ebook

FIGURE 20.3 Principal and Cash Flows for $100,000 Par Value 30-Year, 8 Percent
GNMA Bonds

Outstanding principal $100,000
90,000
80,000 60 120 180 240 300 360
70,000 Age of mortgage pool (months)
60,000
Cash flows 50,000
40,000
30,000 60 120 180 240 300 360
20,000 Age of mortgage pool (months)
10,000
0
0

$2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
0

PSA 50 PSA 100
PSA 200 PSA 400

As shown in Figures 20.3A and 20.3B, prepayments significantly affect the cash flow
characteristics of GNMA bonds. However, these illustrations assume that prepayment
schedules remain unchanged over the life of a mortgage pool. This can be unrealistic, since
prepayment rates often change from those originally forecast. For example, sharply falling
interest rates could easily cause a jump in prepayment rates from 100 PSA to 400 PSA.
Since large interest rate movements are unpredictable, future prepayment rates can also be
unpredictable. Consequently, GNMA mortgage-backed bond investors face substantial cash
flow uncertainty. This makes GNMA bonds an unsuitable investment for many investors,
especially relatively unsophisticated investors unaware of the risks involved. Nevertheless,
GNMA bonds offer higher yields than U.S. Treasury bonds, which makes them attractive to
professional fixed-income portfolio managers.

✓ 20.5a GNMA bond investors face significant cash flow uncertainty. Why might
20.5b cash flow uncertainty be a problem for many portfolio managers?
CHECK THIS
Why might cash flow uncertainty be less of a problem for investors with a
very long-term investment horizon?

20-14 Part 6 ■ Topics in Investments

Macaulay duration MACAULAY DURATIONS FOR GNMA
A measure of interest rate risk for MORTGAGE-BACKED BONDS
fixed-income securities.
For mortgage pool investors, prepayment risk is important because it complicates the effects
of interest rate risk. With falling interest rates, prepayments speed up and the average life of
mortgages in a pool shortens. Similarly, with rising interest rates, prepayments slow down
and average mortgage life lengthens. Recall from a previous chapter that interest rate risk for
a bond is often measured by Macaulay duration. However, Macaulay duration assumes a
fixed schedule of cash flow payments. But the schedule of cash flow payments for mortgage-
backed bonds is not fixed because it is affected by mortgage prepayments, which in turn are
affected by interest rates. For this reason, Macaulay duration is a deficient measure of inter-
est rate risk for mortgage-backed bonds. The following examples illustrate the deficiency of
Macaulay duration when it is unrealistically assumed that interest rates do not affect mort-
gage prepayment rates.2

1. Macaulay duration for a GNMA bond with zero prepayments. Suppose a GNMA
bond is based on a pool of 30-year, 8 percent fixed-rate mortgages. Assuming an
8 percent interest rate, their price is equal to their initial par value of $100,000. The
Macaulay duration for these bonds is 9.56 years.

2. Macaulay duration for a GNMA bond with a constant 100 PSA prepayment schedule.
Suppose a GNMAbond based on a pool of 30-year, 8 percent fixed-rate mortgages
follows a constant 100 PSAprepayment schedule. Accounting for this prepayment sched-
ule when calculating Macaulay duration, we obtain a Macaulay duration of 6.77 years.

Examples 1 and 2 illustrate how Macaulay duration can be affected by mortgage prepayments.
Essentially, faster prepayments cause earlier cash flows and shorten Macaulay durations.

However, Macaulay durations are still misleading because they assume that prepayment
schedules are unaffected by changes in interest rates. When falling interest rates speed up
prepayments, or rising interest rates slow down prepayments, Macaulay durations yield in-
accurate price-change predictions for mortgage-backed securities. The following examples
illustrate the inaccuracy.

3. Macaulay duration for a GNMA bond with changing PSA prepayment schedules.
Suppose a GNMA bond based on a pool of 30-year, 8 percent fixed-rate mortgages
has a par value price of $100,000 and that, with no change in interest rates, the pool
follows a 100 PSA prepayment schedule. Further suppose that when the market
interest rate for these bonds rises to 9 percent, prepayments fall to a 50 PSA schedule.
In this case, the price of the bond falls to $92,644, representing a 7.36 percent price
drop, which is more than .5 percent larger than the drop predicted by the bond’s
Macaulay duration of 6.77.

4. Macaulay duration for a GNMA bond with changing PSA prepayment schedules.
Suppose a GNMA bond based on a pool of 30-year, 8 percent fixed-rate mortgages
has a par value price of $100,000 and that, with no change in interest rates, the pool
follows a 100 PSA prepayment schedule. Further suppose that when the market in-
terest rate for these bonds falls to 7 percent, prepayments rise to a 200 PSA sched-
ule. In this case, the bond price rises to $105,486, which is over 1.2 percent less
than the price increase predicted by the bond’s Macaulay duration of 6.77.

Examples 3 and 4 illustrate that simple Macaulay durations overpredict price increases
and underpredict price decreases for changes in mortgage-backed bond prices caused by
changing interest rates. These errors are caused by the fact that Macaulay duration does not
account for prepayment rates changing in response to interest rate changes. The severity of
these errors depends on how strongly interest rates affect prepayment rates. Historical expe-
rience indicates that interest rates significantly affect prepayment rates and that Macaulay
duration is a very conservative measure of interest rate risk for mortgage-backed securities.

2 The Macaulay duration formula for a mortgage is not presented here since, as our discussion suggests,
its usage is not recommended.

Chapter 20 ■ Mortgage-Backed Securities 20-15

INVESTMENT UPDATES

MORTGAGE PASS-THROUGH SECURITIES ARE NOT ALWAYS FREE OF RISK

The brouhaha over rapidly rising defaults in subprime Until recently, default was not a problem; rigorous
mortgages suggests that it is time for a refresher course credit standards were used for granting mortgages. How-
on mortgage-backed securities. ever, during the housing “boom” standards were greatly
relaxed for subprime mortgages. A subprime mortgage
The simplest type of mortgage-backed security is loan is a loan made to someone who could not qualify
a mortgage pass-through security, or MPS, like those for a more favorable rate. These loans carry a higher
issued by the Government National Mortgage Associa- rate because of the checkered credit history of the
tion, called the GNMA. borrowers.

An MPS is a bond that is secured by a pool of resi- The relaxed standards have led to problems for bonds
dential mortgages. An issuer like GNMA puts together backed by subprime mortgages. That type of bond is
a pool of 15- or 30-year mortgages with the same issued by major institutions like brokerage firms and is
interest rate, and issues bonds in the amount of the not insured against losses by the government sponsored
pool. The bondholder receives periodic payments of agencies, or GSAs, such as GNMA. Bonds insured by GSAs
his pro-rata share of the pool’s principal and interest do not have this risk.
payments.
While not having default risk, a MPS issued by a GSA
These are touted as risk-free bonds that pay higher has a unique type of interest rate risk because of a du-
interest rates than comparable U.S. Treasury bonds. But ration change not found in normal bonds. As interest
this is not quite correct. In actuality, these securities have rates fall, an MPS will not rise in price as normal bonds
a complex risk-reward profile. do. Falling interest rates mean that homeowners will
refinance in greater-than-expected numbers. Increased
Bonds have two different kinds of risk: refinancing means the duration shortens because bond-
holders are getting principal back earlier than forecast.
• Default risk: The chance that the bondholder Thus, the bond’s sensitivity to interest rates decreases.
will not receive the interest payments or the
return of his principal. In other words bondholders will get back part of
their principal at a time when interest rates are low,
• Interest rate risk: The chance that the security will and they have to reinvest these dollars at this inauspi-
fall in price. cious time.

One way to measure the former is by the bond’s rating The situation is no better when interest rates rise.
by a major bond rating agency like Standard & Poor’s or In this case, homeowners refinance in lower-than-
Moody’s. One way to measure the latter is by a bond’s expected numbers. This means an increased duration.
duration. This is a measure of the sensitivity of a bond’s Thus, the bond’s sensitivity to interest rates increases
price to interest rate changes. The greater the duration, and that means that the bond’s price will fall more than
the greater the interest rate risk. normal bonds.

Duration is determined by how quickly the bondholder Individual investors need to consider whether they are
receives money back. Thus, for a fixed interest rate, the comfortable with this risk-reward profile. There are even
duration of bonds with longer maturities is larger than more complex bonds called collateralized mortgage obli-
for bonds with shorter maturities. gations that seek to deal with these risks.

What does this have to do with the risk-reward pro- Source: Robert Sepleman, www.heraldtribune.com, Copyright © 2008,
file of an MPS? An MPS has a published expected life Sarasota Herald-Tribune. Reprinted by express permission of the Sarasota
shorter than its stated maturity date due to routine early Herald-Tribune.
repayment of mortgages when homeowners move or
refinance. The market price of an MPS is tightly linked to
these expectations. So what is the problem?

effective duration for To correct the deficiencies of Macaulay duration, a method often used in practice to assess
MBS interest rate risk for mortgage-backed securities is to first develop projections regarding mort-
Duration measure that accounts gage prepayments. Projecting prepayments for mortgages requires analyzing both economic
for how mortgage prepayments and demographic variables. In particular, it is necessary to estimate how prepayment rates will
are affected by changes in interest respond to changes in interest rates. A duration model that accounts for these factors is called
rates. effective duration. In practice, effective duration is used to calculate predicted prices for
mortgage-backed securities based on hypothetical interest rate and prepayment scenarios.
A nearby Investment Updates box summarizes the risks of mortgage-backed securities.

20-16 Part 6 ■ Topics in Investments

✓ 20.5c Why is it important for portfolio managers to know by how much a change
20.5d in interest rates will affect mortgage prepayments?
CHECK THIS
Why is it important for portfolio managers to know by how much a change
in interest rates will affect mortgage-backed bond prices?

20.6 Collateralized Mortgage Obligations

collateralized mortgage When a mortgage pool is created, cash flows from the pool are often carved up and distributed
obligations (CMOs) according to various allocation rules. Mortgage-backed securities representing specific rules
Securities created by splitting for allocating mortgage cash flows are called collateralized mortgage obligations (CMOs).
mortgage pool cash flows accord- Indeed, a CMO is defined by the rule that created it. Like all mortgage passthroughs, primary
ing to specific allocation rules. collateral for CMOs are the mortgages in the underlying pool. This is true no matter how the
rules for cash flow distribution are actually specified.
interest-only strips (IOs)
Securities that pay only the interest The three best-known types of CMO structures using specific rules to carve up mortgage
cash flows to investors. pool cash flows are (1) interest-only strips (IOs) and principal-only strips (POs), (2) sequen-
principal-only strips tial CMOs, and (3) protected amortization class securities (PACs). Each of these CMO struc-
(POs) tures is discussed immediately below. Before beginning, however, we retell an old Wall Street
Securities that pay only the princi- joke that pertains to CMOs: Question: “How many investment bankers does it take to sell a
pal cash flows to investors. lightbulb?” Answer: “401; one to hit it with a hammer, and 400 to sell off the pieces.”

The moral of the story is that mortgage-backed securities can be repackaged in many
ways, and the resulting products are often quite complex. Even the basic types we con-
sider here are significantly more complicated than the basic fixed-income instruments we
considered in earlier chapters. Consequently, we do not go into great detail regarding the
underlying calculations for CMOs. Instead, we examine only the basic properties of the most
commonly encountered CMOs.

INTER E S T-O N LY A N D P R I N C I PA L -O N LY
MORTGAGE STRIPS

Perhaps the simplest rule for carving up mortgage pool cash flows is to separate payments
of principal from payments of interest. Mortgage-backed securities paying only the inter-
est component of mortgage pool cash flows are called interest-only strips, or simply IOs.
Mortgage-backed securities paying only the principal component of mortgage pool cash
flows are called principal-only strips, or simply POs. Mortgage strips are more compli-
cated than straight mortgage passthroughs. In particular, IO strips and PO strips behave quite
differently in response to changes in prepayment rates and interest rates.

Let us begin an examination of mortgage strips by considering a $100,000 par value
GNMA bond that has been stripped into a separate IO bond and a PO bond. The whole
GNMA bond receives a pro rata share of all cash flows from a pool of 30-year, 8 percent
mortgages. From the whole bond cash flow, the IO bond receives the interest component,
and the PO bond receives the principal component. The sum of IO and PO cash flows repro-
duces the whole bond cash flow.

Assuming various PSA prepayment schedules, cash flows to IO strips are illustrated in
Figure 20.4A, and cash flows to PO strips are illustrated in Figure 20.4B. Holding the inter-
est rate constant at 8 percent, IO and PO strip values for various PSA prepayment schedules
are listed immediately below:

Prepayment Schedule IO Strip Value PO Strip Value
50 PSA $63,102.80 $36,897.20
53,726.50 46,273.50
100 PSA 41,366.24 58,633.76
200 PSA 28,764.16 71,235.84
400 PSA

Chapter 20 ■ Mortgage-Backed Securities 20-17

FIGURE 20.4 Cash Flows for $100,000 Par Value 30-Year, 8 Percent Bonds

IO StripCash flows

$700Cash flows 60 120 180 240 300 360
600 Age of mortgage pool (months) 360
500
400 60 120 180 240 300
300 Age of mortgage pool (months)
200
100
0
0

PO Strip

$1,600
1,400
1,200
1,000
800
600
400
200
0
0

PSA 50 PSA 100
PSA 200 PSA 400

Notice that total bond value is $100,000 for all prepayment schedules because the interest rate
is unchanged from its original 8 percent value. Nevertheless, even with no change in interest rates,
faster prepayments imply lower IO strip values and higher PO strip values, and vice versa.

There is a simple reason why PO strip value rises with faster prepayment rates. Essen-
tially, the only cash flow uncertainty facing PO strip holders is the timing of PO cash flows,
not the total amount of cash flows. No matter what prepayment schedule applies, total cash
flows paid to PO strip holders over the life of the pool will be equal to the initial principal of
$100,000. Therefore, PO strip value increases as principal is paid earlier to PO strip holders
because of the time value of money.

In contrast, IO strip holders face considerable uncertainty regarding the total amount
of IO cash flows that they will receive. Faster prepayments reduce principal more rapidly,
thereby reducing interest payments since interest is paid only on outstanding principal. The
best that IO strip holders could hope for is that no mortgages are prepaid, which would
maximize total interest payments. Prepayments reduce total interest payments. Indeed, in the
extreme case, where all mortgages in a pool are prepaid, IO cash flows stop completely.

The effects of changing interest rates compounded by changing prepayment rates are
illustrated by considering IO and PO strips from a $100,000 par value GNMA bond based on
a pool of 30-year, 8 percent mortgages. First, suppose that an interest rate of 8 percent yields

20-18 Part 6 ■ Topics in Investments

a 100 PSA prepayment schedule. Also suppose that a lower interest rate of 7 percent yields
200 PSA prepayments, and a higher interest rate of 9 percent yields 50 PSA prepayments.
The resulting whole bond values and separate IO and PO strip values for these combinations
of interest rates and prepayment rates are listed immediately below:

Interest Rate Prepayments IO Strip Value PO Strip Value Whole Bond Value
9% 50 PSA $59,124.79 $35,519.47 $ 94,644.26
8 53,726.50 46,273.50 100,000.00
7 100 PSA 43,319.62 62,166.78 105,486.40
200 PSA

✓ When the interest rate increases from 8 percent to 9 percent, total bond value falls by
$5,355.74. This results from the PO strip price falling by $10,754.03 and the IO strip price
CHECK THIS increasing by $5,398.29. When the interest rate decreases from 8 percent to 7 percent, total
bond value rises by $5,486.40. This results from the PO strip price increasing by $15,893.28
and the IO strip price falling by $10,406.88. Thus, PO strip values change in the same direc-
tion as the whole bond value, but the PO price change is larger. Notice that the IO strip price
changes in the opposite direction of the whole bond and PO strip price change.

20.6a Suppose a $100,000 mortgage financed at 9 percent (.75 percent monthly)
is paid off in the first month after issuance. In this case, what are the cash
flows to an IO strip and a PO strip from this mortgage?

sequential CMOs SEQUENTIAL COLLATERALIZED MORTGAGE OBLIGATIONS
Securities created by splitting a
mortgage pool into a number of One problem with investing in mortgage-backed bonds is the limited range of maturities avail-
slices, called tranches. able. An early method developed to deal with this problem is the creation of sequential CMOs.
Sequential CMOs carve a mortgage pool into a number of tranches. Tranche, the French word
for slice, is a commonly used financial term to describe the division of a whole into various
parts. Sequential CMOs are defined by rules that distribute mortgage pool cash flows to sequen-
tial tranches. While almost any number of tranches are possible, a basic sequential CMO struc-
ture might have four tranches: A-tranche, B-tranche, C-tranche, and Z-tranche. Each tranche is
entitled to a share of mortgage pool principal and interest on that share of principal.

As a hypothetical sequential CMO structure, suppose a 30-year, 8 percent GNMA bond
initially represents $100,000 of mortgage principal. Cash flows to this whole bond are
then carved up according to a sequential CMO structure with A-, B-, C-, and Z-tranches.
The A-, B-, and C-tranches initially represent $30,000 of mortgage principal each. The
Z-tranche initially represents $10,000 of principal. The sum of all four tranches reproduces
the original whole bond principal of $100,000. The cash flows from the whole bond are
passed through to each tranche according to the following rules:

Rule 1: Mortgage principal payments. All payments of mortgage principal, including
scheduled amortization and prepayments, are first paid to the A-tranche. When all
A-tranche principal is paid off, subsequent payments of mortgage principal are then
paid to the B-tranche. After all B-tranche principal is paid off, all principal payments are
then paid to the C-tranche. Finally, when all C-tranche principal is paid off, all principal
payments go to the Z-tranche.

Rule 2: Interest payments. All tranches receive interest payments in proportion to
the amount of outstanding principal in each tranche. Interest on A-, B-, and C-tranche
principal is passed through immediately to A-, B-, and C-tranches. Interest on Z-tranche
principal is paid to the A-tranche as cash in exchange for the transfer of an equal amount
of principal from the A-tranche to the Z-tranche. After A-tranche principal is fully paid,
interest on Z-tranche principal is paid to the B-tranche in exchange for an equal amount
of principal from the B-tranche to the Z-tranche. This process continues sequentially
through each tranche.

Chapter 20 ■ Mortgage-Backed Securities 20-19

FIGURE 20.5 Sequential CMO Principal and Cash Flows for a $100,000 Par Value
GNMA Bond
✓
Outstanding principal $35,000 C-tranche Z-tranche A
CHECK THIS 30,000 B-tranche
25,000 A-tranche 360
20,000 B
15,000 60 120 180 240 300
10,000 Age of mortgage pool (months) 360
5,000
0
0

Cash flows $900

800 A-tranche B-tranche
700 C-tranche
600

500

400 Z-tranche
300

200

100

0
0 60 120 180 240 300
Age of mortgage pool (months)

For example, the first month’s cash flows from a single whole bond are allocated as
follows. Scheduled mortgage payments yield a whole bond cash flow of $733.76, which is
divided between $67.10 principal amortization and $666.67 payment of interest. All sched-
uled principal amortization is paid to the A-tranche, and A-tranche principal is reduced by
a like amount. Since outstanding principal was initially equal to $30,000 for the A-, B-, and
C-tranche bonds, each of these tranches receives an interest payment of $30,000 ϫ .08/12 ϭ
$200. In addition, the Z-tranche interest payment of $10,000 ϫ .08/12 ϭ $66.67 is paid to
the A-tranche in cash in exchange for transferring $66.67 of principal to the Z-tranche. In
summary, A-tranche principal is reduced by $67.10 ϩ $66.67 ϭ $133.77 plus any prepay-
ments, and Z-tranche principal is increased by $66.67.

Remaining principal amounts for A-, B-, C-, and Z-tranches, assuming 100 PSA pre-
payments, are graphed in Figure 20.5A. Corresponding cash flows for the A-, B-, C-, and
Z-tranches, assuming 100 PSA prepayments, are graphed in Figure 20.5B.

20.6b Figures 20.5A and 20.5B assume a 100 PSA prepayment schedule. How
20.6c would these figures change for a 200 PSA prepayment schedule or a 50 PSA
prepayment schedule?

While A-, B-, and C-tranche principal is being paid down, Z-tranche interest
is used to acquire principal for the Z-tranche. What is the growth rate of
Z-tranche principal during this period?

20-20 Part 6 ■ Topics in Investments

protected amortization PROTECTED AMORTIZATION CLASS BONDS
class bond (PAC)
Mortgage-backed security that Another popular security used to alleviate the problem of cash flow uncertainty when invest-
takes priority for scheduled ing in mortgage-backed bonds is a protected amortization class (PAC) bond, or simply
payments of principal. PAC. Like all CMOs, PAC bonds are defined by specific rules that carve up cash flows from
a mortgage pool. Essentially, a PAC bond carves out a slice of a mortgage pool’s cash flows
PAC support bond according to a rule that gives PAC bondholders first priority entitlement to promised PAC
Mortgage-backed security that has cash flows. Consequently, PAC cash flows are predictable so long as mortgage pool pre-
subordinate priority for scheduled payments remain within a predetermined band. PAC bonds are attractive to investors who
payments of principal. Also called require a high degree of cash flow certainty from their investments.
PAC companion bond.
After PAC bondholders receive their promised cash flows, residual cash flows from the
PAC collar mortgage pool are paid to non-PAC bonds, often referred to as PAC support bonds or PAC
Range defined by upper and lower companion bonds. In effect, almost all cash flow uncertainty is concentrated in the non-
prepayment schedules of a PAC PAC bonds. The non-PAC bond supports the PAC bond and serves the same purpose as a
bond. Z-tranche bond in a sequential CMO structure. For this reason, a non-PAC bond is some-
times called a PAC Z-tranche.

Creation of a PAC bond entails three steps. First, we must specify two PSA prepay-
ment schedules that form the upper and lower prepayment bounds of a PAC bond. These
bounds define a PAC collar. For example, suppose we create a single PAC bond from a
new $100,000 par value GNMA bond based on a pool of 30-year fixed-rate mortgages.
The PAC collar specifies a 100 PSA prepayment schedule as a lower bound and a 300 PSA
prepayment schedule as an upper bound. Cash flows to the PAC bond are said to enjoy
protected amortization so long as mortgage pool prepayments remain within this 100–300
PSA collar.

Our second step in creating a PAC bond is to calculate principal-only (PO) cash flows
from our 30-year, $100,000 par value GNMA bond, assuming 100 PSA and 300 PSA pre-
payment schedules. These PO cash flows, which include both scheduled amortization and
prepayments, are plotted in Figure 20.6A. In Figure 20.6A, notice that principal-only cash
flows for 100 PSA and 300 PSA prepayment schedules intersect in month 103. Before
the 103rd month, 300 PSA PO cash flows are greater. After that month, 100 PSA PO cash
flows are greater. PAC bond cash flows are specified by the 100 PSA schedule before month
103 and the 300 PSA schedule after month 103. Because the PAC bond is specified by
100 PSA and 300 PSA prepayment schedules, it is called a PAC 100/300 bond.

Our third step is to specify the cash flows to be paid to PAC bondholders on a prior-
ity basis. PAC bondholders receive payments of principal according to the PAC collar’s
lower PSA prepayment schedule. For the PAC 100/300 bond in this example, principal
payments are made according to the 100 PSA prepayment schedule until month 103, when
the schedule switches to the 300 PSA prepayment schedule. The sum of all scheduled prin-
cipal to be paid to PAC 100/300 bondholders represents total initial PAC bond principal. In
addition to payment of principal, a PAC bondholder also receives payment of interest on
outstanding PAC principal. For example, if the mortgage pool financing rate is 9 percent,
the PAC bondholder receives an interest payment of .75 percent per month of outstanding
PAC principal.

Total monthly cash flows paid to the PAC bond, including payments of principal and in-
terest, are graphed in Figure 20.6B. As shown, total cash flow reaches a maximum in month
30, thereafter gradually declining. So long as mortgage pool prepayments remain within the
100/300 PSA prepayment collar, PAC bondholders will receive these cash flows exactly as
originally specified.

PAC collars are usually sufficiently wide so that actual prepayments move outside the
collar only infrequently. In the event that prepayments move outside a collar far enough to
interfere with promised PAC cash flows, PAC bonds normally specify the following two
contingency rules:

PAC contingency rule 1. When actual prepayments fall below a PAC collar’s lower
bound, there could be insufficient cash flow to satisfy a PAC bond’s promised cash flow
schedule. In this case, the PAC bond receives all available cash flow, and any shortfall
is carried forward and paid on a first-priority basis from future cash flows. Non-PAC

Chapter 20 ■ Mortgage-Backed Securities 20-21

FIGURE 20.6 GNMA PAC 100/300 Cash Flows for $100,000 Par Value 30-Year,
8 Percent Bond

$1,400 A

1,200 PSA 300

Cash flows 1,000

800 PAC 100/300 principal PSA 100
payment schedule 150 180
600
30 60 90 120
400 Age of mortgage pool (months)

200 Total cash flow B

Cash flows 0 Principal cash flows
0
Interest cash flows 150 180
$1,000
900 30 60 90 120
800 Age of mortgage pool (months)
700
600
500
400
300
200
100
0
0

bonds receive no cash flows until all cumulative shortfalls to PAC bonds
are paid off.

PAC contingency rule 2. When actual prepayments rise above a PAC collar’s upper
bound, it is possible that all outstanding principal for the non-PAC support bonds
is paid off before the PAC bond. When all non-PAC principal is paid off, the PAC
cash flow schedule is abandoned and all mortgage pool cash flows are paid to PAC
bondholders.

✓ 20.6d A PAC 100/300 bond based on a pool of fully modified 30-year fixed-rate
20.6e mortgages switches payment schedules after 103 months. Would switching
CHECK THIS 20.6f occur earlier or later for a PAC 50/300 bond? For a PAC 100/500 bond?

Figures 20.6A and 20.6B assume a PAC 100/300 bond based on a pool of
fully modified 30-year fixed-rate mortgages. What would these figures look
like for a PAC 50/300 and a PAC 100/500 bond?

How might a large change in market interest rates cause mortgage pool
prepayments to move outside a PAC collar far enough and long enough to
interfere with an originally stated PAC bond cash flow schedule?

20-22 Part 6 ■ Topics in Investments

cash flow yield 20.7 Yields for Mortgage-Backed Securities
Yield to maturity for a and Collateralized Mortgage Obligations
mortgage-backed security
conditional on an assumed Yields for mortgage-backed securities (MBSs) and collateralized mortgage obligations
prepayment pattern. (CMOs) for representative GNMA, FHLMC, and FNMA mortgage pools appear online daily
at www.wsj.com. Figure 20.7 is a sample listing. The first column lists the type of mort-
FIGURE 20.7 gage pool. For example, the first mortgage pool type is 30-year FMAC (i.e., Freddie Mac)
Gold paying 5.5 percent interest on outstanding principal. The second mortgage pool type is
30-year FMAC Gold paying 6.0 percent interest on outstanding principal. Column 2 reports
the price (in 32nds of a point) for the MBS. The third column is the change in the price from
the previous day. The fourth column shows the estimated average life of the mortgages in the
underlying pool. The fifth column gives the spread (in basis points) between the yield to ma-
turity on the MBS and the yield on a U.S. Treasury note or bond with a maturity similar to the
average life of the MBS. Column 6 shows the change in this spread from the previous day.

Finally, column 7 shows the assumed PSA prepayment rate and the last column shows the
yield to maturity on the MBS calculated using the assumed prepayment rate. This yield to ma-
turity is also known as the cash flow yield. Essentially, cash flow yield is the interest rate that
equates the present value of all future cash flows on the mortgage pool to the current price of the
pool, assuming a particular prepayment rate. Spread information on CMOs is also reported.

MBS Yields

Source: www.wsj.com, June 1, 2007.

Chapter 20 ■ Mortgage-Backed Securities 20-23

20.8 Summary and Conclusions

This chapter discusses the large and growing market for mortgage-backed securities. This
chapter covers many aspects of this market, including the following items—grouped by the
chapter’s important concepts.

1. The workings of a fixed-rate mortgage.

A. Most Americans finance their homes with a down payment and a loan for the remain-
ing amount—known as a mortgage. Mortgages are often repackaged into mortgage-
backed securities through a process called mortgage securitization. Currently, about
half of all mortgages in the United States have been securitized, yet the risks involved
in these investments are often misunderstood.

B. Most home mortgages are 15- or 30-year fixed-rate mortgages with fixed monthly
payments. The present value of all monthly payments is equal to the original amount
of the mortgage loan. Each monthly payment has two parts: interest on the remaining
principal and a scheduled pay-down of the principal. Through time, the interest pay-
ment gradually declines, and the pay-down of the principal gradually increases.

C. A mortgage borrower has the right to pay off a mortgage early—known as mort-
gage prepayment. Borrowers frequently prepay to refinance an existing mortgage at
a lower interest rate. Prepayment and refinancing, which are advantages to mortgage
borrowers, are disadvantages to mortgage investors. Therefore, mortgage investors
face prepayment risk.

D. In a reverse mortgage, borrowers (with home equity) receive monthly payments from
a lender. Borrowers generally do not have to repay money received from a reverse
mortgage as long as they live in their homes. However, the loan becomes due if the
borrowers die, sell their home, or move to another principal residence.

2. Government’s role in the secondary market for home mortgages.

A. In 1968, Congress established the Government National Mortgage Association
(GNMA) as a government agency charged with promoting liquidity in the secondary
market for home mortgages. GNMA is the largest single guarantor of mortgage-backed
securities. Two government-sponsored enterprises (GSEs) are also significant mort-
gage repackaging sponsors: the Federal Home Loan Mortgage Corporation (FHLMC)
and the Federal National Mortgage Association (FNMA).

B. Each month, GNMA, FHLMC, and FNMA mortgage-backed bond investors
receive cash flows derived from fully modified mortgage pools. Each monthly cash
flow has three distinct components: payment of interest on outstanding mortgage
principal, scheduled amortization of mortgage principal, and mortgage principal
prepayments.

3. The impact of mortgage prepayments.

A. Mortgage prepayments are stated as a prepayment rate. The greater the prepayment
rate, the faster mortgage pool principal is paid off. Because they depend on prevailing
interest rates, prepayment rates vary substantially from year to year. In practice, the
industry states prepayment rates using the Public Securities Association (PSA) pre-
payment model. This model states prepayment rates as a percentage of a PSA bench-
mark. This benchmark, called 100 PSA, represents an annual prepayment rate of
6 percent for seasoned mortgages. Deviations from the 100 PSA benchmark are stated
as a percentage of the benchmark.

B. Prepayment risk complicates the effects of interest rate risk. Interest rate risk for a
bond is related to its effective maturity, as measured by Macaulay duration. Macaulay
duration assumes a fixed schedule of cash flow payments. However, the schedule of
cash flow payments for mortgage-backed bonds varies because of mortgage prepay-
ments (which, in turn, are affected by interest rates). For this reason, Macaulay dura-
tion is a deficient measure of interest rate risk for mortgage-backed bonds.

20-24 Part 6 ■ Topics in Investments

4. How collateralized mortgage obligations are created and divided.

A. Cash flows from mortgage pools are often carved up and distributed according to vari-
ous rules. Mortgage-backed securities representing specific rules for allocating mort-
gage cash flows are called collateralized mortgage obligations (CMOs). The three
best known types of CMO structures are interest-only (IO) and principal-only (PO)
strips, sequential CMOs, and protected amortization class securities (PACs).

B. Cash flow yields for mortgage-backed securities (MBSs) and collateralized mortgage
obligations (CMOs) for GNMA, FHLMC, and FNMA mortgage pools appear online
daily at www.wsj.com. Cash flow yield for a mortgage-backed security corresponds
to the yield to maturity for an ordinary bond. Essentially, cash flow yield is the interest
rate that discounts all future expected cash flows from a mortgage pool to be equal to
the price of the mortgage pool.

GET REAL

This chapter covered one of the more complex investments available, mortgage-
backed securities (MBSs). Ironically, these investments are fairly complicated, but un-
like most exotic instruments, the basic types of MBSs are very suitable for ordinary
individual investors. In fact, GNMAs and similar investments are frequently recom-
mended, and rightly so, for even very conservative investors.

However, directly buying into mortgage pools is not practical for most individual
investors. It is also probably unwise, because not all pools are equally risky in terms
of prepayments, and analysis of individual pools is best left to experts. Instead, most
investors in MBSs end up in mutual funds specializing in these instruments, and most
of the major mutual fund families have such funds.

If you are interested in learning more about these investments, the Internet
contains a large amount of information. The first places to visit are the Web sites
for GNMA (www.ginniemae.gov), FNMA (www.fanniemae.com), and FHLMC (www
.freddiemac.com). For much information on the home mortgage business, along with
current mortgage rates across the country, try Mortgage Mag (www.mortgagemag
.com). Some informative sites with good-to-excellent sections on mortgage-backed
securities include Investing in Bonds (www.investinginbonds.com) and Bond Markets
(www.sifma.org). If you are thinking about a research project and need some data
on mortgage-backed securities, look at what’s available for sale at Financial Data
Services (www.financialdata.com).

Key Terms Government National Mortgage Association www.mhhe.com/jm5e
(GNMA) 10
average life 12
cash flow yield 23 interest-only strips (IOs) 17
collateralized mortgage obligations Macaulay duration 15
mortgage amortization 5
(CMOs) 17 mortgage-backed securities (MBSs) 2
conditional prepayment rate (CPR) 12 mortgage passthroughs 2
effective duration for MBS 16 mortgage prepayment 6
Federal Home Loan Mortgage Corporation mortgage principal 3
mortgage securitization 2
(FHLMC) 11 PAC collar 21
Federal National Mortgage Association PAC support bond 21

(FNMA) 11
fixed-rate mortgage 2
fully modified mortgage pool 10

Chapter 20 ■ Mortgage-Backed Securities 20-25

prepayment rate 11 seasoned mortgages 12
prepayment risk 10 sequential CMOs 19
principal-only strips (POs) 17 unseasoned mortgages 12
protected amortization class bond (PAC) 21

Chapter Review Problems and Self-Test

1. Mortgage Payments What are the monthly payments on a 30-year, $150,000 mortgage if the
mortgage rate is 6 percent? What portion of the first payment is interest? Principal?

2. Mortgage Prepayments Consider a 15-year, $210,000 mortgage with a 7 percent interest
rate. After 10 years, the borrower (the mortgage issuer) pays it off. How much will the lender
receive?

Answers to Self-Test Problems

1. This is a standard time value of money calculation in which we need to find an annuity-type
payment. The present value is $150,000. The interest rate is .06/12 ϭ .005, or .5 percent, per
month. There is a total of 360 payments. Using the formula from the text, we have:

Monthly payment ϭ _M_o_r_t_g_a_g_e_a_m__o_u_n_t _ϫ__r_/1_2_

1 Ϫ ______1______
(1 ϩ r/12)T ϫ 12

www.mhhe.com/jm5e Plugging in r ϭ .06 and T ϭ 30, we get a payment of $899.33. The interest portion for a month
is equal to the mortgage balance at the beginning of the month ($150,000 in this case) multiplied
by the interest rate per month (.5 percent), or $150,000 ϫ .005 ϭ $750. The remaining portion
of the payment, $899.33 Ϫ $750 ϭ $149.33, goes to reduce the principal balance.

2. We first need to know the monthly payment. Here, the original balance is $210,000, the rate
is 7 percent, and the original life is 15 years. Plugging in the numbers using the formula just
above, check that we get a monthly payment of $1,887.54. From here, there are two ways to go.
One is relatively easy; the other is relatively tedious. The tedious way would be to construct an
amortization table for the mortgage and then locate the balance in the table. However, we need
only a single balance, so there is a much faster way. After 10 years, we can treat this mortgage
as though it were a five-year mortgage with payments of $1,887.54 and an interest rate of 7 per-
cent. We can then solve for the mortgage balance using the same formula:

Monthly payment ϭ _M_o_r_t_g_a_g_e_b_a_l_a_n_c_e_ϫ__._0_7_/1_2_ ϭ $1,887.54

1 Ϫ _______1_______
(1 ϩ .07/12)5 ϫ 12

Solving for the mortgage balance gets us $95,324.50.

IQ Test Your Investment Quotient

For the remaining questions and problems, the circled numbers in the margin refer to the
corresponding learning objective in the chapter.
1 1. Fixed-Rate Mortgages Which of the following statements about fixed-rate mortgages is false?

a. 15-year mortgages have higher monthly payments than 30-year mortgages.
b. Scheduled monthly payments are constant over the life of the mortgage.
c. Actual monthly payments may vary over the life of the mortgage.
d. Actual monthly payments are never more than scheduled monthly payments.
1 2. Fixed-Rate Mortgages The interest component of a monthly payment for a fixed-rate
mortgage is

a. Highest during the first year of the mortgage.
b. Highest during the middle year of the mortgage.
c. Highest during the last year of the mortgage.
d. Constant throughout the life of the mortgage.

20-26 Part 6 ■ Topics in Investments

1 3. Fixed-Rate Mortgages The principal reduction component of a monthly payment for a
fixed-rate mortgage is

a. Highest during the first year of the mortgage.
b. Highest during the middle year of the mortgage.
c. Highest during the last year of the mortgage.
d. Constant throughout the life of the mortgage.

1 4. Fixed-Rate Mortgages The remaining balance on a 30-year, $100,000 mortgage loan
financed at 8 percent after the 180th payment is (no calculation necessary)

a. $100,000
b. $50,000
c. $76,782
d. $23,219

1 5. Fixed-Rate Mortgages Which of the following mortgages has the lowest monthly payment
(no calculation necessary)?

a. 30-year, 8 percent
b. 30-year, 10 percent
c. 15-year, 8 percent
d. 15-year, 10 percent

1 6. Fixed-Rate Mortgages Which of the following mortgages will pay the smallest total interest
over the life of the mortgage (no calculation necessary)?

a. 30-year, 8 percent www.mhhe.com/jm5e
b. 30-year, 10 percent
c. 15-year, 8 percent
d. 15-year, 10 percent

1 7. Fixed-Rate Mortgages Which of the following mortgages will have the largest remaining
balance after 180 monthly payments (no calculation necessary)?

a. 30-year, 8 percent
b. 30-year, 10 percent
c. 15-year, 8 percent
d. 15-year, 10 percent

2 8. GNMA Bonds Mortgages in GNMA pools are said to be fully modified because GNMA
guarantees bondholders which of the following?

a. A minimum rate of return on their investment.
b. A modified schedule of cash flows over the life of the pool.
c. Full and timely payment of both principal and interest in the event of default.
d. Eventual payment of both principal and interest in the event of default.

2 9. GNMA Bonds Which of the following is not a source of risk for GNMA mortgage pool investors?

a. Prepayment risk
b. Default risk
c. Interest rate risk
d. Reinvestment risk

2 10. GNMA Bonds Which one of the following sets of features most accurately describes a
GNMA mortgage passthrough security?

Average Life Payment Frequency Credit Risk
a. Predictable Monthly High
b. Predictable Semiannual Low
c. Unpredictable Monthly Low
d. Unpredictable Semiannual Low

2 11. GNMA Bonds In contrast to original-issue U.S. Treasury securities, original-issue GNMA
passthrough securities

a. Provide quarterly payments to the investor.
b. Have a limited availability of maturities.
c. Are often issued in zero coupon form.
d. Have interest payments.

Chapter 20 ■ Mortgage-Backed Securities 20-27

2 12. GNMA Bonds Which of the following should a bond portfolio manager purchase if the man-
ager is looking for mortgage-backed securities that would perform best during a period of rising

interest rates?

a. A 12 percent GNMA with an average life of 5.6 years.
b. An 8 percent GNMA with an average life of 6.0 years.
c. A 10 percent GNMA with an average life of 8.5 years.
d. A 6 percent GNMA with an average life of 9.0 years.

2 13. GNMA Bonds Why will the effective yield on a GNMA bond be higher than that of a U.S.
Treasury bond with the same quoted yield to maturity? Because

a. GNMA yields are figured on a 360-day basis.
b. GNMAs carry higher coupons.
c. GNMAs have longer compounding periods.
d. GNMA interest is paid monthly.

4 14. Mortgage-Backed Bonds If a mortgage-backed bond is issued as a fully modified
passthrough security, it means that

a. Bondholders will receive full and timely payment of principal and interest even if underlying
mortgage payments are not made.

b. The bond has been structured to include both conforming and nonconforming loans.
c. The interest rates on the underlying mortgages have been altered so that they equal the

weighted-average coupon on the bond.
d. The security carries a balloon payment to ensure that the bond is fully amortized in a set time

frame (12 to 15 years).

3 15. Prepayments Projecting prepayments for mortgage passthrough securities

www.mhhe.com/jm5e a. Requires only a projection of changes in the level of interest rates.
b. Requires analyzing both economic and demographic variables.
c. Is not necessary to determine a cash flow yield.
d. Is not necessary to determine duration.

3 16. Prepayments A bond analyst at Omnipotent Bank (OB) notices that the prepayment
experience on his holdings of high-coupon GNMA issues has been moving sharply higher. What
does this indicate?

a. Interest rates are falling.
b. The loans comprising OB’s pools have been experiencing lower default rates.
c. The pools held by OB are older issues.
d. All of the above.

4 17. Mortgage-Backed Bonds Which of the following statements about mortgage passthrough
securities is (are) correct?

I. Passthroughs offer better call protection than most corporates and Treasuries.
II. Interest and principal payments are made on a monthly basis.
III. It is common practice to use the weighted-average maturity on a passthrough in place of its

duration.
IV. Passthroughs are relatively immune from reinvestment risk.

a. I and III only
b. II and III only
c. II only
d. IV only

4 18. Mortgage-Backed Bonds Which of the following are advantages of mortgage-backed
securities (MBSs)?

I. MBS yields are above those of similarly rated corporate and U.S. Treasury bonds.
II. MBSs have high-quality ratings, usually AAA, with some backed by the full faith and credit

of the U.S. government.
III. MBSs have no call provision, thus protecting the investor from having to make a

reinvestment decision before maturity.

a. I and II only
b. II and III only
c. I and III only
d. I, II, and III

20-28 Part 6 ■ Topics in Investments

4 19. Mortgage-Backed Bonds Which of the following are characteristics that would make
mortgage-backed securities (MBSs) inappropriate for less sophisticated, conservative investors?

I. The maturity of MBSs is quite variable and difficult to determine.
II. Due to their convexity, the realized total return on MBSs is often more dependent on

interest rate levels than other bonds of similar maturity.
III. Due to a possible unfamiliarity with prepayment concepts, investors may not be able to

evaluate the true yield on MBS issues.
IV. Many MBS issues are not quoted widely and are difficult to monitor.

a. I, II, and III only
b. I, III, and IV only
c. II and IV only
d. I, II, III, and IV

4 20. Collateralized Mortgage Obligations For a given mortgage pool, which of the following
CMOs based on that pool is the riskiest investment?

a. 100/300 PAC bond
b. A-tranche sequential CMO
c. Interest-only (IO) strip
d. Principal-only (PO) strip

4 21. Collateralized Mortgage Obligations For a given mortgage pool, which of the following
CMOs based on that pool is most likely to increase in price when market interest rates increase?

a. 100/300 PAC bond www.mhhe.com/jm5e
b. A-tranche sequential CMO
c. Interest-only (IO) strip
d. Principal-only (PO) strip

4 22. MBS Duration Higher prepayments have what impact on the effective duration of a mortgage
passthrough security?

a. Decrease effective duration for all maturity mortgages.
b. Increase effective duration for all maturity mortgages.
c. Increase (decrease) effective duration for short (long) maturity mortgages.
d. Increase (decrease) effective duration for long (short) maturity mortgages.

4 23. MBS Duration Which of the following most accurately measures interest rate sensitivity for
mortgage passthrough securities with prepayment risk?

a. Static duration
b. Effective duration
c. Modified duration
d. Macaulay duration

4 24. CMO Duration Which of the following most accurately measures interest rate sensitivity for
collateralized mortgage obligations?

a. Static duration
b. Effective duration
c. Modified duration
d. Macaulay duration

4 25. MBS Duration The most important difference between effective duration and Macaulay
duration for a mortgage passthrough security is that

a. Macaulay duration is easier to calculate.
b. Effective duration is easier to calculate.
c. Macaulay duration accounts for prepayment sensitivity.
d. Effective duration accounts for prepayment sensitivity.

Concept Questions

4 1. Mortgage Securitization How does mortgage securitization benefit borrowers?
4 2. Mortgage Securitization How does mortgage securitization benefit mortgage

originators?

Chapter 20 ■ Mortgage-Backed Securities 20-29

1 3. Mortgage Payments All else the same, will the payments be higher on a 15-year mortgage or
a 30-year mortgage? Why?

2 4. Ginnie, Freddie, and Fannie From an investor’s point of view, what is the difference
between mortgage pools backed by GNMA, FNMA, and FHLMC?

4 5. Mortgage Pools What does it mean for a mortgage pool to be fully modified?

6. Prepayments What are some of the reasons that mortgages are paid off early? Under what
3 circumstances are mortgage prepayments likely to rise sharply? Explain.

3 7. Prepayments Explain why the right to prepay a mortgage is similar to the call feature con-
tained in most corporate bonds.

3 8. Prepayments Evaluate the following argument: “Prepayment is not a risk to mortgage inves-
tors because prepayment actually means that the investor is paid both in full and ahead of sched-
ule.” Is the statement always true or false?

3 9. Prepayments Mortgage pools also suffer from defaults. Explain how defaults are handled
in a fully modified mortgage pool. In the case of a fully modified mortgage pool, explain why
defaults appear as prepayments to the mortgage pool investor.

4 10. CMOs What is a collateralized mortgage obligation? Why do they exist? What are three
popular types?

4 11. IO and PO Strips What are IO and PO strips? Assuming interest rates never change, which is
riskier?

4 12. IO and PO Strips Which has greater interest rate risk, an IO or a PO strip?

www.mhhe.com/jm5e 13. Sequential CMOs Consider a single whole bond sequential CMO. It has two tranches, an
4 A-tranche and a Z-tranche. Explain how the payments are allocated to the two tranches. Which

tranche is riskier?

4 14. PACs Explain in general terms how a protected amortization class CMO works.

15. Duration and MBSs Why is Macaulay duration an inadequate measure of interest rate risk
4 for an MBS? Why is effective duration a better measure of interest rate risk for an MBS?

Core Questions Questions and Problems

1 1. Mortgage Payments What is the monthly payment on a 30-year fixed-rate mortgage if the
original balance is $220,000 and the rate is 6.3 percent?

1 2. Mortgage Balances If a mortgage has monthly payments of $945, a life of 30 years, and a
rate of 6.9 percent per year, what is the mortgage amount?

1 3. Mortgage Payments A homeowner takes out a $260,000, 30-year fixed-rate mortgage at a
rate of 6.5 percent. What are the monthly mortgage payments?

1 4. Mortgage Balance You have decided to buy a house. You can get a mortgage rate of 6.4 percent,
and you want your payments to be $1,325 or less. How much can you borrow on a
30-year fixed-rate mortgage?

4 5. SMM What is the single monthly mortality assuming the conditional prepayment rate is
5 percent?

4 6. CPR What is the conditional prepayment rate if the single monthly mortality is .493 percent?

7. IO and PO Values A $100,000 GNMA passthrough bond issue has a value of $113,830.
4 The value of the interest-only payments is $46,921. What is the value of the principal-only

payment?
1 8. Mortgage Interest A 30-year, $235,000 mortgage has a rate of 7.1 percent. What are the

interest and principal portions in the first payment? In the second?
1 9. Mortgage Balances A homeowner takes a 25-year fixed-rate mortgage for $190,000 at

7.6 percent. After seven years, the homeowner sells the house and pays off the remaining
principal. How much is the principal payment?
1 10. Mortgage Balances Consider a 30-year, $280,000 mortgage with an 8.3 percent interest
rate. After six years, the borrower (the mortgage issuer) pays it off. How much will the lender
receive?

20-30 Part 6 ■ Topics in Investments

Intermediate 3 11. Prepayments Consider a 30-year, $210,000 mortgage with a rate of 8 percent. Nine years into
Questions 3 the mortgage, rates have fallen to 6 percent. What would be the monthly saving to a homeowner
3 from refinancing the outstanding mortgage balance at the lower rate?
3
12. Prepayments Consider a 25-year, $180,000 mortgage with a rate of 7.25 percent. Eight years
3 into the mortgage, rates have fallen to 6.6 percent. What would be the monthly saving to a home-
owner from refinancing the outstanding mortgage balance at the lower rate?
3
13. Prepayments Consider a 30-year, $230,000 mortgage with a rate of 6.72 percent. Five years
Spreadsheet Problems into the mortgage, rates have fallen to 6.18 percent. Suppose the transaction cost of obtaining a
new mortgage is $2,500. Should the homeowner refinance at the lower rate?
www.mhhe.com/jm5e
14. Mortgage Prepayments A homeowner took out a 30-year, fixed-rate mortgage of $185,000.
The mortgage was taken out six years ago at a rate of 7.43 percent. If the homeowner refinances,
the charges will be $3,500. What is the highest interest rate at which it would be beneficial to
refinance the mortgage?

15. Mortgage Prepayments A homeowner took out a 30-year fixed-rate mortgage of $170,000.
The mortgage was taken out 20 years ago at a rate of 7.95 percent. If the homeowner refinances,
the charges will be $3,000. What is the highest interest rate at which it would be beneficial to
refinance the mortgage?

16. CPRs What are the conditional prepayment rates for seasoned 50 PSA, 200 PSA, and 400 PSA
mortgages if the 100 PSA benchmark is 5 percent per year? How do you interpret these numbers?

17. SMMs In the previous question, what is the single monthly mortality for seasoned 50 PSA,
200 PSA, and 400 PSA mortgages? How do you interpret these numbers?

18. Mortgage Payments A 30-year mortgage has an annual interest rate of 7.18 percent and a
loan amount of $180,000. What are the monthly mortgage payments?

19. Mortgage Amortization A 30-year mortgage has an annual interest rate of 6.84 percent and a
loan amount of $250,000. What are the interest and principal for the 120th payment?

20. Mortgage Balance A 30-year mortgage has an annual interest rate of 7.42 percent and a loan
amount of $200,000. What is the remaining balance at the 180th payment?

What’s on the Web?

1. Fixed Income Clearing Corporation (FICC) Go to www.dtcc.com. What is the role of
the FICC? What par value of mortgage-backed securities was cleared in each of the last three
months?

2. Fannie Mae Go to the mortgage-backed security section at www.fanniemae.com. What were
the longest term bonds recently issued by Fannie Mae? What are the coupon rates? What are the
coupon rates on the shortest term bonds issued?

3. SMBS Go to the mortgage-backed security section at www.fanniemae.com. Find the SMBS
section. What is an SMBS? How do they work? Is an SMBS a suitable investment for most
investors?

Chapter 20 ■ Mortgage-Backed Securities 20-31

Appendix A

Answers to Test Your Investment
Quotient Questions

Chapter 1 Chapter 4

1-1 b (Source: 1994 Level I CFA Study Guide © 1994) 4-1 c (Source: 2001 Level I CFA Practice Exam © 2001)
1-2 b (Source: 2001 Level I CFA Practice Exam © 2001) 4-2 b
1-3 c (Source: 2001 Level I CFA Practice Exam © 2001) 4-3 d
1-4 b (Source: 2001 Level I CFA Practice Exam © 2001) 4-4 d
1-5 b (Source: 2003 Level I CFA Practice Exam © 2003) 4-5 d
1-6 c (Source: 1994 Level I CFA Study Guide © 1994) 4-6 d
1-7 d 4-7 a
1-8 a 4-8 b
1-9 a 4-9 a
1-10 d 4-10 c
1-11 d 4-11 b
1-12 d 4-12 d
1-13 d 4-13 a
1-14 a (Source: 2003 Level I CFA Practice Exam © 2003) 4-14 a
1-15 b (Source: 2001 Level I CFA Practice Exam © 2001) 4-15 d

Chapter 2 Chapter 5

2-1 a (Source: 2003 Level I CFA Practice Exam © 2003) 5-1 c
2-2 c (Source: 2003 Level I CFA Practice Exam © 2003) 5-2 b
2-3 c 5-3 c
2-4 c 5-4 c (Source: 2003 Level I CFA Practice Exam © 2003)
2-5 b 5-5 a (Source: 2003 Level I CFA Practice Exam © 2003)
2-6 b 5-6 b (Source: 1991 Level I CFA Study Guide © 1991)
2-7 b 5-7 c (Source: 1991 Level I CFA Study Guide © 1991)
2-8 a 5-8 a (Source: 1991 Level I CFA Study Guide © 1991)
2-9 c 5-9 a (Source: 1991 Level I CFA Study Guide © 1991)
2-10 b 5-10 b (Source: 1990 Level I CFA Study Guide © 1990)
2-11 a 5-11 c (Source: 1990 Level I CFA Study Guide © 1990)
2-12 a 5-12 b
2-13 c 5-13 c
2-14 c 5-14 b
2-15 d 5-15 c

Chapter 3 Chapter 6

3-1 d 6-1 c
3-2 a 6-2 a (Source: 1994 Level I CFA Study Guide © 1994)
3-3 c 6-3 a (Source: 1998 Level I CFA Practice Exam © 1998)
3-4 a 6-4 b (Source: 1994 Level I CFA Study Guide © 1994)
3-5 c 6-5 b (Source: 1994 Level I CFA Study Guide © 1994)
3-6 b 6-6 c (Source: 1994 Level I CFA Study Guide © 1994)
3-7 c 6-7 d (Source: 1994 Level I CFA Study Guide © 1994)
3-8 c 6-8 c (Source: 1998 Level I CFA Study Guide © 1998)
3-9 c 6-9 c (Source: 1994 Level I CFA Study Guide © 1994)
3-10 c (Source: 2003 Level I CFA Practice Exam © 2003) 6-10 a (Source: 1991 Level I CFA Study Guide © 1991)

643

6-11 a (Source: 1994 Level I CFA Study Guide © 1994) Chapter 10
6-12 d
6-13 d 10-1 b (Source: 1993 Level I CFA Study Guide © 1993)
6-14 c 10-2 c (Source: 1989 Level I CFA Study Guide © 1989)
6-15 c (Source: 1998 Level I CFA Study Guide © 1998) 10-3 d (Source: 1992 Level I CFA Study Guide © 1992)
6-16 c (Source: 2001 Level I CFA Practice Exam © 2001) 10-4 a
6-17 c (Source: 2001 Level I CFA Practice Exam © 2001) 10-5 a
6-18 a 10-6 b (Source: 1991 Level I CFA Study Guide © 1991)
6-19 a 10-7 a (Source: 1991 Level I CFA Study Guide © 1991)
6-20 b 10-8 a (Source: 1998 Level I CFA Practice Exam © 1998)
10-9 b (Source: 1992 Level I CFA Study Guide © 1992)
Chapter 7 10-10 c (Source: 1992 Level I CFA Study Guide © 1992)
10-11 a (Source: 1994 Level I CFA Study Guide © 1994)
7-1 d (Source: 2003 Level I CFA Practice Exam © 2003) 10-12 a
7-2 c (Source: 2001 Level I CFA Practice Exam © 2001) 10-13 c (Source: 1988 Level I CFA Study Guide © 1988)
7-3 d 10-14 c (Source: 1990 Level I CFA Study Guide © 1990)
7-4 d 10-15 c (Source: 1992 Level I CFA Study Guide © 1992)
7-5 c 10-16 a (Source: 1991 Level I CFA Study Guide © 1991)
7-6 a 10-17 a (Source: 1992 Level I CFA Study Guide © 1992)
7-7 a 10-18 b (Source: 1992 Level I CFA Study Guide © 1992)
7-8 d 10-19 a (Source: 1992 Level I CFA Study Guide © 1992)
7-9 c 10-20 d (Source: 2003 Level I CFA Practice Exam © 2003)
7-10 d 10-21 b
7-11 c 10-22 a
7-12 d 10-23 c
7-13 b 10-24 c (Source: 2003 Level I CFA Practice Exam © 2003)
7-14 d 10-25 c (Source: 2003 Level I CFA Practice Exam © 2003)
7-15 d
Chapter 11
Chapter 8
11-1 d
8-1 d (Source: 1994 Level I CFA Practice Exam © 1994) 11-2 c
8-2 c 11-3 c
8-3 d 11-4 b (Source: 1994 Level I CFA Study Guide © 1994)
8-4 b 11-5 c (Source: 2003 Level I CFA Practice Exam © 2003)
8-5 a 11-6 a (Source: 2003 Level I CFA Practice Exam © 2003)
8-6 b 11-7 a (Source: 2003 Level I CFA Practice Exam © 2003)
8-7 c 11-8 b
8-8 a 11-9 b
8-9 d 11-10 a
8-10 b 11-11 d
8-11 c 11-12 b
8-12 b 11-13 d
8-13 c 11-14 c (Source: 1994 Level I CFA Study Guide © 1994)
8-14 b 11-15 a (Source: 1994 Level I CFA Study Guide © 1994)
8-15 d
Chapter 12
Chapter 9
12-1 d (Source: 1994 Level I CFA Study Guide © 1994)
9-1 b 12-2 a
9-2 a 12-3 a
9-3 a 12-4 d
9-4 d 12-5 b
9-5 d (Source: 1988 Level I CFA Study Guide © 1988) 12-6 b
9-6 b 12-7 b
9-7 a 12-8 c
9-8 c 12-9 d
9-9 c (Source: 1991 Level I CFA Study Guide © 1991) 12-10 d
9-10 b (Source: 2001 Level I CFA Practice Exam © 2001) 12-11 d
9-11 a (Source: 2001 Level I CFA Practice Exam © 2001) 12-12 a
9-12 a 12-13 b (Source: 2003 Level I CFA Practice Exam © 2003)
9-13 d (Source: 1993 Level I CFA Study Guide © 1993) 12-14 a (Source: 2003 Level I CFA Practice Exam © 2003)
9-14 a (Source: 1988 Level I CFA Study Guide © 1988) 12-15 b (Source: 2003 Level I CFA Practice Exam © 2003)
9-15 b (Source: 1989 Level I CFA Study Guide © 1989)
9-16 a (Source: 1992 Level I CFA Study Guide © 1992) Chapter 13
9-17 b
9-18 c 13-1 b (Source: 1994 Level I CFA Study Guide © 1994)
9-19 d (Source: 1994 Level I CFA Study Guide © 1994) 13-2 a (Source: 1994 Level I CFA Study Guide © 1994)
9-20 d (Source: 1998 Level I CFA Practice Exam © 1998) 13-3 b (Source: 1994 Level I CFA Study Guide © 1994)

644 Appendix A

13-4 c 16-9 d
13-5 a 16-10 a
13-6 b 16-11 c
13-7 b 16-12 d
13-8 d 16-13 a
13-9 c (Source: 1994 Level I CFA Study Guide © 1994) 16-14 b
13-10 c 16-15 b
13-11 d 16-16 d
13-12 a 16-17 a
13-13 d 16-18 c
13-14 b 16-19 c
13-15 c 16-20 d

Chapter 14 Chapter 17

14-1 d 17-1 b (Source: 1999 Level I CFA Practice Exam © 1999)
14-2 a 17-2 b
14-3 b 17-3 d
14-4 a 17-4 c
14-5 d (Source: 1993 Level I CFA Study Guide © 1993) 17-5 a
14-6 a (Source: 1999 Level I CFA Practice Exam © 1999) 17-6 a
14-7 c 17-7 b
14-8 d (Source: 2003 Level I CFA Practice Exam © 2003) 17-8 d
14-9 c (Source: 2003 Level I CFA Practice Exam © 2003) 17-9 c
14-10 d 17-10 a
14-11 a 17-11 b
14-12 d 17-12 c
14-13 d (Source: 1993 Level I CFA Study Guide © 1993) 17-13 c
14-14 b 17-14 b (Source: 1994 Level I CFA Study Guide © 1994)
14-15 b 17-15 c (Source: 1994 Level I CFA Study Guide © 1994)
14-16 b 17-16 b (Source: 1994 Level I CFA Study Guide © 1994)
14-17 d 17-17 a (Source: 1994 Level I CFA Study Guide © 1994)
14-18 c 17-18 b (Source: 1994 Level I CFA Study Guide © 1994)
14-19 a 17-19 c
14-20 d 17-20 d

Chapter 15 Chapter 18

15-1 a 18-1 d (Source: 1990 Level I CFA Study Guide © 1990)
15-2 c 18-2 c (Source: 1988 Level I CFA Study Guide © 1988)
15-3 d 18-3 a (Source: 1989 Level I CFA Study Guide © 1989)
15-4 c (Source: 2003 Level I CFA Practice Exam © 2003) 18-4 c (Source: 1990 Level I CFA Study Guide © 1990)
15-5 c 18-5 c (Source: 1998 Level I CFA Practice Exam © 1998)
15-6 b (Source: 1992 Level I CFA Study Guide © 1992) 18-6 a
15-7 d 18-7 b (Source: 1991 Level I CFA Study Guide © 1991)
15-8 a 18-8 a
15-9 a (Source: 1990 Level I CFA Study Guide © 1990) 18-9 b (Source: 2003 Level I CFA Practice Exam © 2003)
15-10 c (Source: 1994 Level I CFA Study Guide © 1994) 18-10 b
15-11 a 18-11 c (Source: 1992 Level I CFA Study Guide © 1992)
15-12 b (Source: 1993 Level I CFA Study Guide © 1993) 18-12 a (Source: 1989 Level I CFA Study Guide © 1989)
15-13 a (Source: 1993 Level I CFA Study Guide © 1993) 18-13 d (Source: 1990 Level I CFA Study Guide © 1990)
15-14 b (Source: 1991 Level I CFA Study Guide © 1991) 18-14 a
15-15 d 18-15 c (Source: 1998 Level I CFA Practice Exam © 1998)
15-16 a (Source: 2003 Level I CFA Practice Exam © 2003) 18-16 b (Source: 1990 Level I CFA Study Guide © 1990)
15-17 d (Source: 2003 Level I CFA Practice Exam © 2003) 18-17 b (Source: 1988 Level I CFA Study Guide © 1988)
15-18 c (Source: 2003 Level I CFA Practice Exam © 2003) 18-18 d (Source: 1994 Level I CFA Study Guide © 1994)
15-19 d 18-19 b (Source: 1991 Level I CFA Study Guide © 1991)
15-20 c 18-20 c (Source: 1993 Level I CFA Study Guide © 1993)
18-21 c (Source: 1991 Level I CFA Study Guide © 1991)
Chapter 16 18-22 d (Source: 1994 Level I CFA Study Guide © 1994)
18-23 d
16-1 a 18-24 b
16-2 d 18-25 a (Source: 2003 Level I CFA Practice Exam © 2003)
16-3 c
16-4 a (Source: 1992 Level I CFA Study Guide © 1992) Chapter 19
16-5 d (Source: 1990 Level I CFA Study Guide © 1990)
16-6 a (Source: 1989 Level I CFA Study Guide © 1989) 19-1 a
16-7 a (Source: 1993 Level I CFA Study Guide © 1993) 19-2 c
16-8 b (Source: 1998 Level I CFA Study Guide © 1998) 19-3 a

Appendix A 645

19-4 c (Source: 1990 Level I CFA Study Guide © 1990) 20-3 c
19-5 b (Source: 1998 Level I CFA Practice Exam © 1998) 20-4 c
19-6 b 20-5 a
19-7 d 20-6 c
19-8 b 20-7 b
19-9 b 20-8 c
19-10 a 20-9 b
19-11 b 20-10 c (Source: 1988 Level I CFA Study Guide © 1988)
19-12 a 20-11 b (Source: 1988 Level I CFA Study Guide © 1988)
19-13 a 20-12 a (Source: 1989 Level I CFA Study Guide © 1989)
19-14 c 20-13 d (Source: 1991 Level I CFA Study Guide © 1991)
19-15 d (Source: 1992 Level I CFA Study Guide © 1992) 20-14 a (Source: 1991 Level I CFA Study Guide © 1991)
19-16 d (Source: 1989 Level I CFA Study Guide © 1989) 20-15 b (Source: 1990 Level I CFA Study Guide © 1990)
19-17 d 20-16 a (Source: 1989 Level I CFA Study Guide © 1989)
19-18 a 20-17 c (Source: 1991 Level I CFA Study Guide © 1991)
19-19 b 20-18 a (Source: 1991 Level I CFA Study Guide © 1991)
19-20 c (Source: 1990 Level I CFA Study Guide © 1990) 20-19 d (Source: 1989 Level I CFA Study Guide © 1989)
19-21 d 20-20 c
19-22 b (Source: 1991 Level I CFA Study Guide © 1991) 20-21 c
19-23 b (Source: 1992 Level I CFA Study Guide © 1992) 20-22 a
19-24 a (Source: 1991 Level I CFA Study Guide © 1991) 20-23 b
19-25 a (Source: 1994 Level I CFA Study Guide © 1994) 20-24 b
20-25 d
Chapter 20 (Web site only)

20-1 d
20-2 a

646 Appendix A

Appendix B

Answers to Selected Questions and Problems

Chapter 1 Chapter 6

1-1 $988 6-1 $40.00
1-5 Cherry average return ϭ 9.20% 6-4 $5.59
6-9 $3.74; $4.08
Straw average return ϭ 13.80% 6-13 $75.78
1-9 Arithmetic average ϭ 11.67% 6-17 $17.95
6-22 $28.23
Geometric average ϭ 9.820% 6-25 18.90 times
1-13 Probability of doubling ϭ 0.58% 6-29 Ϫ$30.17
6-33 ROE ϭ 11.87%
Probability of tripling ϭ 0.0000012%
1-17 Small company stocks ϭ 12.69% g ϭ 8.31%

Long-term government bonds ϭ 5.42% Chapter 7
Treasury bills ϭ 3.72%
Inflation ϭ 3.03% None

Chapter 2 Chapter 8

2-1 305.16 shares 8-2 1.232; 0.963; 0.776; 1.025; 0.862
2-5 $21,818.18 8-6 0.4793; 0.4380; 0.3884; 0.4132; 0.3554
2-9 Critical stock price ϭ $75.12 8-15 0.8703; 0.8901; 0.9035; 0.9120

Account equity ϭ $22,530 Chapter 9
2-13 $77.14
2-17 $1,234.60 9-1 78.50%
2-21 Ϫ18.90%
2-25 Effective annual return ϭ 18.23% 9-5 8.30%

Chapter 3 9-9 $987,127.22

3-1 Closing price ϭ $65.89 9-13 BEY ϭ 5.811%
Round lots ϭ 186,491
Discount yield ϭ 5.633%
3-5 Next payment ϭ $126,000
Payment at maturity ϭ $3,126,000 9-17 5-year STRIP ϭ 76:06

3-9 Current yield ϭ 6.62% f1,5 ϭ 5.589%
Treasury yield ϭ 6.85% 2-year STRIP ϭ 89:05

3-13 Ϫ$2,156 f ϭ 5.902%
3-20 137.41%
2,3
Chapter 4
9-21 f ϭ 6.50%
4-1 $41.43
4-5 $51.31 1,1
4-9 $22.06; Ϫ16.73%
4-13 2.45% f1,2 ϭ 6.91%
4-17 9.03%
4-21 $113,350 f1,3 ϭ 8.04%

Chapter 5 Chapter 10

5-1 2.21863 10-1 $913.90
5-5 19.78% 10-5 9.18%
5-9 3.88973 10-9 9.75%
5-13 0.208594 10-13 9.09%
10-19 11.48 years
10-21 YTM ϭ 6.95%

Realized yield ϭ Ϫ1.02%
10-25 $0.606
10-29 Macaulay duration ϭ 10.498

Modified duration ϭ 10.143
10-33 5.33%

647

Chapter 11 15-9 $82.68
15-13 $13.17
11-1 10.80% 15-16 $900
11-5 Roll ϭ 17.41%
Chapter 16
Ross ϭ 5.96%
11-9 a. 7.93% 16-1 $14.42
16-5 $5.73
b. 0.03419; 18.49% 16-9 3,163
11-17 Standard deviation ϭ 17.39% 16-13 $3.48
16-17 $7.43
Expected return ϭ 10.30% 16-20 $5.26
11-20 Standard deviation ϭ 32.65%
Chapter 17
Expected return ϭ 13.05%
17-1 $46,885
Chapter 12 17-5 P/B ϭ 3.87 times

12-1 1.32 P/E ϭ 11.26 times
12-5 1.155 P/CF ϭ 8.98 times
12-9 $58.95 17-9 $250,000
12-13 2.64% 17-13 ROA ϭ 16.99%
12-17 1.72 ROE ϭ 40.11%
12-23 Expected return ϭ 0.645% 17-17 Maximum sales growth ϭ 11.11%

Standard deviation ϭ 2.13% Chapter 18

Chapter 13 18-1 $35.71
18-5 $1,150
13-1 15.92% 18-8 $79.79
13-4 Monthly standard deviation ϭ 12.96% 18-12 Conversion value ϭ $880

Annual standard deviation ϭ 46.73% Conversion price ϭ $47.73
13-9 Ϫ44.93%
13-13 Ϫ14.10% Chapter 19
13-18 Ϫ121.93%
13-21 Ϫ10.78% 19-1 $3,053.67
19-5 5.78%
Chapter 14 19-9 5.11%
19-13 $1,074.6875
14-1 a. $49,706.25 19-17 4.33%
b. $872,046
c. $11,750 Chapter 20 (Web site only)
d. Ϫ$4,860
20-1 $1,361.74
14-5 $16,794,515,050 20-5 0.4265%
14-9 $95.38 20-9 $166,460.81
14-13 Day 1: $200,325 20-13 $56.29
20-17 50 PSA: 0.2108%
Day 2: $170,925
Day 3: $185,625 200 PSA: 0.8742%
Day 4: $185,625 400 PSA: 1.8423%
Profit ϭ Ϫ$64,050
14-17 851.85
14-21 8,805.64
14-25 a. 190.55
b. 190.40

Chapter 15

15-1 $1,600
15-5 $37,500; $12,000

648 Appendix B

Appendix C

Key Equations

Chapter 1 2. P0 ϭ _D_0_(_1_ϩ___g_) (6.2)
kϪg (6.3)
1. Dividend yield ϭ Dt ϩ 1/Pt (1.1)
(1.2) __D_1__
2. Capital gains yield ϭ (Pt ϩ 1 Ϫ Pt)/Pt (1.3) 3. P ϭ kϪg
(1.4) 0

3. Total return ϭ (Dt ϩ 1 ϩ P ϩ 1 Ϫ Pt)/Pt (1.5) _D_N_ 1/N
t D0
4. Var(R) ϭ [(R1 Ϫ R-)2 ϩ (R2 Ϫ R-)2 ϩ . . . ϩ (RN Ϫ R-)2]/(N Ϫ 1) ΄ ΅4.gϭ Ϫ1

5. Geometric average return ϭ [(1 ϩ R1) ϫ (1 ϩ R2) ϫ . . . 5. Payout ratio ϭ D/EPS

ϫ (1 ϩ RN)]1/N Ϫ 1 6. Sustainable growth rate ϭ ROE ϫ Retention ratio (6.7)
ϭ ROE ϫ (1 Ϫ Payout ratio)
6. 1 ϩ EAR ϭ (1 ϩ holding period percentage return)m

7. Blume’s formula: R(T) ϭ _T__Ϫ__1_ ϫ Geometric average 7. Return on equity (ROE) ϭ Net Income/Equity (6.8)
NϪ1
_N__Ϫ__T_
ϩ NϪ1 ϫ Arithmetic average 8. The two-stage dividend growth model:

_D_0_(1__ϩ__g_1_) _1_ϩ___g_1 T _1_ϩ___g_1 T
k Ϫ g1 1ϩk 1ϩk
΄ ͑ ͒ ΅ ͑ ͒P0ϭ ϫ 1Ϫ ϩ

Chapter 2 _D_0_(1__ϩ__g_2_)
k Ϫ g2
1. Margin ϭ _A_c_c_o_u_n_t_e_q_u_i_ty_ ϫ (6.9)
Value of stock

Buying on margin: 9. Discount rate ϭ U.S. T-bill rate ϩ (Stock beta ϫ Stock market

2. Maintenance margin risk premium) (6.15)

_N_u_m__b_e_r _o_f_s_h_a_re_s_ϫ___P_*_Ϫ___A_m__o_u_n_t _b_o_rr_o_w__ed_ In this equation:
Number of shares ϫ P*
ϭ U.S. T-bill rate ϭ Return on 90-day U.S. T-bills

In equation 2: Stock beta ϭ Risk relative to an average stock

3. P* ϭ _A_m__o_u_n_t _b_o_rr_o_w__ed_/_N_u__m_b_e_r_o_f_s_h_a_r_e_s (2.1) Stock market risk premium ϭ Risk premium for an
1 Ϫ Maintenance margin
average stock

Short selling: 10. P0 ϭ B0 ϩ _E_P_S_1_Ϫ___B_0_ϫ__k_ ϩ _E_P_S_2_Ϫ___B_1_ϫ__k_
(1 ϩ k)1 (1 ϩ k)2
4. Maintenance margin

ϭ _In_i_ti_a_l _m_a_r_g_in__d_ep_o_s_i_t _ϩ__S_h_o_rt_p_r_o_c_e_e_d_s_Ϫ__N_u_m__b_e_r_o_f_s_h_ar_e_s_ϫ__P_*_ ϩ _E_P_S_3_Ϫ___B_2_ϫ__k_ ϩ . . . (6.16)
Number of shares ϫ P* (1 ϩ k)3

In equation 4: _E_P_S_0_(_1_ϩ___g_) _Ϫ__B_0_ϫ___k
kϪg
5. P* ϭ _(I_n_i_ti_a_l _m_a_r_g_in__d_e_p_o_s_it_ϩ__S__h_o_rt_p_r_o_c_e_e_d_s_)/_N_u_m__b_e_r_o_f_s_h_a_r_e_s 11. P ϭ B ϩ (6.17)
1 ϩ Maintenance margin 0 0

12. P0 ϭ _E_P_S_1_Ϫ___B_0_ϫ__g_ (6.18)
kϪg
Chapter 3
13. D ϭ EPS ϩ B Ϫ B ϭ EPS ϩ B Ϫ B0(1 ϩ g)
1. EAR ϭ [1 ϩ (APR/m)]m Ϫ 1 1 1 0 1 1 0

ϭ EPS1 Ϫ B0 ϫ g (6.19)

14. Expected price ϭ Historical P/E ratio ϫ Projected EPS

Chapter 4 ϭ Historical P/E ratio ϫ Current EPS

1. Net asset value ϭ ________A__s_se_t_v_a_l_u_e________ ϫ (1 ϩ Projected EPS growth rate)
Number of shares outstanding
15. Expected price ϭ Historical P/CF ratio ϫ Projected CFPS
Chapter 5 ϭ Historical P/CF ratio ϫ Current CFPS
ϫ (1 ϩ Projected CFPS growth rate)

1. Price-weighted index level ϭ _S_u_m__o_f_s_to_c_k__p_ri_c_e_s 16. Expected price ϭ Historical P/S ratio ϫ Projected SPS
Divisor ϭ Historical P/S ratio ϫ Current SPS
ϫ (1 ϩ Projected SPS growth rate)

Chapter 6

1. P0 ϭ ___D__1 __ ϩ ___D_2___ ϩ ___D_3___ ϩ . . . ϩ ___D_T___ (6.1) Chapter 7
(1 ϩ k) (1 ϩ k)2 (1 ϩ k)3 (1 ϩ k)T
1. Abnormal return ϭ Observed return Ϫ Expected return (7.1)

649

Chapter 8 7. Callable bond price

1. Market Sentiment Index (MSI) __C__ ______1______ _____C__P_____
YTC (1 ϩ YTC/2)2T (1 ϩ YTC/2)2T
΄ ΅ϭ 1 Ϫ ϩ (10.4)

ϭ _____________N__u_m_b_e_r_o_f_b_e_a_r_is_h__in_v_e_s_to_r_s_____________ In this formula:
Number of bullish investors ϩ Number of bearish investors
C ϭ Constant annual coupon
__D_e_c_l_in_i_n_g_V_o_l_u_m__e_/ D__e_c_li_n_in_g__I_ss_u_e__
2. Arms ϭ Advancing Volume/Advancing Issues (8.1) CP ϭ Call price of the bond

T ϭ Time in years until earliest possible call date

YTC ϭ Yield to call assuming semiannual coupons

Chapter 9 8. Percentage change in bond price Ϸ ϪDuration

1. Future value ϭ Present value ϫ (1 ϩ r)N (9.1) ϫ _C_h_a_n_g_e_i_n_Y__T_M_ (10.5)
(9.3) (1 ϩ YTM/2)
_F_u_tu__re__v_a_lu_e_ (9.4)
2. Present value ϭ (1 ϩ r)N (9.5) _M_a_c_a_u_l_a_y_d_u__ra_t_io_n_
(1 ϩ YTM/2)
3. Present value ϭ Future value ϫ (1 ϩ r)ϪN (9.6) 9. Modified duration ϭ (10.6)
(10.7)
4. Current price (9.7) 10. Percentage change in bond price Ϸ ϪModified duration
(9.8)
͑ ͒ϭ Face value ϫ (9.11) ϫ Change in YTM
_D_a_y_s_t_o_m__a_t_u_ri_ty_
1 Ϫ 360 ϫ Discount yield (9.13) 11. Par value bond duration

_(1__ϩ__Y_T_M__/_2_) Ϫ ______1_______
YTM (1 ϩ YTM/2)2M
5. Bond equivalent yield ΄ ΅ϭ 1 (10.8)

ϭ _________3_6_5_ϫ__D__is_c_o_u_n_t_y_i_e_ld_________ In this formula:
360 Ϫ Days to maturity ϫ Discount yield
M ϭ Bond maturity in years

YTM ϭ Yield to maturity assuming semiannual coupons

6. Bill price 12. Duration

ϭ _________________F_a_c_e_v_a_l_u_e_________________ ϭ _1_ϩ___Y_T_M__/2_ Ϫ _(_1_ϩ__Y__T_M_/_2_)_ϩ__M__(_C_P_R__Ϫ__Y_T__M_)_ (10.9)
1 ϩ Bond equivalent yield ϫ Days to maturity/365 YTM YTM ϩ CPR[(1 ϩ YTM/2)2M Ϫ 1]

͑ ͒7. 1 ϩ EAR ϭ 1 ϩ _A_mP_R_ m In this formula:

8. Real interest rate ϭ Nominal interest rate Ϫ Inflation rate CPR ϭ Constant annual coupon rate

M ϭ Bond maturity in years

9. STRIPS price ϭ __F__a_ce__v_a_l_u_e__ YTM ϭ Yield to maturity assuming semiannual coupons
(1 ϩ YTM/2)2M
13. Dollar value of an 01 Ϸ Modified duration ϫ
_1__ Bond price ϫ 0.0001

2M Ϫ 1
΄ ͑ ͒ ΅10. YTM ϭ 2 ϫ
__F_a_c_e_v__al_u_e__ (10.10)
STRIPS price
___________1____________
_(1__ϩ__r_2_)_2 14. Yield value of a 32nd Ϸ 32 ϫ Dollar value of an 01 (10.11)

11. f ϭ 1 ϩ r Ϫ 1
1
1,1

12. NI ϭ RI ϩ IP ϩ RP ϩ LP ϩ DP Chapter 11

In this equation: 1. Risk premium ϭ Expected return Ϫ Risk-free rate (11.1)
(11.2)
NI ϭ Nominal interest rate Risk premium ϭ E(RJ) Ϫ Rf (11.3)
(11.4)
RI ϭ Real interest rate
(11.5)
IP ϭ Inflation premium 2. Portfolio return for an “N” asset portfolio: (11.6)
E(RP) ϭ x1 ϫ E(R1) ϩ x2 ϫ E(R2) ϩ . . . ϩ xn ϫ E(Rn) (11.7)
RP ϭ Interest rate risk premium

LP ϭ Liquidity premium 3. Portfolio variance for two asset portfolio:

DP ϭ Default premium ␴ 2 ϭ x 2 ␴ 2 ϩ x 2 ␴ 2 ϩ 2xAxB␴A␴BCorr(RA, RB)
P A A B B

4. Portfolio variance for three asset portfolio:

Chapter 10 ␴ 2 ϭ x 2A␴ 2 ϩ x 2 ␴ 2 ϩ x 2 ␴ 2 ϩ 2xAxB␴A␴BCorr(RA, RB)
P A B B C C

_A_n_n_u_a_l_c_o_u_p_o_n_ ϩ 2xAxC ␴A␴CCorr(RA, RC) ϩ 2xB x ␴B␴CCorr (RB, RC)
Par value C

1. Coupon rate ϭ (10.1) 5. The weight in asset A in the minimum variance portfolio:
(10.2)
2. Current yield ϭ _A_n_n_u_a_l_c_o_u_p_o_n_ x * ϭ ___␴__2B_Ϫ__␴__A␴__BC__o_r_r(_R_A_,_R_B_)___
Bond price A
␴ 2 ϩ ␴ 2 Ϫ 2␴A␴BCorr(RA, RB)
A B

3. Bond price 6. Portfolio return for three asset portfolio:

__C___ ______1_______ ______F_V______ RP ϭ xF RF ϩ xS RS ϩ xB RB
YTM (1 ϩ YTM/2)2M (1 ϩ YTM/2)2M
΄ ΅ϭ 1 Ϫ ϩ (10.3) 7. Portfolio variance for three asset portfolio when all

In this formula: correlations are zero:
C ϭ Annual coupon, the sum of two semiannual coupons
␴ 2 ϭ x 2 ␴ 2 ϩ x 2 ␴ 2 ϩ x 2 ␴ 2
FV ϭ Face Value P F F S S B B
M ϭ Maturity in years
YTM ϭ Yield to maturity Chapter 12

4. Premium bonds: Coupon rate Ͼ Current yield Ͼ Yield to 1. Total return Ϫ Expected return ϭ Unexpected return (12.1)
maturity
R Ϫ E(R) ϭ U (12.2)
(12.3)
5. Discount bonds: Coupon rate Ͻ Current yield Ͻ Yield to 2. Announcement ϭ Expected part ϩ Surprise (12.4)
maturity (12.5)
3. R Ϫ E(R) ϭ Systematic portion ϩ Unsystematic portion

6. Par value bonds: Coupon rate ϭ Current yield ϭ Yield to 4. R Ϫ E(R) ϭ U ϭ m ϩ ⑀
maturity
5. Total risk ϭ Systematic risk ϩ Unsystematic risk

650 Appendix C

_E_(_R_A_)_Ϫ__R__f ϭ _E_(_R_B_)_Ϫ__R__f (12.6) 2. Call Value, One Period Binomial Model: (16.2)
␤A ␤B
6. (12.7) _⌬_S_(_1_ϩ__r__Ϫ__u_)_ϩ__C__u
(12.8) 1ϩr
_E_(_R_M_)_Ϫ___R_f _E_(_R_M_)_Ϫ___R_f (12.9) C ϭ
␤M 1 (12.10)
7. SML slope ϭ ϭ ϭ E(RM) Ϫ R (12.11) 3. Black-Scholes Call Option Pricing Model: (16.3)
f (16.4)

8. E(Ri) ϭ Rf ϩ [E(RM) Ϫ Rf ] ϫ ␤i C ϭ SN(d1) Ϫ KeϪrT N(d2)
9. R Ϫ E(R) ϭ m ϩ ⑀
4. Black-Scholes Put Option Pricing Model:
10. m ϭ [RM Ϫ E(RM)] ϫ ␤
11. R Ϫ E(R) ϭ m ϩ ⑀ ϭ [RM Ϫ E(RM)] ϫ ␤ ϩ ⑀ P ϭ KeϪrT N(Ϫd2) Ϫ SN(Ϫd1)
12. ␤i ϭ Corr(Ri, RM) ϫ ␴i /␴M Where, in the Black-Scholes formula, d1 and d2 are:

5. d1 ϭ _ln_(_S_/_K_)_ϩ___(r___ϩ___␴_2_/_2_)T_
␴ ͙T
__
6. d2 ϭ d1 Ϫ ␴͙T

Chapter 13 7. Call option delta ϭ N(d1) Ͼ 0

1. Sharpe ratio ϭ _R_P_␴Ϫ_p__R_f (13.1) 8. Put option delta ϭ ϪN(Ϫd1) Ͻ 0
(13.2)
_R_P_Ϫ___R_f (13.3) 9. A useful option hedging equation:
␤p (13.4)
2. Treynor ratio ϭ (13.5) Change in stock price ϫ shares ϭ Option delta ϫ Number
(13.6)
(13.7) of options

3. E(RP) ϭ Rf ϩ [E(RM) Ϫ Rf ] ϫ ␤p (13.8) 10. Number of stock options needed to hedge an equity portfolio:
4. ␣P ϭ Rp Ϫ E(Rp)
Number of option contracts (16.7)
ϭ Rp Ϫ {Rf ϩ [E(RM) Ϫ Rf ] ϫ ␤p}
___P_o_r_tf_o_l_io__b_e_ta__ϫ__P_o_r_tf_o_l_io__v_a_lu_e___
_E_(_R_p␴)_p_Ϫ__R_f ϭ ______________x__S__E__(R____S)__ϩ______x__BE__(__R__B__)__Ϫ____R____f ______________ ϭ Option delta ϫ Option contract value

͙5. x 2 ␴ 2 ϩ x 2 ␴ 2 ϩ 2xS xB␴S␴BCorr(RS, RB) 11. Black-Scholes-Merton call option formula:
S S B B

6. E(Rp,T) ϭ E(Rp) ϫ T C ϭ SeϪyT N(d1) Ϫ KeϪrT N(d2) (16.8)
Where, in the Black-Scholes-Merton call option formula,
__
d1 and d2 are:
7. ␴p,T ϭ ␴p ϫ ͙T

8. Value-at-Risk: 12. d1 ϭ _ln_(_S_/K__)_ϩ__(_r_Ϫ____y__ϩ__␴_2_/_2_)T_
␴͙T
__ __
ϭ Ϫ ␴
Prob[Rp,T Յ E(Rp) ϫ T Ϫ 2.326 ϫ ␴p͙__T ] ϭ 1% 13. d d ͙T
Prob[Rp,T Յ E(Rp) ϫ T Ϫ 1.96 ϫ ␴p͙T_]_ ϭ 2.5% 2 1
Prob[Rp,T Յ E(Rp) ϫ T Ϫ 1.645 ϫ ␴p͙T ] ϭ 5%

Chapter 17

Chapter 14 Profitability ratios:

1. Basis ϭ Cash price Ϫ Futures price (14.1) 1. Gross margin ϭ _G_r_o_s_s_p_r_o_fi_t
(14.3) Net sales
(14.6)
2. Spot-futures parity: FT ϭ S(1 ϩ r)T (14.7) _O_p_e_r_a_ti_n_g_i_n_c_o_m__e
Net sales
3. Spot-futures parity (with dividend yield): (14.8) 2. Operating margin ϭ

F ϭ S(1 ϩ r Ϫ d )T (14.9) _N_e_t_i_n_c_o_m_e_
T Total assets

4. Number of index futures contracts, N, needed to change 3. Return on assets (ROA) ϭ

equity portfolio beta: ____N_e_t_i_n_c_o_m_e____
Shareholder equity
N ϭ (␤D Ϫ ␤P) ϫ _V_P_ 4. Return on equity (ROE) ϭ
VF
Per share calculations:
5. Number of U.S. Treasury note futures contracts, N,

needed to hedge a bond portfolio: 5. Book value per share (BVPS) ϭ _S_h_a_re_h_o_l_d_e_r_e_q_u_i_ty_
Shares outstanding
ϭ _D_P_ϫ__V__P
N DF ϫ VF

6. Duration of an interest rate futures contract 6. Earnings per share (EPS) ϭ ____N_e_t_i_n_c_o_m_e____
Shares outstanding

(rule of thumb): D ϭ D ϩ M _O_p_e_r_a_ti_n_g__ca_s_h__fl_o_w_
F U F Shares outstanding
7. Cash flow per share (CFPS) ϭ

Chapter 15 Price ratios:

1. Call option intrinsic value ϭ MAX(S Ϫ K,0) (15.1) 8. Price-book (P/B) ϭ _S_to_c_k__p_r_ic_e_
2. Put option intrinsic value ϭ MAX(K Ϫ S,0) (15.2) BVPS
3. The put-call parity relationship: C Ϫ P ϭ S0 Ϫ K/(1 ϩ rf )T (15.6)
4. The put-call parity relationship (with dividends): 9. Price-earnings (P/E) ϭ _S_to_c_k__p_r_ic_e_
(15.8) EPS
C Ϫ P ϭ S0 Ϫ Div Ϫ K/(1 ϩ rf )T
10. Price-cash flow (P/CF) ϭ _S_to_c_k__p_r_ic_e_
CFPS

Two-stage residual income model (RIM):

Chapter 16 _E_P_S_0_(1__ϩ__g_1_)_Ϫ__B__V_P_S_0_ϫ___k _1_ϩ___g_1 T
k Ϫ g1 1ϩk
΄ ͑ ͒ ΅11.ϭ ϩ 1Ϫ
P0 BVPS0
1. Delta, One Period Binomial Model:

⌬ ϭ _C_u_Ϫ__C__d ϩ _E_P_S_0_(_1_ϩ__g_1_)_T_(_1_ϩ__g_2_)_Ϫ__B_V__P_S_0(_1__ϩ__k_)T__k (17.3)
Su Ϫ Sd (k Ϫ g2)/(1 ϩ k)T

Appendix C 651

Chapter 18 Bond Price ϭ _A_n_n_u_a_l_C_o_u_p_o_n_ ϫ 1 Ϫ ______1_______
YTM (1 ϩ YTM/2)2M
Convertible bond to stock conversion formulas: ΄ ΅3.
1. Conversion ratio ϭ Number of stock shares acquired
by conversion ϩ __F_a_c_e__V_a_l_u_e__
(1 ϩ YTM/2)2M

2. Conversion price ϭ _B__o_n_d_p_a_r_v_a_l_u_e_ 4. Equivalent taxable yield ϭ Tax-exempt yield / (1 Ϫ Marginal
Conversion ratio tax rate)

3. Conversion value ϭ Price per share of stock ϫ Conversion ratio 5. After-tax yield ϭ Taxable yield ϫ (1 Ϫ Marginal tax rate)

6. Critical marginal tax rate ϭ 1 Ϫ (tax-exempt yield/taxable yield)

Chapter 19

1. STRIPS price ϭ ___F_a_c_e_v__al_u_e___
(1 ϩ (YTM/2))2N

΄͑ ͒ ΅2. _1__
STRIPS yield ϭ 2 _F_a_c_e__v_a_lu_e_ 2N Ϫ 1
Price

652 Appendix C

Name Index

Page numbers followed by n indicate notes. Elliott, Ralph Nelson, 255
Elton, E. J., 357n
A
F
Arms, Richard, 258
Fama, Gene, 402–403
B Fayard, Gary, 535
Feather, William, 133
Bacanovic, Peter, 216 Fisher, Irving, 297
Bachelier, Louis, 508 Fleming, Charles, 595n
Barber, Brad, 245 Fontaine, Tom, 250
Bary, Andrew, 185n Ford, Henry, 2
Bernanke, Ben, 291 Fournier, Alan, 185
Bernstein, William, 359, 425 Frank, Art, 291
Berra, Yogi, 166n Franklin, Benjamin, 277, 581
Bickel, Joanna, 58 Freadhoff, Chuck, 117
Black, Fischer, 519, 520, 535 French, Ken, 402–403
Blayney, Eleanor, 425 Freund, John, 218
Blume, Marshall, 26n Fridson, Martin, 603
Bohr, Niels, 166
Bollinger, John, 263 G
Borrett, Emely, 291n
Briloff, Abraham, 545 Gates, Bill, 215–216, 218
Brockelman, John, 117 Goldwyn, Samuel, 166n
Buffett, Warren, 166, 217–218, 243, 467, 535, 552 Goncalves, George, 291
Burke, Thomas, 442 Goodman, George J. W., 133
Byrne, Patrick, 49 Gordon, Jeff, 265
Graham, Benjamin, 71, 218, 240
C Greenspan, Alan, 300
Gregory, Ken, 603
Cassidy, Don, 250 Gross, Leon, 530
Cedarbaum, Miriam, 216 Gruber, M. J., 357n
Cervantes, Miguel de, 349 Guera, Dawn, 442
Chang, Kenneth, 207 Gullapalli, Diya, 81n
Chen, Peng, 49
Ciesielski, Jack, 535 H
Clements, Jonathan, 15n, 328n, 359n, 425n, 488n,
Half, Robert, 436
603n, 622n Haliburton, Thomas Chandler, 277
Coffin, Peter, 633 Harvick, Kevin, 266
Corter, James, 58 Herman, Tom, 627n
Hotchkiss, Lynnette K., 627
D
I
Damato, Karen, 117n
Darst, David, 80 Ibbotson, Roger G., 8n, 10n, 11n, 12n, 15n,
Defotis, Dimitra, 402n 16n, 17n, 20n, 48, 402
Devoe, Raymond, 314
di Galoma, Tom, 291 Ip, Greg, 300n
Dow, Charles, 254
Dugan, Ianthe Jeanne, 423n J

E James, Barry, 402
James, LeBron, 246
Edison, Thomas, 79 Jarrell, Gregg, 520
Einstein, Albert, 170, 548
Eisinger, Jesse, 49n 653

Jefferson, Thomas, 613 Phillips, David J., 564n
Jensen, Michael C., 416 Phillips, Michael M., 520n
Johnson, Eric, 117 Pierce, Cathy, 442
Johnson, Jimmie, 266 Pierce, Robert, 442
Pollack, Gary, 633
K Pulliam, Susan, 218n

Kehoe, Bill, 520 R
Keillor, Garrison, 113n
Keynes, John Maynard, 251 Reichenstein, William, 358–359
Kill, Larry, 597 Richard, Nic, 81
Kinnel, Russel, 116–117 Richardson, Karen, 218n
Klammer, Franz, 380 Roeser, Donald “Buck Dharma,” 227n
Rogers, Will, 37, 413
L Rom, Brian, 58
Rosevear, John, 125n
Lahey, Gary, 146
Laise, Eleanor, 81n S
Lebenthal, Alexandra, 627
Leeson, Nicholas, 243 Sanders, Lewis, 250
Leistner, Gilbert, 442 Santayana, George, 2
Levin, Ross, 488 Scholes, Myron, 519, 520
Liegl, Peter, 218 Scholes, Myron S., 535
Lo, Andrew, 423 Sears, Steven M., 530n
Lucchetti, Aaron, 146n Seff, Eric, 488
Sharpe, William F., 415, 423
M Shefrin, Hersh, 425
Shiller, Robert J., 58
Macaulay, Frederick, 329 Siegel, Jeremy J., 9n, 278n
Malkiel, Burton C., 326 Sinquefield, Rex, 8n, 10n, 11n, 12n, 15n, 16n, 17n, 20n
Markowitz, Harry, 350 Smith, Adam, 133
Marriott, J. W., 597 Smith, Richard, 633
Marriott, Richard E., 597 Sokol, David, 218
Mazzaferro, Aldo, 185 Sortino, Frank, 423
McGee, Suzanne, 442n Statman, Meir, 357n
McKay, Betsy, 535n Stewart, Martha, 216
McKay, Peter A., 52n, 146n Stovall, Sam, 81
McNeela, Dan, 250 Strauss, Lawrence C., 250n
Medley, Tim, 116 Surma, John, 185
Merton, Robert, 519, 520
Meyer, Laurence, 300 T
Milevsky, Moshe, 488
Milligan, Spike, 1 Tarca, Silvio, 250
Morgan, J. P., 413 Temel, Judy Wesalo, 633
Tepper, David, 185
N Thottam, Jyoti, 597n
Treynor, Jack L., 415
Norman, Laurence, 291n Twain, Mark, 2, 166n, 436
Norwitz, Steven, 15
Notzon, Ned, 402 V
Nunes, Arthur, 402
Van Schyndel, Zoe, 121n
O Volpert, Ken, 622

Odean, Terrance, 245 W
Oliff, James, 442
Olivier, Ken, 116 Waksal, Sam, 216
Olson, Bryan, 81 Weil, Jonathan, 535n
O’Neal, Shaquille, 209, 246 Whitehouses, Mark, 633
Opdyke, Jeff D., 60n Wong, Sally, 423
Orgler, Yair, 520
Y
P
Yellen, Janet, 300
Patton, George S., 96
Paulson, Henry, 291
Perritt, Gerald, 14

654 Name Index

Equation Index

Page numbers followed by n indicate notes. D

A Discount bond duration, 331
Discounting, 279
Abnormal return, 213 Discount rate, 180
Aftertax yield, 634 Discount yield, 289
American call option price, 492 Dividend-adjusted put-call parity, 496
American put option price, 493 Dividend-adjusted spot-futures parity, 453
Announcements, 382, 384 Dividend discount models, 168–169, 171, 180
Arithmetic average dividend growth rate, 171 Dividend growth model, 175–176
Arms, 258 Dividend yield, 4
Asked yield, 287, 296 Dollar value of an 01, 333
Asset, 548 Duration, 329, 331, 457

B E

Balance sheet, 548 Earnings per share (EPS), 551
Bank discount basis, 284 Economic Value Added (EVA), 181–182
Beta, 399–400 Effective annual return (EAR), 6, 288, 289
Black-Scholes formulas, 519 Equivalent taxable yield, 634
Black-Scholes-Merton formulas, 534 European call option price, 493, 519
Blume’s formula, 26 European put option price, 493, 519
Bond equivalent taxable yield, 634 Expected portfolio return, 353–356, 389–391, 416, 427
Bond equivalent yield, 286, 287, 289 Expected return, 350–351, 355
Bond portfolio hedging, 456–457 Exponential moving average, 261–262
Bond prices
F
callable bond, 324
future value, 335 Forward rate, 301
municipal bond, 628 Futures for portfolio hedging, 455–457
percentage change in, 329 Futures price, 452
present value, 316–317, 335 Future value, 279, 296
straight bond, 316–317, 619 Future value of a bond price, 335
Book value per share (BVPS), 551
G
C
Geometric average dividend growth rate, 171
Callable bond price, 324 Geometric average return, 24
Call option delta, 525–526 Gross margin, 551
Call option intrinsic value, 489–490
Call option price, 492–493, 512–513, 519 H
Capital gains yield, 4
Carrying-charge market, 451 Hedging interest rate risk, 456–457
Cash flow per share (CFPS), 551 Hedging stock market risk, 455–456
Clean surplus relationship (CSR), 182 Hedging with index options, 529
Compounding, 279 Hedging with stock options, 527
Constant perpetual growth, 168–169, 182–183
Conversion price, 589 I
Conversion ratio, 589
Conversion value, 589 Index options, 529
Correlations, 399–400 Interest rate futures contracts, 456–457
Coupon rate, 315 Inverted market, 451
Critical marginal tax rate, 634
Critical price, 45, 52 655
Current price, 284
Current yield, 315

J R

Jensen’s alpha, 416 Real interest rate, 297
Residual income model (RIM), 181–182, 569
L Return on assets (ROA), 551
Return on equity (ROE), 173, 551
Leap year bond equivalent yields, 287 Return with systematic/unsystematic components,

M 384, 397
Reward-to-risk ratio, 390, 392–393
Macaulay duration, 329 Risk premium, 351
Margin accounts, 44–45, 51–52
Market risk premium, 394 S
Market sentiment index (MSI), 254
Minimum variance portfolio, 366 Security market line, 394
Modified duration, 329–330 Sharpe-optimal portfolio, 420, 422
Moving average, 261–262 Sharpe ratio, 415, 420
Municipal bond price, 628 Short sale margin calls, 51
Simple moving average, 261
N Spot-futures parity, 452–453
Standard deviation, 18, 352, 355–356, 363, 365, 427
Net income, 550 Stock index futures contracts, 455–456
Nominal interest rate, 304, 305 Stock market risk, 455–456
Stock options, 527
O Stock price, 168–169
Straight bond price, 316–317, 619
One-period binomial option pricing model, 512–513 STRIPS price, 296
Operating margin, 551 Surprise announcements, 384
Option intrinsic value, 489–490 Sustainable growth rate, 172
Systematic risk, 397–398
P
T
Par value bond duration, 331
Percentage change in bond price, 329 Taxable equivalent yield, 634
Percentage return, 4 Three-asset portfolio risk, 362–363
Portfolio betas, 388–390 Three-asset portfolio variance, 367, 369
Portfolio expected return, 353–356, 389–391, 416, 427 Total risk, 385
Portfolio hedging with futures, 455–457 TR(ading) IN(dex) (TRIN), 258
Portfolio return, 354–355, 368 Treasury bill bond equivalent yield, 287
Portfolio value at option expiration, 494 Treasury bill quotes, 285–286
Portfolio variance, 355–356, 362–363, 365, 368 Treasury note futures contracts, 456–457
Present value Treynor index, 390n
Treynor ratio, 415
basic equation, 279, 296 Two-asset portfolio return, 420
of a bond price, 316–317, 335 Two-asset portfolio risk, 362–363
of bond principal, 317 Two-asset portfolio variance, 366, 420
of future dividend stream, 168 Two-period binomial option pricing model, 513–517
of semiannual coupons, 317 Two-stage dividend growth model, 175–176
of subsequent dividends, 176
Price-book ratio, 553 U
Price-cash flow (P/CF) ratio, 553
Price-earnings (P/E) ratio, 553 Unexpected return, 381
Prices; see also Bond prices Unsystematic risk, 398
call option, 492–493, 512–513, 519
conversion, 589 V
critical, 45, 52
current, 284 Variance
futures, 452 basic equation, 18
put options, 493, 512, 519 of expected returns, 352
stock, 168–169 minimum variance portfolio, 366
STRIPS, 296 portfolio, 355–356, 362–363, 365, 368
Put-call parity, 494, 496 three-asset portfolio, 367, 369
Put option delta, 525–526 two-asset portfolio, 366, 420
Put option intrinsic value, 489–490
Put option price, 493, 512, 519 VaR risk statistics, 424, 426–427

Y

Yield to maturity, 296–297, 322–323
Yield value of a 32nd, 333

656 Equation Index

Subject Index

Page numbers followed by n indicate notes; by f, figures; by t, tables.

A APR (annual percentage rate), 288–289
Arbitrage
Abnormal earnings, 181–182
Abnormal returns, 213–214 cash-futures, 450–452
Acanthamoeba keratitis (AK), 212–213 definition, 491
Account equity, 41 index, 454–455
Accrued interest, 320 limits to, 251
Active asset allocation, 57 market efficiency and, 208–209
Adjustable-rate bonds, 599, 630 mispricing examples, 251–253
Adjustable-rate preferred stock, 599 option, 491–493, 496–497
Advance/decline line, 256–258 put-call parity and, 494–497, 509n
Advanced Medical Optics, Inc., 212–214 Arbitrage pricing theory (APT), 395n
Advanced Micro Devices, 590 Arbitration clauses, 40
Advisory accounts, 46 ArcaVision, 148
Agency securities, 290, 293, 624–625; see also Arcelor, 185
Arithmetic average dividend growth rate, 170–172
specific agency Arithmetic average return, 24–26
AK (acanthamoeba keratitis), 212–213 Armor All Products Corporation, 592
AllianceBernstein Investment Research and Artisan Funds, 116
Asian stock market crash, 230
Management, 250 Asked yield, 286–287, 296
Alliance Capital Management, 250 Ask price, 139
Alpha, 416–418 Asset allocation
AlphaSimplex Group, 423 correlation and, 363–365
Alternative minimum tax (AMT), 627 definition, 363
Ambac Assurance Corporation, 633 introduction, 349–350
Ambac Financial Group Inc., 633 investor objectives and, 56–57, 62, 328
American Electric Power, 170, 173 Markowitz efficient frontier and, 367–369
American Express, 177 rebalancing, 80–81, 339, 359
American Funds, 117 with three assets, 362, 367–369
American options with two assets, 360–366
Asset allocation funds, 110
arbitrage with, 491–493 Asset management accounts, 46
definition, 86, 468 Assets
ESOs, 534n derivative, 82–85, 438, 468
index options, 475 on financial statements, 547–548
time value, 490n interest-bearing, 72–75
two-period binomial option pricing model, 513 return on, 551
American Stock Exchange (AMEX), 139, 230–232, riskless, 489, 494–496
underlying, 444–445, 447
469, 604 Asset-specific risk, 383, 385
America Online (AOL), 382 At-the-money, 490
Amex Internet Index, 230–232 AT&T, 137
AMT (alternative minimum tax), 627 Availability bias, 249
Analyst-estimated growth rates, 174 Average returns, 12–16, 24–27
Analyst estimates, 560, 563
Analyst’s Accounting Observer (Ciesielski), 535 B
Announcements and news, 212–214, 227,
Back-end load, 102–103
381–383, 384 Balanced funds, 110
Annualizing returns, 6–7, 45 Balance sheets, 547–549, 555–559; see also
Annual percentage rate (APR), 288–289
Annual reports, 101, 546, 551 Pro forma balance sheets
Anomalies, market, 223–227 BancOne, 250
AOL (America Online), 382
Appaloosa Management, 185
Apple Computer, 148

657



Bank discount basis, 73, 283–284, 614 Black Tuesday, 228
Bank discount yields, 283–284, 286, 289 Block trades, 258
Banker’s acceptances, 282 Blue chip stocks, 114n
Barclays Global Investors, 121, 122, 123 Blue Oyster Cult, 227n
Barings Bank, 243 Bollinger bands, 262–263
Base-year values, 157 Bond equivalent yields, 286–289
Basis, 450 Bond features; see also Bond indenture provisions;
Basis points, 211, 283, 333
Basketball shooting percentages, 246–248 Bond prices and yields; Bond types
Baylor University, 358 basis points, 283, 333
Bear call spreads, 487 coupon, 73–75, 294, 582, 594–595, 615
Bearer bonds, 631 coupon rate, 73, 315–316, 318–320
Bear markets, 15, 254, 265 current yield, 73, 315–316, 319–320
“Beating the market,” 208, 414 leap year equivalent yields, 287
Bedford Falls municipal bond example, 626–628 risk, 335–337, 596–597 (see also Default risk)
Behavioral finance; see also Technical analysis yield measures compared, 319–320
Bond funds, 109–110, 363–366, 603
arbitrage, 251–253 Bond indenture provisions
definition and introduction, 241 bonds without indentures, 598
overconfidence, 245–246 bond-to-stock conversion, 77, 315, 589–593
prospect theory, 241–244 call features, 323, 586–588, 618, 628
randomness and chance events, 246–249 coupon payments, 594–595
sentiment-based risk, 251 definition and introduction, 584–586
Bell curve, 20 maturity and principal payments, 582, 593–594
Bellwether rate, 280 protective covenants, 595–596
Berkshire, 218 put features, 589, 630
Berkshire Hathaway, Inc., 218 seniority, 584, 586, 600
Best efforts underwriting, 136 sinking funds, 593–594
Beta coefficient Bond Market Association, 627
calculating, 398–400 Bond market indexes, 290–293
definition, 386 Bond prices and yields; see also Duration; Yield
discount rates and, 180
Fama-French three-factor model, 402–403 to maturity
performance evaluation measures and, 418, 425 accrued interest and, 320
portfolio, 388–390 calculating yields, 322–323
portfolio hedging with futures, 455–456 convertible bonds, 591–593
portfolio returns and, 391 dedicated portfolios, 334–339
returns and, 397–398 immunization, 337–339
risk premium and, 389–390 interest rate risk and, 325–326, 333
sources of, 400–401 Malkiel’s theorems, 326–327
systematic risk and, 386–389, 397–398 of par bonds, 318
total risk versus, 388 of premium and discount bonds, 318–320, 324
unexpected returns and, 398 price-yield curve, 587
Biases, investor, 249 reinvestment rate risk, 335–337
Bid-ask spread, 619, 625 risk measures based on duration, 333–334
Bid price, 139, 622–623 of straight bonds, 316–317
Bid rates, 280 of Treasury bonds, 321, 618–620
Big Board; see New York Stock Exchange yields with changing interest rates, 325–326
Binomial option pricing models yield to call, 323–325, 618
multiple-period, 517–519 Bond refunding, 586, 587
one-period, 510–513 Bonds; see also Bond features; Bond indenture
two-period, 513–517
Biovail, 48–49 provisions; Bond prices and yields
Black Monday, 229 about, 315–316
Black-Scholes-Merton option pricing model, 519, 534 asset allocation and, 328
Black-Scholes option pricing model common stocks compared, 582
about, 519–522 dedicated portfolios, 334–339
Black-Scholes-Merton model compared, 519, 534 as fixed-income securities, 73
Coca-Cola employee options pricing, 534–536 hedging interest rate risk with futures, 456–457
computing, 519–522 interest payments, 550
delta, 525–527 notes compared, 598
measuring changes to variables, 525–527 Bond types; see also Corporate bonds; Government
varying option price input values
bonds; Municipal bonds; Zero-coupon bonds
interest rate, 524–525 adjustable-rate, 599, 630
option strike price, 523 bearer, 631
stock price volatility, 524 catastrophe, 595
time remaining until expiration, 523–524 collateral trust, 583–584
underlying stock price, 523 convertible, 77, 315, 589–593
coupon, 316–317, 322–325
debentures, 583, 586, 600

658 Subject Index

equipment trust certificates, 584 “naked,” 486
exchangeable, 592–593 one-period binomial option pricing model,
general obligation, 294, 626, 630–631
high-yield (junk), 290–293, 583, 601–604 510–513
hybrid, 631 out-of-the-money, 478–479, 490
indentureless, 598 payoff diagrams, 480–481
limited/unlimited tax, 630 pricing, 491–493
moral obligation, 631 profit diagrams, 482
mortgage, 583, 586 put-call parity, 494–497, 509, 512, 516
notes, 73, 582–585, 598 risk management with, 485
100-year maturity, 594 simple valuation model, 509
par, 318, 331 writing, 479
plain vanilla, 582–583 Call premium, 587–588, 628
private activity, 634–635 Call price, 323–324
registered, 614, 631 Call protection period, 323, 586, 628
revenue, 294, 630–631 Call provisions, 323, 586–588, 618, 628
serial, 594, 629 Call writer, 479
straight, 315, 316–317, 592 Capacity and EFN, 558–559
tax-exempt, 294, 306 Capital appreciation funds, 107
term, 593–594, 630 Capital asset pricing model (CAPM), 180, 394–395,
variable-rate, 599, 630
Yankee, 293 401–403, 416
Book value per share (BVPS), 182, 551 Capital gains yield, 4
Borg Corporation Capital intensity ratio, 555
balance sheet, 547–549 CAR (cumulative abnormal return), 214
cash flow statement, 550–551 Carrying-charge market, 451
income statement, 549–550 Cash accounts, 40
performance ratios and price ratios, 551–553 Cash flow
pro forma balance sheet, 555–559
pro forma income statement, 553–555 definition and overview, 184–186, 550
projected profitability and price ratios, 559–560 financing, 550–551
Boston Stock Exchange (BSE), 139, 469 investment, 550–551
Break-even, 243 operating, 550–551
Breakout, 256 Cash flow matching, 582
Breckinridge Capital, 633 Cash flow per share (CFPS), 551
Brokerage accounts, 38–40, 46, 448–450; see also Cash flow projections; see Financial

Margin accounts statements forecasting
Brokers, 139 Cash flow statements, 547, 550–551
BSE (Boston Stock Exchange), 139, 469 Cash-futures arbitrage, 450–452
Bubbles, 227–230 Cash market, 450
Buffett-Falk & Co., 218 Cash prices, 450–453
Bull call spreads, 487 Cash-settled options, 475
Bullet bonds, 582 Catastrophe bonds, 595
Bull markets, 254, 265 CBOE; see Chicago Board Options Exchange
Bureau of Public Debt, 618 CBOT (Chicago Board of Trade), 84, 437, 441,
Butterfly spreads, 487
Buttonwood Tree Agreement, 133 442, 450n
Buying securities; see Margin accounts; Securities CDs (certificates of deposit), 282, 288–289
CDSC (contingent deferred sales charge), 102
purchases and sales CFPS (cash flow per share), 551
BVPS (book value per share), 182, 551 CFTC (Commodities Futures Trading

C Commission), 473
Charles Schwab, 100, 109
Callable bonds, 323, 586–588, 618, 628 Charting
Call deferment period, 323
Call features, 323, 586–588, 618, 628 Bollinger bands, 262–263
Call money rate, 40–41, 280 head and shoulders patterns, 260–261
Call options; see also Options MACD, 262, 264
money flow, 262, 264
arbitrage, 491–493, 496–497 moving averages, 261–262, 263f
Black-Scholes-Merton pricing model, 519–521 multiple indicators, 262
common stocks compared, 88, 473–475 open-high-low-close, 259
covered calls, 486 price channels, 259–260
definition and overview, 85–86, 468 Cheapest-to-deliver option, 457
delta, 511–513, 515, 525–527 “Cheap” stocks, 167, 184
hedging stock with, 527–528 ChevronTexaco, 260
in-the-money, 478–479, 490 Chicago Board of Trade (CBOT), 84, 437–438, 441,
intrinsic value of, 489–491
442, 450n
Chicago Board Options Exchange (CBOE)

implied volatility indexes, 531–532
index options trading on, 475–477, 529
Reduced Value index options, 476

Subject Index 659

Chicago Board Options Exchange (CBOE) (Cont.) news announcements, 212–214, 227,
stock options price quotes, 470–471 381–383, 384
stock options trading on, 467, 469, 520
random walk, 211–212
Chicago Board Options Exchange Volatility two-stage dividend growth model, 175–181
Index, 530 Competitive bids, 622–623
Compounding, 279
Chicago Mercantile Exchange (CME), 84, Confirmations, 255
437–438, 442 Conservative investments, 328
Constant perpetual growth model, 168–170, 180–183
Chicago Stock Exchange (CHX), 139 Consumer Price Index (CPI), 7
China Fund, 118–119 Continental Airlines, 387
Cincinnati Stock Exchange (CSE), 139 Contingent deferred sales charge (CDSC), 102
Citigroup, 218 Continuation patterns, 259–260
Clean price, 320 Contrarian indicators, 254, 265
Clean surplus relationship (CSR), 182 Conversion price, 589
Closed-end funds, 98–100, 118–120 Conversion ratio, 589
Closed mutual funds, 116–118 Conversion value, 589, 592
Closing Arms, 258 Convertible bond funds, 110
Clustering illusion, 248 Convertible bonds, 77, 315, 589–593
CME (Chicago Mercantile Exchange), 84, Convertible preferred stock, 598
Convex price-yield relationship, 587–588
437–438, 442 Corporate bonds; see also Bond indenture provisions
The CME Group, Inc., 84, 437–438 about, 582–583
CMX (Commodities Exchange), 441 accrued interest calculations, 320n
CNET Networks, Inc., 260–261 adjustable rate, 599, 630
Coca-Cola Company collateral trust bonds, 583–584
credit ratings, 583, 599–601
analyst-estimated growth, 174 debentures, 583, 586, 600
employee stock options, 534–536 equipment trust certificates, 584
margin account illustration, 43 equivalent taxable yield, 633–634
NYSE trading illustration, 142–143 event risk, 596–597
100-year bonds, 594 high-yield (junk) bonds, 290–293, 583, 601–604
stock option ticker symbols, 471 introduction, 581
Coffee, Sugar, and Cocoa Exchange (CSCE), 437 markets and trading, 604
Cognitive errors, 241 mortgage bonds, 583, 586
COGS (cost of goods sold), 549 price quotes, 74–75
Coin toss games, 58, 242, 246–247 without indentures, 598
Collateral trust bonds, 583–584 Corrections, 255
Combinations, 487–488 Correlation
COMEX, 441 asset allocation and, 363–365
Commercial paper, 280–282 calculating, 399–400
Commission brokers, 140 definition, 360
Commissions, 38–39, 40 diversification and, 360–366
Commodities Exchange (CMX), 441 portfolio risk and, 362–363
Commodities Futures Trading Commission positive and negative, 360–361
risk-return tradeoff and, 365–366
(CFTC), 473 Correlation coefficient, 360
Commodity futures, 83, 437; see also Futures contracts Cost of goods sold (COGS), 549
Common stock; see also Historical perspective Costs, transaction, 38–39, 40, 101–105, 251
Coupon, 73–75, 294, 582, 594–595, 615
bonds compared to, 582 Coupon bonds, 316–317, 322–325, 453
characteristics, 76 Coupon rate, 73, 315–316, 318–320
hedging with stock options, 527–529 Coupon strips, 615
initial public offerings (IPOs), 135–137 Coupon yield, 315
options investments compared, 88, 473–475 Covariance, 399–400
options on, 468–472 Covered calls, 486
over-the-counter, 604 Covering the position, 47
price quotes, 5, 77–81 CPI (Consumer Price Index), 7
put-call parity and, 494–497, 509 Crashes, 227–230, 265
single-stock futures contracts, 452 Creation units, 122
Common stock valuation; see also Borg Corporation; Credit ratings, 583, 599–601, 631–632
Credit risk; see Default risk
Dividend discount models; Starbucks Cross-hedge, 455
Corporation Cross-term, 362
cautions about, 167 CSCE (Coffee, Sugar, and Cocoa Exchange), 437
fundamental analysis, 167 CSE (Cincinnati Stock Exchange), 139
introduction, 166 CSR (clean surplus relationship), 182
McGraw-Hill Company example, 188–194
price ratio analysis, 183–188, 568
residual income model, 181–183, 568–570
stock price behavior
anomalies, 223–227
bubbles and crashes, 227–230
event studies, 212–214

660 Subject Index

“Cubes” (QQQQ), 120 McGraw-Hill Company example, 189
Cumulative abnormal return (CAR), 214 observations on, 180–181
Cumulative preferred stock, 76, 598 sustainable growth rate, 172–174
Curing the short, 47 Dividend growth models, 175–181
Current assets, 547 Dividend growth rates, 170–172
Current liabilities, 547 Dividends
Current yield, 73, 284, 315–316, 319–320 common stock, 76
in financial statements, 550, 555
D information sources, 78–81
mutual fund, 107
Data snooping problem, 217, 219 preferred stock, 76, 598
Day-of-the-week effect, 223 spot-futures parity condition with, 453
Daytona 500 indicator, 265–266 terminal, 168
DDMs; see Dividend discount models Dividend yield, 4, 534
Dealers, 139 DJIA; see Dow Jones Industrial Average
Debentures, 583, 586, 600 DJTA (Dow Jones Transportation Average), 255
Dedicated portfolios, 334–339 DJX (Dow Jones Industrial Average index options), 475
Deep-discount brokers, 38 Dodge & Cox Funds, 116
Default premium, 305–306 Dollar returns, 2–4, 21–22
Default risk Dollar value of an 01, 333–334
Dominated portfolios, 365
bond funds, 109, 110 “Dot-com” bubble and crash, 230–232
corporate bonds, 582, 583, 584, 595, 601–603 Dow Jones averages, 154–157
government bonds, 626, 632 Dow Jones Industrial Average (DJIA)
interest rates and, 305–306 about, 151–153
Deferred call provisions, 586 crashes, 227–230, 265
Defined benefit pension plans, 97 Dow theory and, 254–255
Defined contribution pension plans, 97 index futures on, 437
Dell, 148 index options, 475
Delta, 511–513, 515, 525–527 percentage versus dollar returns, 21–22
Depreciation, 184–186, 549, 550 Dow Jones Industrial Average ETF (“Diamonds”), 120
Derivative assets, 82–85, 438, 468; see also Futures Dow Jones Industrial Average index options

contracts; Options (DJX), 475
Deutsche Bank, 291, 633 Dow Jones Transportation Average (DJTA), 255
Dexia, 633 Downtick rule, 146
“Diamonds” (Dow Jones Industrial Average Dow theory, 254–255
Dreyfus Funds, 100
ETF), 120 DTE Energy Co., 170, 173
Direct+, 140–141 Duff and Phelps, Inc., 599–600
Dirty price, 320 Dumb luck problem, 217–219
Discount basis, 73, 283–284, 614 DuPont, 265
Discount bonds, 318–320, 324, 331 Duration
Discount brokers, 38–39
Discounting, 119–120, 279 calculating, 330–332
Discounting an announcement, 382 dedicated portfolios and, 334–339
Discount rate, 180–181, 189, 280 definition, 329
Discount securities, 283, 294 dollar value of an 01, 333–334
Discount yield, 283–284, 286, 289 immunization and, 338
Discretionary accounts, 46 interest rate risk and, 329, 333
Disney Corporation, 188, 471, 594 Macaulay, 329–332
Disposition effect, 243 modified, 329–334
Diversifiable risk, 359, 385 properties, 332–333
Diversification reinvestment rate risk and, 335–337
yield value of a 32nd, 333–334
calculating portfolio risk, 362–363 Duration matching, 338
correlation and, 360–366 Dutch auction underwriting, 136–137
definition, 357–359 Dynamic immunization, 338–339
expected returns and, 350–353
global, 358–359 E
historical returns and, 356–359
introduction, 349–350 EAFE (Europe, Australasia, and Far East) Index,
Markowitz efficient frontier, 367–369 120, 121
mutual funds and, 97–98, 363–365, 367–369
portfolio, 245–246, 353–359 EAR (effective annual return), 6, 288–289
systematic/unsystematic risk and, 385 Earnings; see also Financial statements;
Dividend discount models (DDMs)
constant perpetual growth, 168–170, 180–183 Price-earnings ratio
definition and introduction, 167–168 abnormal, 181–182
discount rate, 180–181 retained, 172, 547, 549–550, 555
historical growth rates, 170–172 sustainable growth rate, 172–173, 182

Subject Index 661

Earnings announcements, 227 Expected returns
Earnings per share (EPS), 551 diversification and, 350–352
Earnings yield (E/P), 183–184 portfolio, 353–356, 391
eBay, 134 systematic risk and, 386, 393
ECNs (electronic communications networks), 149 unexpected returns and, 381
Economic states and expected returns, 350–356 variance of, 352–353
Economic Value Added (EVA), 181–182
EDGAR (Electronic Data Gathering and Expected risk premium, 351
Expiration day for options, 85–86, 468, 470
Retrieval), 546 Expiry, 519
Effective annual return (EAR), 6, 288–289 Exponential moving averages, 261–262
Effective maturity, 330 Extendible bonds, 589
Efficient markets hypothesis (EMH), 208, 213; External financing needed (EFN), 556–559, 565, 567
ExxonMobil, 386
see also Market efficiency
Efficient portfolios, 365; see also Markowitz F

efficient frontier Face value, 582, 614
EFN (external financing needed), 556–559, Fair Disclosure Regulation, 546
Fallen angels, 601
565, 567 False consensus, 249
Electronic communications networks (ECNs), 149 False piercings, 261
Electronic Data Gathering and Retrieval Fama-French three-factor model, 402–403
Fannie Mae (FNMA), 283, 293, 625
(EDGAR), 546 FASB (Financial Accounting Standards Board), 534
Elliott wave theory, 255 FDA (Food and Drug Administration), 216
Emerging markets funds, 108 FDIC (Federal Deposit Insurance Corporation), 39, 106
Emerson Electric Co., 483–484, 486 Federal Farm Credit Bank, 625
EMH (efficient markets hypothesis), 208, 213; see Federal Financing Bank, 624
Federal funds rate, 280
also Market efficiency Federal Home Loan Bank, 625
Employee stock options (ESOs), 532–536 Federal Home Loan Mortgage Corporation
Endowment effect, 244
E/P (earnings yield), 183–184 (FHLMC), 283, 293, 625
EPS (earnings per share), 551 Federal National Mortgage Association (FNMA),
Equipment trust certificates, 584
Equities, 76–81; see also Common stock; Common 283, 293, 625
Federal Reserve
stock valuation
Equity, 547 inflation controls by, 279–280, 291, 300
Equity analysts, 174 initial margin requirements, 42
Equity income funds, 107 interest rate history and, 279, 297
Equivalent taxable yield, 633–634 money market rates, 280
Errors, investor, 241, 244, 249 Treasury auctions, 622–623
ESOs (employee stock options), 532–536 Federation of Tax Administrators, 627
ETFs (exchange-traded funds), 120–123 FGIC Corporation, 633
ETNs (exchange-traded notes), 123 FHLMC (Federal Home Loan Mortgage
Eurodollar futures, 438
Eurodollars, 282 Corporation), 283, 293, 625
Euro Interbank Offered Rate (EURIBOR), 282 Fibonacci numbers, 264–265
Europe, Australasia, and Far East (EAFE) Index, Fidelity Blue Chip Growth Fund, 114–116, 118f
Fidelity Capital & Income Fund, 603
120, 121 Fidelity Contrafund, 117
European options Fidelity Independence Fund, 107
Fidelity Investments, 100–101, 103–105, 107, 117
arbitrage with, 491–493 Fidelity Low-Priced Stock Fund, 103, 117, 419
Black-Scholes option pricing model, 519 Fidelity Magellan Fund, 99, 105, 117, 211
definition, 86, 468 Financial Accounting Standards Board (FASB), 534
ESOs, 534n Financial assets; see Security types
index options as, 475 Financial Engines, 423
SPX index options as, 529 Financial futures, 83, 437–438
time value, 490n Financial Guaranty Insurance Company, 633
two-period binomial option pricing model, Financial information, sources of, 546
Financial leverage, 43
513–517 Financial Security Assurance Inc., 633
EVA (Economic Value Added), 181–182 Financial statements; see also Price ratio analysis
Event risk, 596–597
Event studies, 212–214 balance sheets, 547–549, 555–559
Excess return, 16, 208 cash flow statements, 547, 550–551
Exchangeable bonds, 592–593 income statements, 547, 549–550, 553–555,
Exchange members, 140
Exchanges; see specific exchange, e.g., New York 560–562
introduction, 545–546
Stock Exchange performance ratios, 551–553
Exchange-traded funds (ETFs), 120–123
Exchange-traded notes (ETNs), 123
Exercise price, 85, 468
Expectations theory, 301–302

662 Subject Index

pro forma, 553 Futures margin, 448–449
as sources of financial information, 546 Futures price, 437
Financial statements forecasting Future value, 279, 296
percentage of sales approach, 553
pro forma balance sheets G

Borg Corporation example, 555–559 Gambler’s fallacy, 249
Starbucks case study, 560–570 Games of chance, 58, 242, 246–249
pro forma financial statements, 553 The Gap, 532–534
pro forma income statements, 553–555, 560–562 GEFs (general equity mutual funds), 220–222
projected profitability and price ratios, 559–560 Gender and trading frequency, 245
sales projection scenarios, 556–559 General cash offers, 135
Starbucks Corporation case study, 560–570 General Electric Capital Corporation, 281
Financing cash flow, 550–551 General Electric Company, 478–479
Financing options, 134–139, 556–559 General equity mutual funds (GEFs), 220–222
Firm commitment underwriting, 136 General funds, 110, 111
Firm-specific risk, 251 General Motors, 184, 186, 187, 251, 258,
First-stage financing, 134
Fisher hypothesis, 297–298, 302–303 262, 361, 386
Fitch Investors Service, 599, 631–633 General obligation bonds (GOs), 294, 626, 630–631
Fixed assets, 547 Geometric average dividend growth rate, 170–172
Fixed-income securities, 73–75, 290–294 Geometric average return, 24–27
Fixed-price call provisions, 586–587 “Get-evenitis,” 243
Floating-rate bonds (floaters), 599, 630 Ginnie Mae; see Government National
Floor brokers, 140
Floor traders, 141 Mortgage Association
Floor value, 592 Global diversification, 358–359
Florida Department of Revenue, 627 Global funds, 108
FNMA (Federal National Mortgage Association), GNMA; see Government National

283, 293, 625 Mortgage Association
Follow-on offering, 135 “Godzilla” (song), 227n
Food and Drug Administration (FDA), 216 Gold, historical returns, 14–15
Ford, 251, 258, 361 Golden mean, 264–265
Foreign stocks, 14–15, 358–359 Goldman Sachs, 185
Forest River Inc., 218 Goodwill, 547
Forward contracts, 437 Google, 136, 148
Forward rate, 301–302 GOs (general obligation bonds), 294, 626, 630–631
401(k) plans, 55 Government bonds; see also Municipal bonds;
Fourth market, 149
Frame dependence, 242 Treasury bills; Treasury bonds; Treasury notes
Franklin Funds, 100 agency securities, 290, 293, 624–625
Fraud, investment, 39 auctions, 622–623
Freddie Mac (FHLMC), 283, 293, 625 call features, 618, 628
Frequency distribution, 17 historical returns, 7–12, 14–16, 19–20, 25
Front-end load, 102–103 introduction, 613–614
Full faith and credit bonds, 630 savings bonds, 614, 623–624
Full hedge, 445 Treasury STRIPS, 294–297, 615–618
Full price of a bond, 320 Government National Mortgage Association (GNMA)
Full-service brokers, 38 agency bond quotes, 625
Fundamental analysis, 167, 210 interest rate reports for, 293
Fundamentals, 167 mortgage mutual funds, 110
Funds of funds, 125 Gradient, 49
Futures contracts Gross margin, 551
Gross profit, 549
cash prices versus futures prices, 450–453 Growth and income funds, 107
definition and introduction, 82–83, 436–438 Growth funds, 107
delivery options, 83–84, 437–438, 449, 457 Growth models; see Common stock valuation
gains and losses on, 84–85 Growth stocks, 14–15, 22–23, 111, 113, 184
gold example, 443 Gymboree, 382
heating oil example, 444–447
hedging with, 444–448, 455–457 H
history, 437–438
options contracts compared, 86 Harvard Business School, 520
price quotes, 83–84, 439–443 Head and shoulders patterns, 260–261
purpose of, 443–448 Hedge funds, 48–49, 123–125, 423
single-stock, 452 Hedgers, 444
speculating with, 443–444 Hedging
stock index, 437, 453–458
trading accounts, 448–450 cross-hedging, 455
with futures, 444–448, 455–457

Subject Index 663

Hedging (Cont.) Indexes, stock market, 152–157, 531–532
with index options, 529–531 Index funds, 108–109, 122–123, 220–222
interest rate risk, 456–457 Index futures, 437, 453–458
price risk, 444–445 Index options, 475–478, 529–531
stock market risk, 455–456 Index staleness, 157
with stock options, 527–529 Individual retirement accounts (IRAs), 124–125
Inefficient portfolios, 365
Hedging risk, 49 Inflation; see also Interest rates
“Hemline” indicator, 265
HIBOR (Hong Kong Interbank Offered bond market and, 300
Fed monetary policy and, 279–280, 291, 300
Rate), 282 historical rates of, 12f, 298f
High-yield bond funds, 110 real interest rates and, 297–301, 304–305
High-yield bonds, 290–293, 583, 601–604 Treasury security prices and, 291
Historical growth rates, 170–172 Inflation-indexed Treasury securities, 298–300,
Historical perspective; see also Risk and
620–622
return history Inflation premium, 304–305
corporate bonds, 19–20 Information effect on price
diversification and, 356–359
foreign stocks, 14–15, 358–359 news and announcements, 212–214, 227,
futures contracts, 437–438 381–383, 384
government bonds, 7–12, 14–16, 19–20, 25
growth stocks, 14–15, 22–23 nonpublic, 215, 546
inflation rates, 298f past returns as predictor of future, 211
interest rates, 278–280, 298f relevant, 217
large-company stocks, 7–12, 14–15, 356–359 types, 209–210
small-company stocks, 358–359, 402 Informed traders, 215
S&P 500 index, 218, 358–359 Initial margin, 42, 449
T-bill rates, 298f Initial public offerings (IPOs), 135–137
value stocks, 14–15, 402 Innovation, 382
Historical variance, 17–19 Inside quotes, 149
Holding period, 6 Insider trading, 215–216
Hong Kong Interbank Offered Rate Instinet, 149
Insured bond funds, 110
(HIBOR), 282 Insured municipal bonds, 632–633
Hong Kong Investment Funds Association, 423 Intangible assets, 547
Horizon as investor constraint, 54–55, 62 Intel, 148, 187–188, 212, 383, 384, 469
Host Marriott Corporation, 596–597 The Intelligent Asset Allocator (Bernstein),
Hotchkis & Wiley Funds, 116
“Hot-hand” fallacy, 246–248 359, 425
House money, 244 IntercontinentalExchange (ICE), 437
Hurricane Katrina, 595, 633 Interest
Hybrid bonds, 631
Hybrid market, 141, 143 accrued, 320
Hybrid securities, 72, 76 bond (coupon), 73–75, 294, 582, 594, 595, 615
Hypothecation, 45–46 in cash flow statements, 550
imputed, 614
I Interest-bearing assets, 72–75
Interest expense, 549
Ibbotson Associates, 358–359, 402 Interest-only strips (IOs), 615
IBM, 386–388, 468, 473–474, 478, 480, 520 Interest rate futures, 437–438
ICE (IntercontinentalExchange), 437 Interest rate risk
Imclone, 216 definition, 304, 325
IMM (International Monetary Market), 437 dollar value of an 01, 333
Immunization, 337–339 duration and, 329, 333
Implementation costs, 251 hedging with futures, 456–457
Implied standard deviations (ISD), 531–532 Macaulay duration and, 329
Implied volatility (IVOL), 531–532 Malkiel’s theorems and, 325–327
Imputed interest, 614 modern term structure theory, 304
IMS Capital, 402 yield value of a 32nd, 333
Income, 549 Interest rate risk premium, 304–305
Income funds, 110 Interest rates; see also Inflation
Income statements, 547, 549–550, 553–555, APR, 288–289
bellwether, 280
560–562 call money, 40–41, 280
Income taxes, 549 coupon rate, 73, 315–316, 318–320
Indentures, 584–586, 598; see also Bond discount rate, 280
EAR, 288–289
indenture provisions Federal funds, 280
Indenture summary, 584 on fixed-income securities, 290–294
Index arbitrage, 454–455 forward, 301–302
Index divisors, 156–157 history, 278–280, 298f

664 Subject Index

interest rate risk premium, 304–305 L
introduction, 277–278
LIBOR, 282 Large-company funds, 108
money market, 278, 280–283 Large-company stocks, 7–12, 14–15, 114n,
money market prices and, 283–289
nominal, 297–301, 303–306 224–225, 356–359
option values and, 524–525 Law of small numbers, 249
prime, 280 Leap year bond equivalent yields, 287
real, 297–301, 304–305 Lebenthal & Co., 627
simple, 288 Lehman Brothers, 290, 292f
term structure of, 294–297, 301–303 Liabilities, 547
theories, 301–303 LIBOR (London Interbank Offered Rate), 282
on Treasury bills, 282, 284–285, 298f Limited tax bonds, 630
Intermediate-term bond funds, 109 Limit orders, 143–144
International funds, 108, 120 Limits to arbitrage, 251
International Monetary Market (IMM), 437 Lipper, 250
International Securities Exchange, 469 Liquidity as investor constraint, 55, 62
In-the-money, 478–479, 490, 591 Liquidity preference theory, 302n
Intrepid Funds, 250 Liquidity premium, 302n, 305–306
Intrinsic bond value, 592 Listed bonds, 604
Intrinsic value of options, 489–491 Litman/Gregory, 603
Inverted market, 451 Load funds, 102–103, 105
Investment advisory firms, 100 London Interbank Offered Rate (LIBOR), 282
Investment banking firms, 135 Long hedge, 445–447
Investment cash flow, 550–551 Longleaf Partners Funds, 116
Investment companies, 98–100 Long positions, 47, 443
Investment fraud, 39 Long straddles, 487
Investment-grade bonds, 600, 631–632 Long-Term Capital Management (LTCM), 423
Investment horizon as constraint, 54–55, 62 Long-term corporate bonds, 7–12, 15–16, 19–20, 25
Investment management, 56, 62 Long-term debt, 547, 553
Investment opportunity set, 363 Long-term mutual funds
Investment portfolios; see Portfolios
Investment psychology; see Behavioral finance bond, 109–110
Investment risk management, 422–423 objectives, 107, 111–113
Investment Technologies Inc., 58–60 stock, 107–109
Investment value, 592 stock and bond, 110
Investor protection, 39–40 Long-term U.S. government bonds, 7–12, 14–16,
Investors; see also Behavioral finance
constraints on, 54–56, 62 19–20, 25
irrationality of, 208–209, 229, 230, 241–242 Loss aversion, 243–244
prudent investment guidelines, 601 Lowe’s, 266
risk and return decisions, 54 Low-load funds, 102
strategies and policies, 56–57, 62–63 LTCM (Long-Term Capital Management), 423
Invoice price of a bond, 320
IOs (interest-only strips), 615 M
IPath ETNs, 123
IPOs (initial public offerings), 135–137 Macaulay duration, 329–332
IRAs (individual retirement accounts), 124–125 MACD (moving average convergence divergence),
ISD (implied standard deviations), 531–532
IShares ETFs, 122 262f, 264
ISO management firm, 595 Macroeconomic Advisers, 300
IVOL (implied volatility), 531–532 Maintenance margin, 42–43, 449
Make-whole call price, 323
J Make-whole call provisions, 586, 588
Make-whole premium, 588
James Investment Research, 402 Malkiel’s theorems, 326–327
January effect, 223–226 Management fees, 102
Jefferies & Co., 291 Margin, 41
Jensen’s alpha, 416–418 Margin accounts
JP Morgan Asset Management, 250
Jpod, 350–355, 361 account balance sheets, 41–43, 48–50
Junk bonds, 290–293, 583, 601–604 account equity, 41
annualizing returns, 45
K call money rate, 40–41, 280
effects of, 43–45
Kamp Re, 595 as financial leverage, 43–45
Kansas City Board of Trade (KBT), 437, 441 for futures trading, 448–450
hypothecation, 45–46
initial margin, 42, 449
maintenance margin, 42–43, 449
margin calls, 42–43, 449
reverse trades, 449

Subject Index 665

Margin accounts (Cont.) Money flow, 262f, 264
short sales in, 47–53 Money illusion, 244
spread, 41 Money managers, 97, 217–222, 244, 530
street name registration, 46 Money market deposit accounts (MMDAs), 106
Money market instruments
Margin calls, 42–43, 51, 449
Market-book ratio, 187 banker’s acceptances, 282
Market capitalization, 108, 403 CDs, 282, 288–289
Market efficiency commercial paper, 280–282
definition and introduction, 72–73
anomalies, 223–227 Eurodollars, 282
“beating the market,” 208 pure discount securities, 283, 294
bubbles and crashes, 227–230 Money market interest rates
driving forces, 210–211 bank discount basis, 73, 283–284, 614
efficient markets hypothesis, 208, 213 bellwether rate, 280
forms of, 209–210 call money rate, 40–41, 280
foundations of, 208–209 discount rate, 280
implications, 211–215, 219 Federal funds rate, 280
informed traders, 215 LIBOR, 282
insider trading, 215–216 prime rate, 280
introduction, 207–208 Money market mutual funds (MMMFs),
money manager performance, 217–222
testing, 217–219 105–106
Market orders, 142–143 Money market prices and yields
Market portfolios, 394, 401, 417
Market risk, 383, 385, 425, 455–456 bank discount yield versus bond equivalent
Market risk premium, 394 yield, 286–287
Market segmentation theory, 303, 304
Market sentiment index (MSI), 254 bond equivalent yields, 286–289
Market timing, 56, 62 current yield, 284
Marking-to-market, 449 Treasury bills, 284–286
Markowitz efficient frontier, 367–369, 420 Moody’s Investors Service, Inc., 583, 597,
Marriott Corporation, 596–597
Marriott International, Inc., 596–597 599–601, 631–633
Martha Stewart Living Omnimedia, Inc., 216 Moral obligation bonds, 631
Massachusetts Institute of Technology, 423 Morgan Stanley, 291
Master portfolios, 418 Morgan Stanley Europe, Australasia and
Material nonpublic information, 215, 546
Maturity; see also Yield to maturity Far East Index, 358
effective, 330 Morningstar
interest rate risk and, 325–326, 333
100-year maturity bonds, 594 on behavioral finance, 250
principal payments at, 582, 593–594 on closing mutual funds, 116–117
Maturity preference theory, 302–304 on ETFs, 120
Maturity premium, 302, 304 on junk bonds, 603
MBIA Inc., 633 mutual fund information, 107, 112
MBSs; see Mortgage-backed securities stewardship ratings, 117
McCarthy, Crisanti and Maffei, 599 Mortgage-backed securities (MBSs); see also
McGraw-Hill Company analysis
dividend discount model, 189 Government National Mortgage
information sources, 188–191 Association
price ratio analysis, 192–194 issuers, 293
residual income model, 189–192 Mortgage bonds, 583, 586
McKesson Corporation, 592–593 Mortgage debt, 328
Mental accounting, 242–244 Mortgage funds, 110
Merrill Lynch, 100, 140, 290, 292f, 520, 603 Mortgage market, 283, 291
Mezzanine-level financing, 134 Moving average convergence divergence (MACD),
Microcaps, 150 262f, 264
Microsoft, 5, 96, 147, 148, 151, 215, 382, 488 Moving averages, 261–262, 263f
MidAmerica Commodity Exchange, 437 MPLS (Minneapolis Grain Exchange), 437, 441
MidAmerican Energy, 218 MSI (market sentiment index), 254
Midcap funds, 108 Municipal bond funds, 109–110
Minimum variance portfolio, 364–365 Municipal bonds
Minneapolis Grain Exchange (MPLS), 437, 441 about, 626–628
MMDAs (money market deposit accounts), 106 call provisions, 628
MMMFs (money market mutual funds), credit ratings, 631–632
equivalent taxable yield, 633–634
105–106 features of, 628–630
Modern term structure theory, 304–305 general obligation, 294, 626, 630–631
Modified duration, 329–334 hybrid, 631
insurance, 632–633
liquidity, 628–629
revenue, 294, 630–631
taxable, 627
tax treatment of, 109, 294, 306, 626–627

666 Subject Index

Mutual funds New York Stock Exchange (NYSE)
advantages and drawbacks, 97–98 circuit breakers, 230
behavioral finance and, 244, 248, 250 competitors, 149
bond funds, 109–110 crashes, 227–230, 265
as brokerage account alternative, 46 history, 133, 140
closed, 116–118 hybrid market, 141, 143
closed-end, 98–100, 118–120 listed bonds, 604
costs and fees, 101–105 listed stocks, 141
creation of, 100–101 maintenance margin requirements, 42
definition and overview, 96–97 membership, 140–141
diversification using, 97–98, 363–365, 367–368 operations, 142–147
exchange-traded funds, 120–123 options trading on, 469
expenses, 103–104 program trading, 454–455
general equity, 220–222 short-selling activity, 52
hedge funds, 48–49, 123–125, 423 as trading venue, 139
investment companies and, 98–100 trading volume, 133, 142
long-term, 107–110
money market, 105–106 Nikkei Index, 230, 231f
net asset value, 99–100 Nobel Prize in Economics, 350, 519–520
objectives, 107, 111–113 Noise traders, 251
open-end, 98–100 No-load funds, 102, 105
operations, 100–101 Nominal interest rates, 297–301, 303–306
performance, 113–118 Nominal yield, 315
prospectuses and annual reports, 101 Noncash items, 550
redemptions, 102–103, 123 Noncompetitive bids, 622–623
short-term, 105–106 Nonconstant growth, 178–180
stock and bond funds, 110 Nondiversifiable risk, 359, 385
stock funds, 107–109 Nonpublic information, 215, 546
taxation of, 101 Nordstrom, Inc., 145, 148
types, 98–100 Normal distribution, 20–21, 424
Northeast Investors Trust Fund, 603
Myopic loss aversion, 244 Northwest Airlines, 584–585
Notes, 73, 582–583, 598
N NYBOT (New York Board of Trade), 437
NYCE (New York Cotton Exchange), 437
Nabisco, 382 NYFE (New York Futures Exchange), 437
“Naked” options, 486 NYMEX (New York Mercantile Exchange),
Nanocaps, 150
Nascar, 265 84, 437, 441, 445
NASDAQ NYSE; see New York Stock Exchange
NYSE circuit breakers, 230
AMEX merger with, 139 NYSE Euronext, 140
Crash of 1987, 228–230, 265 NYSE uptick rule, 145–146
operations, 133, 147–148
participants, 149 O
stock option ticker symbols, 471
NASDAQ 100 Index (QQQQ), 120, 121 OCC (Options Clearing Corporation),
NASDAQ 100 Volatility Index (VXN), 531–532 472–473
National Indemnity Cos., 218
NAV (net asset value), 99–100 October 1929 stock market crash, 227–228
Near closing bid, 280 October 1987 stock market crash, 228–230, 265
Near closing offered, 280 Odd-lot indicator, 265
Ned Kelley Hedge Fund, 426–427 OEX (S&P 100 Index options), 475
Negative convexity, 587, 588 Offering price, 102
Negative correlation, 360–361 Offer rates, 280
Negative covenants, 596 OHLC (open-high-low-close charts), 259
Negative pledge clause, 586 OIC (Options Industry Council), 473
Net asset value (NAV), 99–100 OneChicago, 452
Net income, 184, 550 100-year maturity bonds, 594
Net sales, 549 One-period binomial option pricing model,
News and announcements, 212–214, 227,
510–513
381–383, 384 Online brokers, 39
New York Board of Trade (NYBOT), 437 Open-end funds, 98–100
New York Coffee Exchange, 437 Open-high-low-close charts (OHLC), 259
New York Cotton Exchange (NYCE), 437 Operating cash flow, 550–551
New York Futures Exchange (NYFE), 437 Operating expenses, 549
New York Mercantile Exchange (NYMEX), Operating income, 549
Operating margin, 551
84, 437, 441, 445 Option chain, 471

Subject Index 667

Option premium, 85, 479–480 Over-the-Counter Bulletin Board (OTCBB),
Option pricing models; see Option valuation 150–151
Options; see also American options; Call options;
Over-the-counter (OTC) market, 147, 604
European options; Option valuation; Overvalued securities, 394
Put options
about, 467–472 P
arbitrage, 491–493, 496–497
at-the-money, 490 Pacific Stock Exchange (PSE), 139, 469n
common stock investment compared, 88–89, Paid-in capital, 547
473–475 Palm/3Com mispricing example, 251–252
on common stocks, 468–472 Par, 582
contracts, 85–89, 468 Par bonds, 318, 331
definition and overview, 85–89 Parity, 452–453, 494–497, 509, 512, 516
ESOs, 532–536 Parnassus Fund, 109
exchanges, 468–469, 475–477, 520, 529 Passive asset allocation, 57
exercise price, 85, 468 Payout ratio, 172
expiration, 85–86, 468, 470 P/B (price-book) ratio, 187, 553
function of, 473–475 P/CF (price-cash flow) ratio, 184–186, 553
futures contracts compared, 86 Pennant Capital Management, 185
gains and losses on, 88, 479–483 Penny stocks, 150
hedging stock with, 527–529 Pension plans, 97, 335–339, 582, 601
index, 475–478, 529–531 Pension Research Institute, 423
in-the-money, 478–479, 490 Pepsi, 177–178
intrinsic value of, 489–491 P/E (price-earnings) ratio, 183–184, 227, 553
option chains, 471 Percentage of sales approach, 553
Options Clearing Corporation, 472–473 Percentage returns, 4–5, 21–22
out-of-the-money, 478–479, 490 Performance evaluation
payoff and profit diagrams, 479–483
premium, 85, 479–480 of closed-end funds, 118–119
prices, 86–87, 469–471, 491–493 comparing measures of, 417–422
put-call parity, 494–497, 509, 512, 516 definition and introduction, 413–414
risk management using, 483–485 measures
settlement, 468, 475, 478
strategies, 473–475, 485–489 Jensen’s alpha, 416–418
strike price, 85, 468, 523 raw return, 414
ticker symbols, 471–472 Sharpe ratio, 415, 417–423
writing, 475, 479–481, 483 Treynor ratio, 415–418
Options Clearing Corporation (OCC), 472–473 of money managers, 217–222
Options Industry Council (OIC), 473 of open-end funds, 113–118
Option valuation; see also Black-Scholes-Merton Performance ratios, 551–553
option pricing model Philadelphia Stock Exchange (PHLX), 139, 469
employee stock options, 532–536 Pink Sheets, 150–151
fractional shares of stock in, 511, 513, 515–516 Plain vanilla bonds, 582–583
hedging portfolios with index options, 529–531 Plowback ratio, 555
hedging stock with stock options, 527–529 Portfolio betas, 388–390
implied standard deviations, 531–532 Portfolio managers; see Money managers
introduction, 508 Portfolio risk, 356–359, 362–363
multi-period binomial option pricing model, Portfolios; see also Asset allocation
517–519 beta coefficients and, 388–390
one-period binomial option pricing model, comparing performance measures, 417–422
510–513 dedicated, 334–339
price trees, 510–511, 514–515, 517–518 definition, 353
simple model, 509 design, 61–63
stock price change impact on option prices, diversified, 245–246, 357–359, 363–365
525–527 efficient/inefficient, 365
two-period binomial option pricing model, expected returns, 353–355, 391
513–517 hedging with futures, 455–456
varying option price input values, 522–525 hedging with stock index options, 529–531
Option writing, 479 market, 394
Order flow, 142 master, 418
Original-issue junk, 601 minimum variance, 364–365
OTCBB (Over-the-Counter Bulletin Board), performance evaluation measures, 414–417
150–151 put-call parity, 494–497
OTC (over-the-counter) market, 147, 604 raw return, 414
Out-of-the-money, 478–479, 490, 592 rebalancing, 80–81, 339, 359
Overconfidence of investors, 245–246 riskless, 355, 455, 513, 515
Overstock.com, 48–49 security selection, 57, 62, 425
of three assets, 362, 367–369
of two assets, 360–366

668 Subject Index

Portfolio standard deviation or variance, 355–357, Purchasing securities; see Margin accounts;
360, 362–363, 365, 420 Securities purchases and sales

Portfolio weight, 353 Pure discount securities, 283, 294
POs (principal-only strips), 615 Putable bonds, 315
Positive convexity, 587 Put bonds, 589, 630
Positive correlation, 360–361 Put-call parity, 494–497, 509, 512, 516
Positive covenants, 596 Put dates, 589
PowerShares Capital Management, 121 Put options; see also Options
Preferred habitat theory, 303
Preferred stock, 76–77, 598–599 arbitrage, 491–493, 496–497
Premium bonds, 318–320, 324 Black-Scholes-Merton pricing model, 519–521
Present value, 279, 296 definition and overview, 85, 87–89, 468
Pretax income, 549–550 delta, 525–527
Price-book (P/B) ratio, 187, 553 gains and losses, 475
Price-cash flow (P/CF) ratio, 184–186, 553 hedging stock with, 528–529
Price channels, 259–260 in-the-money, 478–479, 490
Price-earnings (P/E) ratio, 183–184, 227, 553 intrinsic value of, 489–491
Price quotes; see also Wall Street Journal one-period binomial option pricing model, 512
out-of-the-money, 478–479, 490
bid/ask, 139 payoff diagrams, 481–482
common stock, 5, 77–81 pricing, 496
corporate bonds, 74–75 profit diagrams, 482–483
fixed-income securities, 74–75 protective put strategy, 483–484
futures contracts, 83–84 put-call parity, 494–497, 509, 512, 516
options, 86–87, 469–471 simple valuation model, 509
preferred stock, 78 writing, 479
ticker tape, 79 Put price, 589
Price ratio analysis Put writer, 479
applications, 187–188
McGraw-Hill Company case study, 192–194 Q
price-book, 187, 553
price-cash flow, 184–186, 553 QQQQ (NASDAQ 100 Index), 120, 121
price-earnings, 183–184, 227, 553 Quaker State Corporation, 323
price-sales, 187
projected, 559–560 R
of value stocks, 552
Price risk, 337, 444–445, 447 Randomness, 246–249
Price-sales (P/S) ratio, 187 Random walk, 211–212
Price-weighted indexes, 154–157 Rating agencies, 583, 599–601, 631–632
Pricing models; see Option valuation Ratios
Primary (primitive) assets, 82
Primary market, 135–137 book value per share, 551
Prime rate, 280 capital intensity, 555
Principal, 582, 594 cash flow per share, 551
Principal-only strips (POs), 615 conversion, 589
Principle of diversification, 357–359 earnings per share, 551
Private activity bonds, 634–635 earnings yield, 183–184
Private equity, 134 gross margin, 551
Private placements, 583, 598 market-book, 187
The Probability of Fortune (Milevsky), 488 operating margin, 551
Profitability ratios, 559–560 payout, 172
Pro forma balance sheets performance, 551–553
Borg Corporation example, 555–559 plowback, 555
Starbucks case study, 560–568 price-book, 187, 553
Pro forma financial statements, 553 price-cash flow, 184–186, 553
Pro forma income statements, 553–555, 560–562 price-earnings, 183–184, 227, 553
Program trading, 229, 454–455 price-sales, 187
Projected risk premium, 351 profitability, 559–560
Promised yield, 316, 325 retention, 172, 555
Proshares, 121 return on assets, 551
Prospect theory, 241–244 return on equity, 551
Prospectuses, 101, 137, 584–585 reward-to-risk, 390–394, 415–416
Protective covenants, 595–596 Sharpe, 415, 417–423
Protective put strategy, 483–484 Sortino, 423
Prudent investment guidelines, 601 Treynor, 415–418
PSE (Pacific Stock Exchange), 139, 469n Raw return, 414
P/S (price-sales) ratio, 187 Real estate investment trusts (REITs),
Psychology of investing; see Behavioral finance
14–15, 63, 125

Subject Index 669

Real interest rates, 297–301, 304–305 market, 383, 385, 425, 455–456
Realized returns, 350 mutual funds and, 98, 105, 107, 116–117
Realized yield, 325 portfolio, 356–359, 362–363
Rebalancing portfolios, 80–81, 339, 359 price, 337, 444–445, 447
Recency bias, 249 reinvestment rate, 335–337
Redemption value, 614 reward-to-risk ratio, 390–394, 415–416
Red herrings, 137 total, 385, 388, 396, 415
Reduced Value index options, 476 unique, 383, 385
Refunding provisions, 586, 587 unsystematic, 383–385, 396, 398
Registered bonds, 614, 631 Risk-adjustment problem, 217
Regret aversion, 244 Risk and return; see also Risk and return history
Regulation FD (Fair Disclosure), 546 announcements and news, 381–383
Reinsurance, 595 beta, 386–390, 396–401
Reinvestment rate risk, 335–337 capital asset pricing model, 401–403
REITs (real estate investment trusts), correlation, 365–366
diversification, 385
14–15, 63, 125 expected and unexpected returns, 381
Relative strength, 258–259 introduction, 380–381
Relevant information problem, 217 reward-to-risk ratio, 390–394, 415–416
Representativeness heuristic, 246 risk tolerance assessment, 54, 61–62
Required earnings per share (REPS), 181 security market line, 394–396
Residual income, 181–182 summary, 396
Residual income model (RIM), 181–183, systematic risk, 383–389
with three assets, 362, 367–369
189–192, 568–570 trade-offs, 365–366
Resistance levels, 255–256, 265 with two assets, 360–366
Resolution Trust Funding Corporation, 624 unsystematic risk, 383–385
Resources as investor constraint, 54, 62 Risk and return history
Retained earnings, 172, 547, 549–550, 555 average returns, 12–16, 24–27
Retention ratio, 172, 555 first lesson, 16
Retirement plans, 97 historical returns, 7–12
Retirement savings accounts, 55 introduction, 1–2
Return on assets (ROA), 551 returns, 2–7
Return on equity (ROE), 172–173, 551 return variability, 17–23
Returns; see also Expected returns risk and return, 27–28
second lesson, 21–23
abnormal, 213–214 trade-offs, 27–28, 208
annualizing, 6–7, 45 Risk-averse behavior, 54, 241
correlation, 360–362 Risk-free rate, 16
dollar, 2–4, 21–22 Riskless assets, 489, 494–496
excess, 16, 208 Riskless portfolios, 355, 455, 512–513, 515
on margin purchases, 45 Risk management; see also Performance
percentage, 4–5, 21–22
portfolio, 353–356, 391, 414 evaluation
realized, 350 alternate views of, 423, 425
total, 381, 384, 396, 397 corporate, 484–485
uncorrelated, 360 definition and introduction, 422–423
unexpected, 381, 383, 398 with futures contracts, 444–448, 455–457
Return variability with options, 483–485
first lesson, 16 value-at-risk, 423–424, 426–428
frequency distributions and, 17 Risk premium
historical returns, 19–20 beta and, 389–390
historical variance and standard calculating, 351
definition, 16, 380
deviation, 17–19 discount rate and, 180
normal distribution, 20–21 interest rate, 304–305
second lesson, 21–23 market, 394
Revenue bonds, 294, 630–631 Risk-taking behavior, 241
Reversal patterns, 260–261 Risk tolerance, 54, 58–61, 328, 425
Reverse trades, 449 ROA (return on assets), 551
Reward-to-risk ratio, 390–394, 415–416 ROE (return on equity), 172–173, 551
Rich stocks, 167 Roth IRAs, 55
Rights offer, 135 Roulette game, 249
RIM (residual income model), 181–183, Royal Dutch/Shell price ratio example,

189–192, 568–570 252–253
Risk; see also Default risk; Interest rate risk; Risk Royal Swedish Academy of Sciences, 520
Russell 2000 Index, 402
management; Systematic risk Rydex Investments, 121
arbitrage limits, 251
asset-specific, 383, 385
diversifiable/nondiversifiable, 359, 385
event, 596–597

670 Subject Index

S Series I savings bonds, 624
Shareholder equity, 547
Safety First pension fund example, 335–339 Sharpe-optimal portfolios, 419–422
Sales charges, 102 Sharpe ratio, 415, 417–423
Salomon Smith Barney, 530 Shell, 266
Samson Capital Advisors, 633 Shell/Royal Dutch price ratio example,
Savings bonds, 614, 623–624
Schwab Funds, 109 252–253
Seasoned equity offering (SEO), 135 Short hedge, 445–448, 456
Secondary market, 135, 137–139 Short interest, 52–53
Secondary offering, 135 Short positions, 47, 443
Second-stage financing, 134 Short sales, 47–53, 144–146, 265
Sector funds, 108 Short-term bond funds, 109
Securities and Exchange Commission (SEC) Short-term mutual funds, 105–106
Sigma, 524, 531
bond regulation by, 585, 604 Simple interest rates, 288
Coca-Cola ESO valuation rules, 535 Simple moving averages, 261–262
definition and overview, 137 Single-country funds, 108
EDGAR archives, 546 Single-price auctions, 623
financial information sources, 546 Single-state municipal bond funds, 110
hedge funds regulation, 123 Single-stock futures contracts, 452
insider trading rules, 215–216 Sinking fund, 593–594, 630
options regulation by, 473 SIPC (Securities Investor Protection Corporation),
Regulation FD, 546
12b-1 fees, 102 39–40, 106
Securities Investor Protection Corporation (SIPC), “Sleeping Beauty” bonds, 594
Small-company funds, 108
39–40, 106 Small-company stocks, 7–12, 14–15, 223–226,
Securities purchases and sales; see also
358–359, 402
Margin accounts SML; see Security market line
brokerage accounts, 38–40, 46 Social conscience funds, 109
futures trading accounts, 448–450 Social Security, 627
introduction, 37 Sortino ratio, 423
investment portfolio design, 61–63 S&P 100 Index options (OEX), 475
investor objectives, constraints and strategies, S&P 100 Volatility Index (VXO), 531–532
S&P 500 Index
54–60, 62
short sales, 47–53 about, 152, 154f, 157
Security analysis, 57; see also Common beta calculations using, 401
diversification and, 358–359
stock valuation dot-com bubble and crash, 230–232
Security market line (SML) historical returns, 11, 13t, 218, 358–359, 424
index fund of, 108–109, 220–222
beta and risk premium, 389–390 index futures on, 437, 454–455
capital asset pricing model, 394–395, index options, 475
as market proxy, 401, 417
401–403 P/E ratio, 184
definition and introduction, 381, 394–396 Russell 2000 Index compared, 402
reward-to-risk ratio, 390–394 technical analysis indicators, 265–266
Security selection, 57, 62, 425 volatility index comparisons, 532f
Security types S&P 500 Index options (SPX), 475–476,
classifying, 72
derivatives, 82–85 529–530
equities, 76–81 S&P 500 Volatility Index (VIX), 531–532
interest-bearing assets, 72–75 SPDRs (Standard & Poor’s Depositary Receipts),
introduction, 71
option contracts, 85–89 120–122
Self-attribution bias, 249 Specialists, 140, 142–144
Self-dealing, 124 Specialist’s post, 142–143
Selling securities; see Margin accounts; Securities Speculating with futures, 443–444
Speculative-grade bonds, 600, 631
purchases and sales Speculators, 443
Selling short; see Short sales Spot-futures parity, 452–453
Semistrong-form efficient markets, 209–210, 212 Spot market, 450
Senior debentures, 586, 600 Spot prices, 450
Senior notes, 584–585 Spread, 41, 139, 486–487, 619, 625
Sentiment-based risk, 251 SPX (S&P 500 Index options), 475–476,
Sentiment indexes, 254
SEO (seasoned equity offering), 135 529–530
Separate Trading of Registered Interest and Standard deviation

Principal of Securities (STRIPS), definition and introduction, 17–19
294–297, 615–618 implied, 531–532
Serial bonds, 594, 629 as measure of risk, 350, 425
Series EE savings bonds, 623
Subject Index 671

Standard deviation (Cont.) Stock screening, 552
portfolio risk and, 356–357 Stock splits, 156
portfolio variance, 355–357, 363, 365, 420 Stock valuation; see Common stock valuation
variance and, 17–19, 352–353 Stop-buy orders, 144
Stop-limit orders, 144
Standardized contracts, 83, 86, 438, 468 Stop-loss orders, 144
Standard & Poor’s 500 Index; see S&P 500 Index Stop orders, 144
Standard & Poor’s Corporation, 583, 596–597, Stop-out bid, 622–623
Stopping stock, 143
599–601, 631–632 Stop-sell orders, 144
Standard & Poor’s Depositary Receipts (SPDRs), Straddles, 487–488
Straight bonds, 315, 316–317, 592
120–122 Street name, 46
Stanford Graduate School of Business, 520 Strike price, 85, 468, 523
Stanford University, 423 Strips, 615
Starbucks Corporation STRIPS (Separate Trading of Registered

employee stock options, 222, 532–533 Interest and Principal of Securities),
financial statements case study 294–297, 615–618
Strong-form efficient markets, 209–210, 215
company overview, 560 Strong High-Yield Bond Fund, 603
pro forma balance sheets, 560–568 Subordinated debentures, 586, 600
pro forma income statements, 560–562 Subordinated notes, 584–585
valuing with market results, 570 Sunk cost fallacy, 244
valuing with ratio analysis, 568 Sun Microsystems, 259, 471
valuing with two-stage RIM, 568–570 Super Bowl indicator, 265–266
as growth stock, 184 SuperDOT system, 140
option chain, 470–471 Superior Offshore International, 182–183
price ratio analysis, 186–187 Supernormal growth, 179–180
stock price, 470, 564 Support levels, 255–256, 265
technical analysis, 263 Surprise announcements, 382
Starcents, 350–355, 361 Sustainable growth rate, 172–174
State Street Global Advisors, 121, 122 Swaps, 291
Stock and bond funds, 110 Swiss Re, 595
Stock exchanges, 139; see also Syndicates, 135–136
Synthetic puts, 497
specific exchange Systematic risk
Stock funds, 107–109, 363–366 beta and, 386–389, 397–398
Stock index futures, 437, 453–458 CAPM and, 395
Stock index options, 475–478, 529–531 definition, 383, 396
Stock markets; see also NASDAQ; New York diversification and, 385
expected returns and, 386, 393
Stock Exchange measuring, 386–388
bubbles and crashes, 227–230, 265 principle of, 386
Dow Jones divisors, 156–157 return and, 384
financing options, 134–139 Treynor ratio and, 415–418
hedging risk with futures, 455–456 Systematic risk principle, 386
historical returns, 7–12, 14–15, 21–23
indexes, 152–157, 531–532 T
introduction, 133
order types, 142–146 T. Rowe Price, 402, 603
over-the-counter, 147, 604 Target date, 334–339
primary/secondary markets, 135–137 Taxable municipal bonds, 627
Stock options; see Options; Option valuation Taxes
Stock price behavior
anomalies, 223–227 bond funds, 109–110
bubbles and crashes, 227–230, 265 equivalent taxable yield, 633–634
event studies, 212–214 on financial statements, 549
news announcements, 212–214, 227, investment companies, 101
as investor constraint, 55, 62
381–383, 384 money market funds, 106
random walk, 211–212 municipal bond funds, 109
Stock price volatility, 524, 531 municipal securities, 626–627
Stocks; see also Common stock; Common mutual funds, 98
preferred stock dividends, 598
stock valuation Tax-exempt bonds, 294, 306
blue chip, 114n Tax-exempt market, 626
foreign, 14–15, 358–359 Tax-managed funds, 109
growth, 14–15, 22–23 Tax Reform Act of 1986, 634–635
hedging with stock options, 527–529
investor relationships with, 242–243
option investments versus, 88–89, 473–475
preferred, 76–77, 598–599
price trees, 510–511, 514–515, 517–518
spot-futures parity, 452
value, 14–15

672 Subject Index

T-bills; see Treasury bills Treasury bonds
Technical analysis accrued interest calculations, 320n
agency bonds compared, 624–625
charting, 259–264 auctions, 622–623
definition, 253 call provisions, 618
Dow theory, 254–255 characteristics, 614–615
Elliott wave theory, 255 coupon, 294, 615
Fibonacci numbers, 264–265 futures trading example, 83–85
indicators, 256–258, 262, 265–266 interest rate history, 278–280
market sentiment index, 254 junk bond yields compared, 601–603
popularity of, 253–254 prices, 321, 618–620
relative strength, 258–259 yields, 321, 618–620
support and resistance levels, 255–256, 265
weak-form efficient market and, 210 Treasury inflation-protected securities (TIPS),
Tel Aviv Stock Exchange, 520 298–300, 620–622
10-K, 546, 551
10-Q, 546 Treasury notes
Tender offer bond, 630 auctions, 622–623
Tennessee Valley Authority (TVA), 290, 624, 625 characteristics, 614–615
Term bonds, 593–594, 630 coupon, 615
Terminal dividend, 168 as fixed-income securities, 73
Term structure of interest rates futures contracts on, 438, 442, 456–457
definition, 294 hedging interest rate risk, 438, 442, 456–457
expectations theory, 301–302 prices, 618–620
liquidity and default risk, 305–306 yields, 618–620
market segmentation theory, 303, 304
maturity preference theory, 302–303 Treasury securities
modern theories, 303–306 agency securities compared, 624–625
nominal versus real interest rates, 297–301, auctions, 622–623
inflation-indexed, 298–300, 620–622
304–305 marketable/nonmarketable, 614
traditional theories, 301–304 prices and inflation, 291
Treasury STRIPS, 294–297
Third Avenue Funds, 116 Treasury STRIPS, 294–297, 615–618
Third market, 149 Treasury yield curve, 290, 291f, 293f, 294
Thomson Financial/Baseline, 402 Treynor index, 390n
3Com/Palm mispricing example, 251–252 Treynor ratio, 415–418
Three-asset portfolios, 362, 367–369 TR(ading) IN(dex) (TRIN), 258
Ticker tape, 79 Triple witching hour, 454–455
Time value of an option, 490 Trust Indenture Act of 1939, 585, 598
Time value of money, 28, 180, 279, 296, 395 Turn-of-the-month effect, 226
Tippers and tippees, 215 Turn-of-the-year effect, 226
TIPS (Treasury inflation-protected securities), Turnover, 103
TVA (Tennessee Valley Authority),
298–300, 620–622
Tombstones, 137–138 290, 624, 625
Total dollar return, 3 Tweedy, Browne Funds, 117
Total market capitalization, 7 12b-1 fees, 102
Total percent return, 4 Two-asset portfolios, 360–366
Total return, 381, 384, 396, 397 Two-period binomial option pricing model,
Total risk, 385, 388, 396, 415
TRACE (Trade Reporting and Compliance Engine), 513–517
Two-stage dividend growth model
74–75, 604
Trading accounts, 38 advantages and disadvantages, 181
Trading frequency, 245 definition and equations, 175–178
Trading volume indicators, 256–257 discount rates for DDMs, 180–181
Traditional fixed-price call provisions, 586–587 nonconstant growth in first stage, 178–180
Treasury bills Two-stage residual income model, 568–570
Two states of the economy, 350–356
auctions, 622–623
bond equivalent yield, 286–289 U
characteristics, 614
definition and overview, 282 Uncorrelated returns, 360
discount rate and, 180 Underlying assets, 444–445, 447
effective annual return, 289 Undervalued securities, 394
historical returns, 7–12, 14–15 Underwater options, 533
interest rate history, 278–280 Underwriter spread, 135
interest rates, 282, 284–285, 298f Underwriting, 135–136
as money market instruments, 73 Unexpected returns, 381, 383, 398
put-call parity, 494–497 Uniform price auction, 136
quotes, 284–286 Unique risk, 383, 385
U.S. government bonds; see Government bonds
U.S. Treasury bills; see Treasury bills

Subject Index 673