CHAPTER 1 Investments: Background and Issues

Investments--commitment of funds to one or more assets in the expectation of reaping future benefits. Financial assetsclaims on real assets Real assetsassets used to produce goods and services. Types of financial assets: fixed income securities, equities, and derivative securities. Investment process: 1-asset allocation-choice among broad asset classes. 2-security selection-choice of specific securities within each asset class. Financial markets are highly competitive: 1- risk-return tradeoff 2- efficient markets Financial intermediaries: bring lenders and borrowers together. Markets: 1- direct search markets 2- brokered markets 3- dealer markets 4- auction markets Recent trends Globalization--ADRs Securitization Financial engineering Perspective on investing: each individual must develop an overall financial planincludes purchase of house, insurance, and emergency reserve Professional designations: 1) Chartered Financial Analyst (CFA), 2) Certified Financial Planner (CFP), and 3) Chartered Financial Consultant (ChFC) Good investors must come to gripes with is uncertainty. All market participants, including professionals, make errors. No one can consistently forecast what will happen in the financial markets.
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CHAPTER 2 Financial Markets and Instruments

The purpose of this chapter is to provide an overview of the major types of financial assets available to investors. Most of these securities will be discussed in much greater detail in later chapters. Money market securities Treasury billssold at discounts; risk-free Certificates of deposit Commercial paper Bankers acceptance Eurodollars Repurchase agreements Federal funds LIBOR Fixed income securities Treasury notes and bonds Federal agency debt Municipal bonds Corporate bonds Mortgages and mortgage-backed securities Equity securities Common stock Preferred stock Stock and bond market indexes Dow Jones Industrial Average: price-weighted S&P 550 Index: value weighted Nikkei 225, FTSE (100), DAX Bond market indicators Derivative Markets Optionsputs and calls Futures

CHAPTER 3 How Securities Are Traded

Chapter provides an analysis of the structure of security markets, with securities organized by where they are traded. Terminology and functioning of the market is explained. NYSE and OTC markets discussed in detail. The importance of financial markets is the allocation function it serves to channel funds from savers to borrowers; operationally efficient with the lowest possible prices for transaction services. Primary markets would not function well without secondary markets. Primary markets: market for new issues; seasoned issues/initial public offerings (IPOs). Private placement: sold directly to financial institutions such as life insurance companies and pension funds. Does not have to be registered with the SEC. Investment banker: firm specializing in the sale of new securities. Underwriting: the purchase of an issue from a firm and resell to the publiccompensated by a spread; may form a syndicate. Issuer files a registration statement with the SEC; issues a prospectus. Shelf registration: (Rule 415) File a short form registration and place the issue on the shelf to be sold over time. Initial Public Offerings (IPOs): Road show; bookbuilding; underpricing; poor long-term performance Secondary Markets: auction vs. negotiated markets. NYSE has 1366 seats, commission brokers, role of the specialist, over 3,000 firms listed. Amexabout 770 firms listed, large volume in options, and derivative securities. Regional exchanges Over-the-counter (OTC) markets: 35,000 issues traded; Bid/ask price; Nasdaq National Market System: about 4,000 firms listed; Level 3 may enter bid/ask prices

Level 2 receive all bid/ask quotes Level 1 receives only highest bid and lowest ask prices Third market: OTC trading of exchange-listed securities Fourth market: direct trading in exchange-listed securities. Electronic Communications networks (ECNs) Types of orders: market order, limit order, stop order Role of specialist: maintain a fair and orderly market and provide price continuity to the market. Block sales: Super-Dot system Settlement: within three business days Full service vs. discount brokers Buying on the margin: initial margin and maintenance margin Short selling: Regulation of securities markets: Securities Act of 1933: new issues Securities Act of 1934 established the SEC Securities Investor Protection Act of 1970 Circuit breakers: trading halts and collars Insider trading

Chapter 4 Mutual Funds and Other Investment Companies Investment company: Financial intermediaries that invest the funds of individual investors in securities or other assets. They provide: 1- record keeping and administration 2- diversification and divisibility 3- professional management 4- lower transaction cost NAV = (market value of assets liabilities)/shares outstanding Types of Investment Companies Unit investment trust: typically an unmanaged portfolio of fixed-income securities that are almost never changed; have one of five year holding periods. Closed-end investment companies: has a fixed capitalization whose shares trade OTC. The shares may sell at premium to NAV or at a discount. Commingled funds: trusts or retirement accounts managed by a bank, or insurance company. Real estate investment trusts (REITs): invest in real estate and is similar to a closed end fund. Mutual funds: new shares are sold and outstanding shares are redeemedformed by an investment advisory firm that selects the board of trustees, who hire a separate management company. Shares are sold and redeemed at NAV. Types of mutual funds 1- Money market fundstaxable and tax-exempt funds. 2- Equity funds 3- Fixed income funds 4- Balanced and income funds 5- Asset allocation funds 6- Index funds 7- Specialized sector funds Use quuotes from WSJ

Costs of investing in mutual funds 1- front end load 2- back end load 3- operating expenses 4- 12b-1 expenses Mutual funds are not taxed but investors are taxed on dividends and gains. Mutual fund performance: Index funds outperformed 81% of managed funds in last decadeSalomon Broad Index outperformed 80% of managed bond funds. Information on mutual funds: use Morningstar. One should match investment objectives with fund types. Prospectus shows investment objectives; its current portfolio; management fees; turnover rate.

CHAPTER 5 Investors and the Investment Process

The basic framework for investing may be divided into four stages. 1- Investors and Objectives: Individual investors need to understand their objectives in terms of expected return and risk. Changes in age will affect risk/return objectives. Professional investors or do it yourself? Pension funds: defined contribution plans-employee bears the risk; defined benefit-risk is borne by the employer. Life insurance companies Endowment funds 2- Specify constraints: Five common constraints: Liquidity: how quickly can an asset be turned into cash Investment horizon: Regulations: prudent man Tax considerations Unique needs 3- Formulate policy: After the determination of investors objectives and constraints, then an investment policy can be formed. The first, and the biggest decision, is the asset allocation decision. Major asset categories: money market assets, fixed income securities, equities, non-US securities, real estate, precious metals and other commodities. Active vs. passive policies. Taxes: Tax shelter options must be considered. The tax deferral option from capital gains. Tax deferred retirement plans should be optimized. 4- Monitor and rebalance

CHAPTER 6 Risk and RETURNS: Past and Prologue

Purpose of this chapter is to present an analysis of risk and return early enough in the text for these concepts to be used throughout the text. Risk/return are key elements of investment decisionsin effect everything else revolves around these two factors. HPR = EP BP + Cash BP Difference between arithmetic average and geometric average Risk: Probability distribution: Possible outcomes with their probabilities. Variance: expected value of the squared deviation from the mean. Standard deviation: square root of the variance. Risk Premiums: Risk free rate: return of T-bill. Risk premium: return in excess of risk-free rate. Risk aversion: reluctance to accept risk. Investors will accept risk because they expect to earn a risk premium. They are speculating on the returns. Look at the historical record. It gives us our best estimate of what we can expect over a long period of time. Go over Ibbotson/Sinquefield studies. What do we learn from standard deviations and normal distributions that help investors understand risk? Inflation and real rates of return: Nominal interest rate indicates the growth rate of an investment while the real interest rate indicates the growth rate of the investors purchasing power. Fisher argued that the nominal rate should increase one for one with increases in the expected inflation. Asset allocation: The choice of the proportion of the total portfolio that will be in the two major assets: risky and
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risk-free. The most important decision an investor makes. This decision accounts for 94% of the differences in returns on institutionally managed funds. In investing, leave the proportion of each asset in the risky portfolio unchanged but change portfolio risk by changing the risky/risk-free asset mix. Risky asset: The weight of the risky portfolio in an investors portfolio. Risk-free asset: The weight of T-bills and/or money market securities in the portfolio. Capital allocation line: Fig. 6.8 Risk tolerance and asset allocation Passive strategies: A strategy built on the premise that securities are fairly priced and the investor should select a diversified portfolio that mirrors a broad group of securities. Such strategies are called indexing. Index funds: their record and why invest in them. Costs and benefits of passive investing:

Chapter 7 Efficient Diversification

Chapter focuses on the construction of the best possible risky portfolio. Two sources of risk: market risk, systematic risk, nondiversifiable risk and unique risk, firm-specific risk, nonsystematic risk, diversifiable risk. Asset allocation between risky assets: The key determination of portfolio risk is the extent to which returns on the two assets tend to vary with each other. The statistical term is the correlation between the returns of the assets in the portfolio. Correlations can range from 1 to + 1. Portfolio risk is reduced the most when the returns of two assets most reliably offset each other. Correlation coefficient = = covarianceij i x j Risk-Return trade-off with two risk assets portfolio Rate of Return: rp = wBrB + wSrS

Expected rate of return: E(rp) = wBE(rB) + wSE(rS) Var.: p2 = (wBB)2 + (wSS)2 + 2(wBB)(wsS)BS Discuss Fig. 7.3 The mean-variance criterion: The selection of those portfolios that are mean-variance efficient. Discuss Fig. 7.4 The optimal portfolio with a risk-free asset: Discuss Fig. 7.5 7.7. Efficient Diversification: 1- identify the most efficient risk-return combinations available, 2- determine the optimal portfolio, & 3- choose an appropriate mix between the optimal risky portfolio and the risk-free asset. Separation property: The portfolio choice can be separated into two independent tasks. First, is the determination of
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the optimal risky portfolio. The second task is the personal choice of the amount of the risky and risk-free asset to have in the portfolio. (This process is sometimes called the separation theorem.) Single-factor asset market A factor model is a statistical model used to measure the firm specific versus systematic risk of a stocks return. The single index model of security returns uses a market index, such as the S&P 500, to represent systematic risk. The excess return on a security may be stated as: Ri = i + M + ei The model specifies the two sources of risk: market or systematic risk attributable to the securitys sensitivity to market movements and firm specific risk. The above equation is a single-variable regression equation of Ri on the market excess return RM. The regression line is called the security characteristic line. The slope of this line is beta. The average security has a beta of 1, while aggressive securities will have a beta that is greater than one. A security can have a negative beta, which means that it provides a hedge against systematic risk. The beta of a portfolio is the simple average of the individual security betas. When risk This risk forming highly diversified portfolios, firm-specific becomes irrelevant. Only systematic risk remains. means that for diversified investors, the relevant measure for a security will be the securitys beta, .

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CHAPTER 8 Capital Asset Pricing and Arbitrage Pricing Theory

The capital asset pricing model, CAPM, provides a precise prediction of the relationship we should observe between risk of an asset and its expected return. The model provides a bench mark rate of return for evaluating possible investments and it helps us make an educated guess as to the expected return on assets that have not yet been traded in the marketplace. The exploitation of security mispricing to earn risk-free economic profits is called arbitrage. Demand for stock and equilibrium prices: market prices are determined by supply and demand. The capital asset pricing model: A model that relates the required rate of return for a security to its risk as measured by beta. Assumptions of the CAPM: p. 233 Implications of the CAPM: 1- All investors will choose to hold the market portfolio 2- The market portfolio will be on the efficient frontier. A passive strategy is efficient. The mutual fund theorem implies that only one mutual fund of risky assets is sufficient to satisfy investors demands. 3- The risk premium of the market portfolio is proportional to both the risk of the market and to the degree of risk aversion of the average investor. 4- The risk premium on individual assets will be proportional to the risk premium on the market portfolio and to the beta of the security on the market E(rp) = rf + p[E(rM) rf] The Security Market Line (SML): graphical representation of the expected return-beta relationship of the CAPM. It is valid booth for portfolios and individual assets. Applications of CAPM: 1- Use of the SML as a benchmark to assess the fair expected return on a risky asset. The difference between fair and actual expected rate on a stock is called the stocks alpha, . 2- May be used in capital budgeting to obtain the hurdle rate for a project.
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The CAPM and Index Models: The CAPM relies on a theoretical market portfolio, however, the use of an index model, utilizing the S&P 500, comes close to representing the market portfolio. ri rj = i + i(rM - rf) ei Estimating the index model: Regression of a securitys return on the returns of an index. Explain Table 8.5 and Fig. 8.6 CAPM and the Index model: Discuss Tables 8.7 8.9 And Figs.8.7 8.10 Predicting Betas: Betas are not consistent; there is a regression toward the mean. CAPM and the real world Arbitrage Pricing Theory (APT): skim pp. 252 260.

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Chapter 9 The Efficient Market Hypothesis

Efficient market: a market in which prices of securities fully reflect all known information quickly and, on average, accurately. Therefore, the current price of a stock reflects all known information. The EM concept does not require a perfect adjustment in prices resulting from information, only unbiased adjustment. Market can be expected to be efficient because: 1- large number of rational, profit maximizing investors 2- information is costless and widely available 3- information is generated in a random fashion 4- investors react quickly and fully to new information Random walk: The notion that stock price changes are random and unpredictable. If stock price changes are predictable then the market is inefficient. Forms of market efficiency: Weak form: prices reflect all price and volume data; past price changes should be unrelated to future price changes. Semistrong form: prices reflect all publicly available information; including earnings reports, dividend announcements, stock splits, product development, financing difficulties. Strong form: prices reflect all information, public and private. Implications of the EMH: technical analysis and the EMH are diametrically opposed. Implications for fundamental analysis: investor must be a superior analyst. Money managers could reduce the resources devoted to assessing individual securities. Task would become: 1- be certain that diversification is achieved. 2- Achieve the appropriate level of risk. 3- Remember the tax situation of the investor 4- Keep transaction costs to a minimum Are markets efficient? There are three factors that will keep us from determining the answer to this question. 1- The magnitude issue

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2- The selection bias issue 3- The lucky event issue Tests of the efficient market Weak form evidence: test statistically the independence of stock prices changes (serial correlation and signs tests). Little evidence exists that technical trading rules based solely on past price and volume data can outperform a simple buy and hold strategy. Filter rules: Predictors of broad market movements: Market anomalies: Semistrong form evidence: use of event studies. Abnormal return = ARit = Rit E(Rit) Cumulative abnormal return = CARi = ARit P/E effect Small firm in January effect Neglected firm effect and liquidity effects Book-to-market ratios Reversal effect Inside information Postearnings announcements Value Line enigma Market crash of October 1987. 20% in one day! Mutual fund performance: these people are professionals arent they? So, are markets efficient? The market is quite efficient but not totally efficient.

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Chapter 10 BOND PRICES and YIELDS

Chapter focuses on two aspects of critical importance to bond investors: prices and yields Basis point- 1/100 of one percentage point. Bond characteristics: A fixed income security that pays a specified cash flow over a specified period. Couponscoupon rate---par/face value---zero coupon bonds Treasury bonds: WSJ quotes. Asked yield and accrued interest Corporate bonds: WSJ quotes. Discuss call provisions, convertible bonds, puttable bonds, and floating rate bonds. Preferred stock: Tax characteristics Municipal bonds Government agencies International bonds: foreign bonds and Eurobonds Innovations: reverse floaters & indexed bonds Default risk: Ratings and rating agencies. Junk bonds Determinants of bond safety Bond indentures: Sinking funds Subordination clauses Dividend restrictions Collateral Bond pricing: the present value of the expected cash flows. (Go over the formula) The inverse relationship between prices and yields. Convexity Bond Yields: Yield to maturity = the promised compounded rate of return of a bond held to maturity. Yield to call = the promised return to the call date Default premium

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Zero coupon bonds: tax treatment Original issue discount bonds STRIPS Yield curve: term structure of interest rate Term structure of interest ratesthe relationship between time to maturity and yields for a particular category of bonds at a particular point in time. Yield curve: the relationship between yields and time for bonds that are identical except for maturity. WSJ CURVE Term structure theories: 1- expectations theorylong-term rate is equal to an average of the short-term rates that are expected over the long-term period. 2-Liquidity preference theoryinvestors receive a liquidity premium to induce them to lend long-term. 3-market segmentation theorymarket participants may operate only within certain maturity ranges. 4-preferred habitat theoryinvestors have preferred maturity sectors but are willing to shift to other maturities if they are adequately compensated.

Chapter 11 Managing Fixed Income Investments

Objectives: 1- To explain two important concepts that influence changes in interest rates, the term structure of interest rates and yield spreads. 2- To examine bond strategies and management, thereby emphasizing the analysis and management in a portfolio sense of one of the major financial assets. 3- To introduce the two key alternatives available to investors, passive management strategies and active management strategies. Why Buy Bonds? Conservative investor Speculative Interest rate risk. Interest rate risk is made up of two parts: price risk and reinvestment risk. Reinvestment rate risk 1-the longer the maturity of a bond, the greater the reinvestment risk
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2-the higher the coupon, the greater the dependence of the total $ return from the bond on reinvestment of the coupons Malkiels bond theorems: 1- Bond prices move inversely to interest rates. 2- A decrease in rates will raise bond prices more than a corresponding increase in rates will lower prices. 3- For a given change in market yields, changes in bond prices are directly related to time to maturity. 4- The % price change that occurs as a result of the direct relationship between a bonds maturity and its price volatility increase at a diminishing rate as the time to maturity increases. 5- Bond price fluctuations (volatility) and bond coupon rates are inversely related. Problem: interest rates affect returns both positively and negatively: price change and reinvestment rate change. Solution: Duration: weighted average time to recover all interest payments plus principal...measured in years. Present duration equation and how to calculate. Duration will always be less than the time to maturity for coupon bonds. Use of duration. 1- measure of the effective maturity. 2- used to immunize portfolios 3- measure of the interest rate sensitivity of a bond portfolio. P = -(D*y)P Duration is related to the key bond variables: 1- Duration expands with time to maturity but at a decreasing rate 2- YTM is inversely related to duration. 3- Coupon is inversely related to duration Duration lives of measures Duration duration tells us the difference between the effective alternate bonds; used in immunizations and of bond sensitivity to interest rate movements. is additive, which means that a bond portfolios is a weighted average of each individual bonds

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duration, i.e. bond portfolio are relatively easy to rebalance. Passive Bond Management Passive management strategiesinvestor does not actively seek out trading possibilities in attempting to outperform the market. Choose bonds that match their objectives, risk, and return profiles. 1- buy and hold. 2- Bond indexmatch an index Immunizationa hybrid strategy. Protect a bond portfolio against interest rate risk. Portfolio is immunized if the duration of the portfolio is equal to the investment horizon. Convexity: a term used to refer to the degree to which duration changes as YTM changes. Active Bond Management The bond variables of major importance in assessing the change in bond prices are coupon and maturity. Implications: 1- to obtain maximum price change for a given expected change in interest rates, purchase low-coupon long maturity bonds. 2- To protect against an expected change in interest rates, choose large coupon, short maturity bonds. Types of bond swaps: 1- Substitution swap: the exchange of one bond for a bond with similar attributes but more attractively priced. 2- Intermarket spread swap: switching from one segment of the bond market to another. 3- Rate anticipation swap: a switch made in response to forecasts of interest rate changes. 4- Pure yield pickup swap: moving to higher yield bond, usually with longer maturities. Spreads change over timewiden during recessions and narrow during times of economic prosperity. Interest rate swaps: derivative security.

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CHAPTER 12 Macroeconomic and Industry Analysis

Chapter presents a broad overview of macroeconomic and industry variables. Global economy: considerable variance in the economic performance of different countries. Effect of changing exchange rates. Domestic macroeconomy: P/E varies with changes in interest rates, risk, inflation, etc. Key economic statistics: GDP: indication of expanding or contracting economy Unemployment rate: Capacity utilization rate Inflation: Interest rates: Budget deficit: Sentiment: Interest rates: The level of interest rates is perhaps the most important macroeconomic factor to consider in ones investment analysis. Factors that determine the level of interest rates: 1- supply of funds from savers 2- demand for funds from business 3- governments net supply and/or demand for funds 4- expected inflation Demand and supply shocks: Demand shocks: reduction in taxes, increases in money supply, increases in government spending. Supply shocks: changes in price of imported oil, freezes, floods, droughts, changes in wage rates. Federal government policy: Fiscal policygovernment spending and tax actions Monetary policy: changes in money supply; open market operations; changes in discount rate. Business cycles: cyclical and defensive industries
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Economic indicators: where are we today? Industry analysis

Chapter 13 Equity Valuation

Balance sheet valuation methods: Book value Liquidation value Replacement costs Tobins q: ratio of market value to replacement costs Intrinsic value: the relationship between intrinsic value (PV analysis) of an asset and market value. Investors have different opinions about k and g. Dividend discount models: Same as from Bus 231. Discuss variable and their impact on stock price. P0 = D1/(k g) Small change in g &/or k can result in large price changes Dividend payout ratio: percentage of earnings paid out as dividends G = ROE x b Where: b = plowback ratio (fraction of earnings reinvested in firm) Life cycles and relationship to growth and earnings retention. Value Line P/E Approach The P/E approach is sometimes called the earnings multiplier approach. P/E is important and is reported every day in the WSJ. Basically an identity: Po = E1 x Po/E1 Determinants of the P/E ratio: P/E = D/E/(k-g) 1- dividend payout ratio 2- required rate of return 3- expected growth rate Following relationship should hold: 1- the higher the payout, the higher the PE 2- the higher the expected growth rate, the higher the PE 3- the higher the required rate of return, the lower the PE

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Pitfalls in P/E analysis 1- earnings based on accounting 2- P/Es change over the business cycle 3- The denominator of the ratio responds more sensitively to the business cylce than the numerator. Understanding the PE model can help investors understand the dividend discount model. Price/Book value sometimes used to value companies particularly financial services companies. Price/Cash Flow ratio: Price/Sales ratio:

Building portfolios: Asset allocation: refers to the allocation of portfolio assets, i.e., how much in stocks and bonds. Asset allocation is the investors most important decision. Passive strategy: Buy and Holdreducing transactions and research costs. Index funds: Active strategy: assumes that investors possess some advantage relative to other market participants, i.e., superior analytical or judgement skills, superior information, or ability to do what other investors are unable to do. Security selection: financial analyst role is to attempt to forecast stock returns through forecasting EPS. Uses management presentations, annual reports, industry data, etc.

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CHAPTER 16 OPTIONS MARKETS

Option is an equity derivative security: a security that derives its value by having a claim on the underlying common stock. (Go over a current quote from the WSJ) Call optionright to buy Put optionright to sell In the money Out of the money At the money Option Clearing Corporation: functions as an intermediary between the brokers representing the buyers and writers. OCC randomly selects, called assignment, and once assigned, the writer can not execute an offsetting transaction to eliminate the obligation. Index options Futures options Foreign currency options Interest rate options How options work: buyer and seller have opposite expectations about the likely performance of the underlying stock. 1- option may expire worthless 2- option may be exercised 3- option may be sold in secondary market Payoffs and profits from basic option positions (Go over payoff profiles from: 1-buying a call, 2-writing a call, 3- buying a put, and 4- writing a put.) Basic option strategies: Buying calls 1- bullish about the price of underlying stock. 2- Provides maximum leverage for speculative purposes. 3- Protect a short sale

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Buying puts 1- bearish on the underlying stock 2- maximize the leverage potential 4- Used to protect an investors profit Covered call Protective puts Portfolio insurance Straddle Spreads Collars Option like Securities Callable bonds Convertible securities Warrants

CHAPTER 18 FUTURES MARKETS

Objectives: 1- to explain the basics of futures markets in general, and 2- to explain financial futures in particular. Cash market: for immediate delivery, includes both the spot and forward markets. Futures markets serve a valuable economic purpose by allowing hedgers to shift price risk to speculators. Futures markets include commodities and financial futures. Regulated by Commodity Futures Trading Commission (CFTC) Function of Clearing House Zero-sum game Future contract: a standardized, transferrable agreement to buy or sell a designated amount of a commodity or asset at a specified future price and date. An obligation to take or make delivery. Mechanics of trading: Short: commit to deliver Long: commit to purchase Offset: typical method of settling a contract
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Daily price movements/limitations (Put quote from WSJ on board and explain terms) Margin: good faith deposit to ensure completion of the contract. Initial margin: each clearing house sets its own but brokerage firm can require a higher margin Market to market daily: maintenance margin, margin calls. Methods of delivery Hedgers: futures position is opposite to their position in the cash market. Short (sell) hedge: sell the futures Long (buy) hedge: purchase a futures position Basis = cash price futures price Basis must be zero on the maturity date of the contract Basis risk Speculators: buy or sell in an attempt to make a profit Floor traders (locals) speculate because: 1- leverage 2- ease of transactions 3- low transaction costs Determination of futures prices: spot-futures parity Financial futures: contracts on equity, fixed-income securities, and currencies. Interest rate futures (Go over quote) Hedging with interest rate futures: short hedge Speculating with interest rate futures Explain basis risks Stock index futures (Go over WSJ quote) Hedging with stock index futures Short hedges Long hedges Limitations of hedging with stock index futures Program trading Triple witching Use of currency futures: car dealer protects against fall in dollar.

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CHAPTER 19 PERFORMANCE EVALUATION & PORTFOLIO MANAGEMENT

Portfolio management as a process: 1- development of investment policies 2- strategies are developed and implemented 3- market conditions, relative asset mix, and the investors circumstances 4- portfolio adjustments Framework for evaluating portfolio performance: performance based on risk and return. Risk-adjusted measures of performance: Sharpe: Measures excess return per unit of total risk. Sharpe measure = [rp rf]/p 1- higher the result the better 2- portfolios can be ranked by the Sharpe measure Treynor: Measures excess return per unit of systematic risk. Treynor assumes that portfolios are well diversified. Treynor measure = [rp rf]/p Comparing the Sharpe and Treynor measures: choice depends upon the definition of risk. If the portfolios are fully diversified, the rankings will be identical. Differences in rankings between the two measures can result from substantial differences in diversification. Jensens measure: difference between what the portfolio actually earned and what it was expected to earn given its level of systematic risk. p = rp [rf + p[rM rf] If alpha is significantly positive, this is evidence of superior performance, and if alpha is negative, then evidence of inferior performance. Choosing the right risk measure Market timing: Example on pp. 623-624 Use of bogey benchmark

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Asset allocation: the % of funds to be placed in stocks, bonds, and cash. The key is to know when and how to rebalance asset allocation because trade-offs are involved. Objectives of active portfolio management:

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