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Essentials of Investments

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Ninth Edition

Essentials of Investments

ZVI BODIE
Boston University

ALEX KANE
University of California, San Diego

ALAN J. MARCUS
Boston College

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To our wives and eight wonderful daughters

ESSENTIALS OF INVESTMENTS, NINTH EDITION

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020.
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Previous editions © 2010,
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Library of Congress Cataloging-in-Publication Data
Bodie, Zvi.
Essentials of investments / Zvi Bodie, Alex Kane, Alan J. Marcus.—9th ed.
p. cm.
Includes index.
ISBN 978-0-07-803469-5 (alk. paper)
ISBN 0-07-803469-8 (alk. paper)
1. Investments. I. Kane, Alex. II. Marcus, Alan J. III. Title.
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v

Zvi Bodie
Boston University

Zvi Bodie is Professor of and Economics at Boston University School of Management.
He holds a PhD from the Massachusetts Institute of Technology and has served on the
finance faculty at Harvard School and MIT’s Sloan School of Management.
Professor Bodie has published widely on pension finance and investment strategy in leading
professional journals. His books include Foundations of Pension , Pensions in the U.S.
Economy, Issues in Pension Economics, and Financial Aspects of the U.S. Pension System. Professor
Bodie is a member of the Pension Research Council of the Wharton School, University of
Pennsylvania. His latest book is Worry-Free Investing: A Safe Approach to Achieving Your
Lifetime Financial Goals.

Alex Kane
University of California, San Diego

Alex Kane is Professor of and Economics at the Graduate School of International
Relations and Pacific Studies at the University of California, San Diego. He holds a PhD
from the Stern School of of New York University and has been Visiting Professor at
the Faculty of Economics, University of Tokyo; Graduate School of , Harvard;
Kennedy School of Government, Harvard; and Research Associate, National Bureau of
Economic Research. An author of many articles in finance and management journals,
Professor Kane’s research is mainly in corporate finance, portfolio management, and capital
markets.

Alan J. Marcus
Boston College

Alan Marcus is the Mario J. Gabelli Professor of in the Carroll School of Management
at Boston College. He received his PhD from MIT, has been a Visiting Professor at MIT’s
Sloan School of Management and Athens Laboratory of Administration, and has
served as a Research Fellow at the National Bureau of Economic Research, where he
participated in both the Pension Economics and the Financial Markets and Monetary
Economics Groups. Professor Marcus also spent two years at the Federal Home Loan
Mortgage Corporation (Freddie Mac), where he helped to develop mortgage pricing and
credit risk models. Professor Marcus has published widely in the fields of capital markets and
portfolio theory. He currently serves on the Research Foundation Advisory Board of the CFA
Institute.

About the Authors

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vi

Brief Contents

Part ONE
ELEMENTS OF INVESTMENTS 1

1 Investments: Background and
Issues 2

2 Asset Classes and Financial
Instruments 26

3 Securities Markets 54
4 Mutual Funds and Other Investment

Companies 84

Part TWO
PORTFOLIO THEORY 109

5 Risk and Return: Past and
Prologue 110

6 Efficient Diversification 148
7 Capital Asset Pricing and Arbitrage

Pricing Theory 193
8 The Efficient Market Hypothesis 234
9 Behavioral and Technical

Analysis 265

Part THREE
DEBT SECURITIES 291

10 Bond Prices and Yields 292
11 Managing Bond Portfolios 337

Part FOUR
SECURITY ANALYSIS 371

12 Macroeconomic and Industry
Analysis 372

13 Equity Valuation 405
14 Financial Statement Analysis 446

Part FIVE
DERIVATIVE MARKETS 485

15 Options Markets 486
16 Option Valuation 522
17 Futures Markets and Risk

Management 561

Part SIX
ACTIVE INVESTMENT
MANAGEMENT 595

18 Portfolio Performance
Evaluation 596

19 Globalization and International
Investing 630

20 Hedge Funds 666
21 Taxes, Inflation, and Investment

Strategy 689
22 Investors and the Investment

Process 714

Appendixes
A References 736

B References to CFA Questions 742

Index I

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vii

Contents

Part ONE
ELEMENTS OF INVESTMENTS 1

1 Investments: Background
and Issues 2

1.1 Real Assets versus Financial Assets 3
1.2 Financial Assets 5
1.3 Financial Markets and the Economy 6

The Informational Role of Financial
Markets 6
Consumption Timing 7
Allocation of Risk 7
Separation of Ownership and Management 7
Corporate Governance and Corporate
Ethics 8

1.4 The Investment Process 9
1.5 Markets Are Competitive 10

The Risk-Return Trade-Off 10
Eff icient Markets 11

1.6 The Players 11
Financial Intermediaries 12
Investment Bankers 14
Venture Capital and Private Equity 15

1.7 The Financial Crisis of 2008 15
Antecedents of the Crisis 15
Changes in Housing 17
Mortgage Derivatives 19
Credit Default Swaps 20
The Rise of Systemic Risk 20
The Shoe Drops 20
The Dodd-Frank Reform Act 21

1.8 Outline of the Text 22
End of Chapter Material 22–25

2 Asset Classes and Financial
Instruments 26

2.1 The Money Market 27

Treasury Bills 27
Certif icates of Deposit 28
Commercial Paper 28
Bankers’ Acceptances 29
Eurodollars 29
Repos and Reverses 29
Brokers’ Calls 29
Federal Funds 30
The LIBOR Market 30
Yields on Money Market Instruments 30

2.2 The Bond Market 31
Treasury Notes and Bonds 31
Inflation-Protected Treasury Bonds 32
Federal Agency Debt 32
International Bonds 33
Municipal Bonds 33
Corporate Bonds 36
Mortgages and Mortgage-Backed Securities 36

2.3 Equity Securities 37
Common Stock as Ownership Shares 37
Characteristics of Common Stock 38
Stock Market Listings 38
Preferred Stock 39
Depository Receipts 40

2.4 Stock and Bond Market Indexes 40
Stock Market Indexes 40
Dow Jones Averages 40
Standard & Poor’s Indexes 42
Other U.S. Market Value Indexes 44
Equally Weighted Indexes 44
Foreign and International Stock Market
Indexes 45
Bond Market Indicators 45

2.5 Derivative Markets 46
Options 46
Futures Contracts 47
End of Chapter Material 48–53

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viii Contents

3 Securities Markets 54
3.1 How Firms Issue Securities 55

Privately Held Firms 55
Publicly Traded Companies 56
Shelf Registration 56
Initial Public Offerings 57

3.2 How Securities Are Traded 57
Types of Markets 58
Types of Orders 59
Trading Mechanisms 61

3.3 The Rise of Electronic Trading 62
3.4 U.S. Markets 64

NASDAQ 64
The New York Stock Exchange 65
ECNs 65

3.5 New Trading Strategies 65
Algorithmic Trading 66
High-Frequency Trading 66
Dark Pools 67
Bond Trading 67

3.6 Globalization of Stock Markets 68
3.7 Trading Costs 68
3.8 Buying on Margin 69
3.9 Short Sales 72
3.10 Regulation of Securities Markets 74

Self-Regulation 76
The Sarbanes-Oxley Act 76
Insider Trading 78

End of Chapter Material 78–83

4 Mutual Funds and Other
Investment Companies 84

4.1 Investment Companies 85
4.2 Types of Investment Companies 86

Unit Investment Trusts 86
Managed Investment Companies 86
Other Investment Organizations 87

4.3 Mutual Funds 88
Investment Policies 88
How Funds Are Sold 91

4.4 Costs of Investing in Mutual
Funds 91
Fee Structure 91
Fees and Mutual Fund Returns 93

4.5 Taxation of Mutual Fund Income 94

4.6 Exchange-Traded Funds 95
4.7 Mutual Fund Investment Performance: A First

Look 98
4.8 Information on Mutual Funds 101

End of Chapter Material 104–108

Part TWO
PORTFOLIO THEORY 109

5 Risk and Return: Past
and Prologue 110

5.1 Rates of Return 111
Measuring Investment Returns over Multiple
Periods 111
Conventions for Annualizing Rates of Return 113

5.2 Risk and Risk Premiums 115
Scenario Analysis and Probability Distributions 115
The Normal Distribution 116
Normality over Time 119
Deviation from Normality and Value at Risk 119
Using Time Series of Return 121
Risk Premiums and Risk Aversion 122
The Sharpe (Reward-to-Volatility) Ratio 123

5.3 The Historical Record 126
World and U.S. Risky Stock and Bond
Portfolios 126

5.4 Inflation and Real Rates of Return 130
The Equilibrium Nominal Rate of Interest 131
U.S. History of Interest Rates, Inflation, and Real
Interest Rates 132

5.5 Asset Allocation across Risky and Risk-Free
Portfolios 133
The Risk-Free Asset 134
Portfolio Expected Return and Risk 134
The Capital Allocation Line 136
Risk Aversion and Capital Allocation 137

5.6 Passive Strategies and the Capital Market
Line 138
Historical Evidence on the Capital Market
Line 138
Costs and Benef its of Passive Investing 139

End of Chapter Material 140–147

6 Efficient Diversification 148
6.1 Diversification and Portfolio Risk 149

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Contents ix

6.2 Asset Allocation with Two Risky Assets 150
Covariance and Correlation 151
Using Historical Data 154
The Three Rules of Two-Risky-Assets
Portfolios 156
The Risk-Return Trade-Off with Two-Risky-Assets
Portfolios 157
The Mean-Variance Criterion 158

6.3 The Optimal Risky Portfolio with a Risk-Free
Asset 161

6.4 Efficient Diversification with Many Risky
Assets 164
The Eff icient Frontier of Risky Assets 164
Choosing the Optimal Risky Portfolio 167
The Preferred Complete Portfolio and the Separation
Property 167
Constructing the Optimal Risky Portfolio: An
Illustration 167

6.5 A Single-Index Stock Market 170
Statistical and Graphical Representation
of the Single-Index Model 171
Diversif ication in a Single-Index Security
Market 173
Using Security Analysis with the Index Model 176

6.6 Risk of Long-Term Investments 179
Risk and Return with Alternative Long-Term
Investments 179
Why the Unending Confusion? 181
End of Chapter Material 181–192

7 Capital Asset Pricing and Arbitrage
Pricing Theory 193

7.1 The Capital Asset Pricing Model 194
The Model: Assumptions and Implications 194
Why All Investors Would Hold the Market
Portfolio 195
The Passive Strategy Is Eff icient 196
The Risk Premium of the Market
Portfolio 197
Expected Returns on Individual Securities 197
The Security Market Line 199
Applications of the CAPM 200

7.2 The CAPM and Index Models 201
The Index Model, Realized Returns, and the
Mean–Beta Equation 201
Estimating the Index Model 203
Predicting Betas 209

7.3 The CAPM and the Real World 210
7.4 Multifactor Models and the CAPM 211

The Fama-French Three-Factor Model 213
Multifactor Models and the Validity of
the CAPM 216

7.5 Arbitrage Pricing Theory 217
Well-Diversif ied Portfolios and Arbitrage Pricing
Theory 217
The APT and the CAPM 220
Multifactor Generalization of the APT
and CAPM 221
End of Chapter Material 223–233

8 The Efficient Market
Hypothesis 234

8.1 Random Walks and the Efficient Market
Hypothesis 235
Competition as the Source of Eff iciency 237
Versions of the Eff icient Market
Hypothesis 238

8.2 Implications of the EMH 239
Technical Analysis 239
Fundamental Analysis 240
Active versus Passive Portfolio
Management 241
The Role of Portfolio Management in an Eff icient
Market 242
Resource Allocation 242

8.3 Are Markets Efficient? 243
The Issues 243
Weak-Form Tests: Patterns in Stock
Returns 245
Predictors of Broad Market Returns 246
Semistrong Tests: Market Anomalies 246
Strong-Form Tests: Inside Information 251
Interpreting the Anomalies 251

8.4 Mutual Fund and Analyst Performance 253
Stock Market Analysts 253
Mutual Fund Managers 254
So, Are Markets Eff icient? 257
End of Chapter Material 257–264

9 Behavioral and Technical
Analysis 265

9.1 The Behavioral Critique 266

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x Contents

10.6 The Yield Curve 322
The Expectations Theory 322
The Liquidity Preference Theory 324
A Synthesis 325

End of Chapter Material 327–336

11 Managing Bond Portfolios 337
11.1 Interest Rate Risk 338

Interest Rate Sensitivity 338
Duration 340
What Determines Duration? 344

11.2 Passive Bond Management 346
Immunization 346
Cash Flow Matching and Dedication 351

11.3 Convexity 353
Why Do Investors Like Convexity? 355

11.4 Active Bond Management 356
Sources of Potential Prof it 356
Horizon Analysis 358
An Example of a Fixed-Income Investment
Strategy 358

End of Chapter Material 359–370

Part FOUR
SECURITY ANALYSIS 371

12 Macroeconomic and Industry
Analysis 372

12.1 The Global Economy 373
12.2 The Domestic Macroeconomy 375

Gross Domestic Product 376
Employment 376
Inflation 376
Interest Rates 376
Budget Def icit 376
Sentiment 377

12.3 Interest Rates 377
12.4 Demand and Supply Shocks 378
12.5 Federal Government Policy 379

Fiscal Policy 379
Monetary Policy 380
Supply-Side Policies 381

12.6 Cycles 382
The Cycle 382

Information Processing 267
Behavioral Biases 268
Limits to Arbitrage 269
Limits to Arbitrage and the of One
Price 271
Bubbles and Behavioral Economics 273
Evaluating the Behavioral Critique 274

9.2 Technical Analysis and Behavioral
275
Trends and Corrections 276
Sentiment Indicators 280
A Warning 281

End of Chapter Material 283–290

Part THREE
DEBT SECURITIES 291

10 Bond Prices and Yields 292
10.1 Bond Characteristics 293

Treasury Bonds and Notes 293
Corporate Bonds 295
Preferred Stock 296
Other Domestic Issuers 297
International Bonds 297
Innovation in the Bond Market 297

10.2 Bond Pricing 299
Bond Pricing between Coupon Dates 302
Bond Pricing in Excel 303

10.3 Bond Yields 304
Yield to Maturity 304
Yield to Call 306
Realized Compound Return versus Yield to
Maturity 308

10.4 Bond Prices Over Time 310
Yield to Maturity versus Holding-Period
Return 311
Zero-Coupon Bonds and Treasury
STRIPS 312
After-Tax Returns 312

10.5 Default Risk and Bond Pricing 314
Junk Bonds 314
Determinants of Bond Safety 314
Bond Indentures 316
Yield to Maturity and Default Risk 317
Credit Default Swaps 319

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Contents xi

14.4 Ratio Analysis 455
Decomposition of ROE 455
Turnover and Asset Utilization 458
Liquidity Ratios 460
Market Price Ratios 461
Choosing a Benchmark 462

14.5 An Illustration of Financial Statement!
Analysis 464

14.6 Comparability Problems 466
Inventory Valuation 467
Depreciation 467
Inflation and Interest Expense 468
Fair Value Accounting 468
Quality of Earnings and Accounting
Practices 469
International Accounting Conventions 471

14.7 Value Investing: The Graham Technique 472
End of Chapter Material 473–484

Part FIVE
DERIVATIVE MARKETS 485

15 Options Markets 486
15.1 The Option Contract 487

Options Trading 488
American and European Options 490
The Option Clearing Corporation 490
Other Listed Options 490

15.2 Values of Options at Expiration 491
Call Options 491
Put Options 492
Options versus Stock Investments 494
Option Strategies 497

15.3 Optionlike Securities 505
Callable Bonds 505
Convertible Securities 506
Warrants 508
Collateralized Loans 508
Leveraged Equity and Risky Debt 509

15.4 Exotic Options 509
Asian Options 510
Currency-Translated Options 510
Digital Options 511

End of Chapter Material 511–521

Economic Indicators 384
Other Indicators 386

12.7 Industry Analysis 387
Def ining an Industry 389
Sensitivity to the Cycle 390
Sector Rotation 391
Industry Life Cycles 392
Industry Structure and Performance 395

End of Chapter Material 396–404

13 Equity Valuation 405
13.1 Valuation by Comparables 406

Limitations of Book Value 406
13.2 Intrinsic Value versus Market Price 408
13.3 Dividend Discount Models 409

The Constant-Growth DDM 410
Stock Prices and Investment
Opportunities 413
Life Cycles and Multistage Growth Models 416
Multistage Growth Models 420

13.4 Price–Earnings Ratios 420
The Price–Earnings Ratio and Growth
Opportunities 420
P/E Ratios and Stock Risk 424
Pitfalls in P/E Analysis 425
Combining P/E Analysis and the DDM 428
Other Comparative Valuation Ratios 428

13.5 Free Cash Flow Valuation Approaches 428
Comparing the Valuation Models 432
The Problem with DCF Models 432

13.6 The Aggregate Stock Market 433
End of Chapter Material 435–445

14 Financial Statement Analysis 446
14.1 The Major Financial Statements 447

The Income Statement 447
The Balance Sheet 448
The Statement of Cash Flows 448

14.2 Measuring Firm Performance 451
14.3 Profitability Measures 451

Return on Assets 452
Return on Capital 452
Return on Equity 452
Financial Leverage and ROE …