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Summaries

Ch 1


•Real assets create wealth. Financial assets represent claims to parts or all of that wealth. Financial assets determine how the ownership of real assets is distributed among investors.

•Financial assets can be categorized as fixed-income (debt), equity, or derivative instruments. Top-down portfolio construction techniques start with the asset allocation decision—the allocation of funds across broad asset classes—and then progress to more specific security-selection decisions.

•Competition in financial markets leads to a risk-return trade-off, in which securities that offer higher expected rates of return also impose greater risks on investors. The presence of risk, however, implies that actual returns can differ considerably from expected returns at the beginning of the investment period. Competition among security analysts also results in financial markets that are nearly informationally efficient, meaning that prices reflect all available information concerning the value of the security. Passive investment strategies may make sense in nearly efficient markets.Page 23

•Financial intermediaries pool investor funds and invest them. Their services are in demand because small investors cannot efficiently gather information, diversify, and monitor portfolios. The financial intermediary, in contrast, is a large investor that can take advantage of scale economies.

•Investment banking brings efficiency to corporate fund raising. Investment bankers develop expertise in pricing new issues and in marketing them to investors. By the end of 2008, all the major stand-alone U.S. investment banks had been absorbed into commercial banks or had reorganized themselves into bank holding companies. In Europe, where universal banking had never been prohibited, large banks had long maintained both commercial and investment banking divisions.

•The financial crisis of 2008 showed the importance of systemic risk. Systemic risk can be limited by transparency that allows traders and investors to assess the risk of their counterparties, capital requirements to prevent trading participants from being brought down by potential losses, frequent settlement of gains or losses to prevent losses from accumulating beyond an institution’s ability to bear them, incentives to discourage excessive risk taking, and accurate and unbiased analysis by those charged with evaluating security risk.

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Ch 2

•Money market securities are very short-term debt obligations. They are usually highly marketable and have relatively low credit risk. Their low maturities and low credit risk ensure minimal capital gains or losses. These securities often trade in large denominations, but they may be purchased indirectly through money market funds.

•Much of U.S. government borrowing is in the form of Treasury bonds and notes. These are coupon-paying bonds usually issued at or near par value. Treasury bonds are similar in design to coupon-paying corporate bonds.

•Municipal bonds are distinguished largely by their tax-exempt status. Interest payments (but not capital gains) on these securities are exempt from income taxes.

•Mortgage pass-through securities are pools of mortgages sold in one package. Owners of pass-throughs receive all principal and interest payments made by the borrower. The firm that originally issued the mortgage merely services the mortgage, simply “passing through” the payments to the purchasers of the mortgage. Payments of interest and principal on government agency pass-through securities are guaranteed, but payments on private-label mortgage pools are not.

•Common stock is an ownership share in a corporation. Each share entitles its owner to one vote on matters of corporate governance and to a prorated share of the dividends paid to shareholders. Stock, or equity, owners are the residual claimants on the income earned by the firm.

•Preferred stock usually pays a fixed stream of dividends for the life of the firm: It is a perpetuity. A firm’s failure to pay the dividend due on preferred stock, however, does not set off corporate bankruptcy. Instead, unpaid dividends simply cumulate. Varieties of preferred stock include convertible and adjustable-rate issues.

•Many stock market indexes measure the performance of the overall market. The Dow Jones averages, the oldest and best-known indicators, are price-weighted indexes. Today, many broad-based, market value–weighted indexes are computed daily. These include the Standard & Poor’s Composite 500 stock index, the NYSE index, the NASDAQ index, the Wilshire 5000 Index, and several international indexes, including the Nikkei, FTSE, and DAX.

Page 49•A call option is a right to purchase an asset at a stipulated exercise price on or before an expiration date. A put option is the right to sell an asset at some exercise price. Calls increase in value, while puts decrease in value, as the price of the underlying asset increases.

•A futures contract is an obligation to buy or sell an asset at a stipulated futures price on a maturity date. The long position, which commits to purchasing, gains if the asset value increases, while the short position, which commits to delivering the asset, loses.

Ch 3

•Firms issue securities to raise the capital necessary to finance their investments. Investment bankers market these securities to the public on the primary market. Investment bankers generally act as underwriters who purchase the securities from the firm and resell them to the public at a markup. Before the securities may be sold to the public, the firm must publish an SEC-approved prospectus that provides information on the firm’s prospects.

Page 79•Already-issued securities are traded on the secondary market, that is, in organized stock markets, or, primarily for bonds, on the over-the-counter market. Brokerage firms holding licenses to trade on an exchange sell their services to individuals, charging commissions for executing trades on their behalf.

•Trading may take place in dealer markets, via electronic communication networks, or in specialist markets. In dealer markets, security dealers post bid and ask prices at which they are willing to trade. Brokers for individuals execute trades at the best available prices. In electronic markets, the existing book of limit orders provides the terms at which trades can be executed. Mutually agreeable offers to buy or sell securities are automatically crossed by the computer system operating the market. In specialist markets, the specialist acts to maintain an orderly market with price continuity. Specialists maintain a limit order book but also sell from or buy for their own inventories of stock.

•NASDAQ was traditionally a dealer market in which a network of dealers negotiated directly over sales of securities. The NYSE was traditionally a specialist market. In recent years, however, both exchanges dramatically increased their commitment to electronic and automated trading. The overwhelming majority of trades today are electronic.

•Buying on margin means borrowing money from a broker in order to buy more securities than can be purchased with one’s own money alone. By buying securities on a margin, an investor magnifies both the upside potential and the downside risk. If the equity in a margin account falls below the required maintenance level, the investor will get a margin call from the broker.

•Short-selling is the practice of selling securities that the seller does not own. The short-seller borrows the securities sold through a broker and may be required to cover the short position at any time on demand. The cash proceeds of a short sale are kept in escrow by the broker, and the broker usually requires that the short-seller deposit additional cash or securities to serve as margin (collateral) for the short sale.

•Securities trading is regulated by the Securities and Exchange Commission, by other government agencies, and through self-regulation of the exchanges. Many of the important regulations have to do with full disclosure of relevant information concerning the securities in question. Insider trading rules also prohibit traders from attempting to profit from inside information.

Ch 22

•The CFA Institute has developed a systematic framework for the translation of investor goals to investment strategy. Its three main parts are objectives, constraints, and policy. Investor objectives include the return requirement and risk tolerance, reflecting the overriding concern of investment with the risk-return trade-off. Investor constraints include liquidity requirements, investment horizon, regulatory concerns, tax obligations, and the unique needs of various investors. Investment policies specify the portfolio manager’s asset allocation and security selection decisions.

•Major institutional investors include pension funds, mutual funds, life insurance companies, non-life-insurance companies, banks, and endowment funds. For individual investors, life-cycle concerns are the most important factor in setting objectives, constraints, and policies.

•Major asset classes include cash (money market assets), fixed-income securities (bonds), stocks, real estate, precious metals, and collectibles. Asset allocation refers to the decision made as to the investment proportion to be allocated to each asset class. An active asset allocation strategy calls for the production of frequent market forecasts and the adjustment of asset allocation according to these forecasts.

•Active security selection requires security analysis and portfolio choice. Analysis of individual securities is required to choose securities that will make up a coherent portfolio and outperform a passive benchmark.

•Perhaps the most important feature of the investment process is that it is dynamic. Portfolios must be continually monitored and updated. The frequency and timing of various decisions are in themselves important decisions. Successful investment management requires management of these dynamic aspects.

Ch 12

•Macroeconomic policy aims to maintain the economy near full employment without aggravating inflationary pressures. The proper trade-off between these two goals is a source of ongoing debate.

•The traditional tools of macro policy are government spending and tax collection, which constitute fiscal policy, and manipulation of the money supply via monetary policy. Expansionary fiscal policy can stimulate the economy and increase GDP but tends to increase interest rates. Expansionary monetary policy works by lowering interest rates.

•The business cycle is the economy’s recurring pattern of expansions and recessions. Leading economic indicators can be used to anticipate the evolution of the business cycle because their values tend to change before those of other key economic variables.

•Industries differ in their sensitivity to the business cycle. More sensitive industries tend to be those producing high-priced durable goods for which the consumer has considerable discretion as to the timing of purchase. Examples are automobiles or consumer durables. Other sensitive industries are those that produce capital equipment for other firms. Operating leverage and financial leverage increase sensitivity to the business cycle.

Ch 13

•One approach to firm valuation is to focus on the firm’s book value, either as it appears on the balance sheet or adjusted to reflect the current replacement cost of assets or the liquidation value. Another approach is to focus on the present value of expected future dividends.

•The dividend discount model holds that the price of a share of stock should equal the present value of all future dividends per share, discounted at an interest rate commensurate with the risk of the stock.

•The constant-growth version of the DDM asserts that if dividends are expected to grow at a constant rate forever, then the intrinsic value of the stock is determined by the formula

This equation shows the value in time zero equals the dividend in time one divided by the difference between the discount rate and the growth rate

•This version of the DDM is simplistic in its assumption of a constant value of g. There are more sophisticated multistage versions of the model for more complex environments. When the constant-growth assumption is reasonably satisfied, however, the formula can be inverted to infer the market capitalization rate for the stock:

This equation shows the discount rate equals the dividend yield plus the growth rate

•Stock market analysts devote considerable attention to a company’s price–earnings ratio. The P/E ratio is a useful measure of the market’s assessment of the firm’s growth opportunities. Firms with no growth opportunities should have a P/E ratio that is just the reciprocal of the capitalization rate, k. As growth opportunities become a progressively more important component of the total value of the firm, the P/E ratio will increase.Page 432

•Many analysts form their estimates of a stock’s value by multiplying their forecast of next year’s EPS by a predicted P/E multiple. Some analysts mix the P/E approach with the dividend discount model. They use an earnings multiplier to forecast the terminal value of shares at a future date and add the present value of that terminal value with the present value of all interim dividend payments.

•The free cash flow approach is the one used most in corporate finance. The analyst first estimates the value of the firm as the present value of expected future free cash flows to the entire firm and then subtracts the value of all claims other than equity. Alternatively, the free cash flows to equity can be discounted at a discount rate appropriate to the risk of the stock.

•The models presented in this chapter can be used to explain or to forecast the behavior of the aggregate stock market. The key macroeconomic variables that determine the level of stock prices in the aggregate are interest rates and corporate profits.

CH 14

•The primary focus of the security analyst should be the firm’s real economic earnings rather than its reported earnings. Accounting earnings as reported in financial statements can be a biased estimate of real economic earnings, although empirical studies confirm that reported earnings convey considerable information concerning a firm’s prospects.

•A firm’s ROE is a key determinant of the growth rate of its earnings. ROE is affected profoundly by the firm’s degree of financial leverage. An increase in a firm’s debt/equity ratio will raise its ROE and hence its growth rate only if the interest rate on the debt is less than the firm’s return on assets.

•It is often helpful to the analyst to decompose a firm’s ROE ratio into the product of several accounting ratios and to analyze their separate behavior over time and across companies within an industry. A useful breakdown is

This equation shows the breakdown of return on equity into its component ratios.

•Other accounting ratios that have a bearing on a firm’s profitability and/or risk are fixed-asset turnover, inventory turnover, days sales in receivables, and the current, quick, and interest coverage ratios.

•Two ratios that make use of the market price of the firm’s common stock in addition to its financial statements are the ratios of market-to-book value and price to earnings. Analysts sometimes take low values for these ratios as a margin of safety or a sign that the stock is a bargain.

•A major problem in the use of data obtained from a firm’s financial statements is comparability. Firms have a great deal of latitude in how they choose to compute various items of revenue and expense. It is, therefore, necessary for the security analyst to adjust accounting earnings and financial ratios to a uniform standard before attempting to compare financial results across firms.

•Comparability problems can be acute in a period of inflation. Inflation can create distortions in accounting for inventories, depreciation, and interest expense.

•Fair value or mark-to-market accounting requires that most assets be valued at current market value rather than historical cost. This policy has proved to be controversial because in many instances it is difficult to ascertain true market value, and critics contend that it makes financial statements unduly volatile. Advocates argue that financial statements should reflect the best estimate of current asset values.

Page 471•International financial reporting standards have become progressively accepted throughout the world, including the United States. They differ from traditional U.S. GAAP procedures in that they are principles-based rather than rules-based.

Ch 4

•Unit investment trusts, closed-end management companies, and open-end management companies are all classified and regulated as investment companies. Unit investment trusts are essentially unmanaged in the sense that the portfolio, once established, is fixed. Managed investment companies, in contrast, may change the composition of the portfolio as deemed fit by the portfolio manager. Closed-end funds are traded like other securities; they do not redeem shares for their investors. Open-end funds will redeem shares for net asset value at the request of the investor.

•Net asset value equals the market value of assets held by a fund minus the liabilities of the fund divided by the shares outstanding.

•Mutual funds free the individual from many of the administrative burdens of owning individual securities and offer professional management of the portfolio. They also offer advantages that are available only to large-scale investors, such as lower trading costs. On the other hand, funds are assessed management fees and incur other expenses, which reduce the investor’s rate of return. Funds also eliminate some of the individual’s control over the timing of capital gains realizations.

Page 104•Mutual funds often are categorized by investment policy. Major policy groups include money market funds; equity funds, which are further grouped according to emphasis on income versus growth; fixed-income funds; balanced and income funds; asset allocation funds; index funds; and specialized sector funds.

•Costs of investing in mutual funds include front-end loads, which are sales charges; back-end loads, which are redemption fees or, more formally, contingent-deferred sales charges; fund operating expenses; and 12b-1 charges, which are recurring fees used to pay for the expenses of marketing the fund to the public.

•Income earned on mutual fund portfolios is not taxed at the level of the fund. Instead, as long as the fund meets certain requirements for pass-through status, the income is treated as being earned by the investors in the fund.

•The average rate of return of the average equity mutual fund in the last 40 years has been below that of a passive index fund holding a portfolio to replicate a broad-based index like the S&P 500 or Wilshire 5000. Some of the reasons for this disappointing record are the costs incurred by actively managed funds, such as the expense of conducting the research to guide stock-picking activities, and trading costs due to higher portfolio turnover. The record on the consistency of fund performance is mixed. In some sample periods, the better-performing funds continue to perform well in the following periods; in other sample periods they do not.

Ch 5

•Investors face a trade-off between risk and expected return. Historical data confirm our intuition that assets with low degrees of risk should provide lower returns on average than do those of higher risk.

•Shifting funds from the risky portfolio to the risk-free asset is the simplest way to reduce risk. Another method involves diversification of the risky portfolio. We take up diversification in later chapters.

•U.S. T-bills provide a perfectly risk-free asset in nominal terms only. Nevertheless, the standard deviation of real rates on short-term T-bills is small compared to that of assets such as long-term bonds and common stocks, so for the purpose of our analysis, we consider T-bills the risk-free asset. Besides T-bills, money market funds hold short-term, safe obligations such as commercial paper and CDs. These entail some default risk but relatively little compared to most other risky assets. For convenience, we often refer to money market funds as risk-free assets.

•A risky investment portfolio (referred to here as the risky asset) can be characterized by its Sharpe, or reward-to-volatility ratio. This ratio is the slope of the capital allocation line (CAL), the line connecting the risk-free asset to the risky asset. All combinations of the risky and risk-free asset lie on this line. Investors would prefer a steeper-sloping CAL, because that means higher expected returns for any level of risk.

•An investor’s preferred choice among the portfolios on the capital allocation line will depend on risk aversion. Risk-averse investors will weight their complete portfolios more heavily toward Treasury bills. Risk-tolerant investors will hold higher proportions of their complete portfolios in the risky asset.

•The capital market line is the capital allocation line that results from using a passive investment strategy that treats a market index portfolio, such as the Standard & Poor’s 500, as the risky asset. Passive strategies are low-cost ways of obtaining well-diversified portfolios with performance that will reflect that of the broad stock market.

Ch 6

•The expected rate of return of a portfolio is the weighted average of the component asset expected returns with the investment proportions as weights.

•The variance of a portfolio is a sum of the contributions of the component-security variances plus terms involving the covariance among assets.

•Even if correlations are positive, the portfolio standard deviation will be less than the weighted average of the component standard deviations, as long as the assets are not perfectlypositively correlated. Thus, portfolio diversification is of value as long as assets are less than perfectly correlated.

•The contribution of an asset to portfolio variance depends on its correlation with the other assets in the portfolio, as well as on its own variance. An asset that is perfectly negatively correlated with a portfolio can be used to reduce the portfolio variance to zero. Thus, it can serve as a perfect hedge.

•The efficient frontier of risky assets is the graphical representation of the set of portfolios that maximizes portfolio expected return for a given level of portfolio standard deviation. Rational investors will choose a portfolio on the efficient frontier.

Page 180•A portfolio manager identifies the efficient frontier by first establishing estimates for the expected returns and standard deviations and determining the correlations among them. The input data are then fed into an optimization program that produces the investment proportions, expected returns, and standard deviations of the portfolios on the efficient frontier.

•In general, portfolio managers will identify different efficient portfolios because of differences in the methods and quality of security analysis. Managers compete on the quality of their security analysis relative to their management fees.

•If a risk-free asset is available and input data are identical, all investors will choose the same portfolio on the efficient frontier, the one that is tangent to the CAL. All investors with identical input data will hold the identical risky portfolio, differing only in how much each allocates to this optimal portfolio and to the risk-free asset. This result is characterized as the separation principle of portfolio selection.

•The single-index model expresses the excess return on a security as a function of the market excess return: Ri = αi + βiRM + ei. This equation also can be interpreted as a regression of the security excess return on the market-index excess return. The regression line has intercept αi and slope βi and is called the security characteristic line.

•In a single-index model, the variance of the rate of return on a security or portfolio can be decomposed into systematic and firm-specific risk. The systematic component of variance equals β2 times the variance of the market excess return. The firm-specific component is the variance of the residual term in the index-model equation.

•The beta of a portfolio is the weighted average of the betas of the component securities. A security with negative beta reduces the portfolio beta, thereby reducing exposure to market volatility. The unique risk of a portfolio approaches zero as the portfolio becomes more highly diversified.