 ϭ $560.
Add these together and you get $616, which is a 44 percent total return on your
$1,400 investment.

Chapter 1 ■ A Brief History of Risk and Return 5