Chapter 1: Introduction

Investment: commitment of current resources in the expectation of deriving greater resources in

the future
Assets:
o Real: assets used to produce goods and services (ie land, equipment, building, knowledge)
[determines the wealth of an economy]
o Financial: claims on real assets or the income generated by them (ie stocks and bonds)
[represents claims on real assets]
Debt (fixed income or debt securities): pay a specified cash flow over a specific
period
Money market: short-term, highly marketable, and generally of very low risk
(US T-bills, bank certificates of deposit (CDs))
Capital market: long-term securities such as T-bonds, bonds issued by federal
agencies, state and local municipalities, and corporations; bonds risk ranges
from default (T securities) to relatively risky (high-yield or junk bonds)
Equity: an ownership share in a corporation
Equityholders are not promised any particular payment, but are paid
dividends which is dependent on the success of the firm
Derivatives: securities providing payoffs that depend on the values of other assets
(options and futures contracts)
Commodity and derivative markets allow firms to adjust their exposure to
various business risks
Financial markets:
o Informational role
o Consumption timing
o Allocation of risk
o Separation of ownership and management
Avoiding agency problems: conflicts of interest between managers and stockholders
Compensation plan
Board of directors can force out underperforming management teams
Outsiders monitor firms (security analysts and large institutional investors
such as pension funds)
Bad performers are subject to threats of takeover (shareholders changing
board of directors)
o Corporate governance and corporate ethics
Sarbanes-Oxley Act
Investment process
o Asset allocation: allocation of an investment portfolio across broad asset classes
o Security allocation: choice of specific securities within each asset class
Security analysis: analysis of the value of securities
o Strategies:
top-down: starts with the asset allocation decision the allocation of funds across
broad asset classes and then progress to more specific security-selection decisions
bottom-up: constructed from the securities that seem attractively price without as
much concern for the resultant asset allocation
The Market (no-free-lunch proposition)
o Risk-return trade-off: assets with higher expected returns entail greater risk
o Efficient markets: the security price usually reflects all the information available to investors
concerning the value of the security in a quick and efficient manner
Passive management: buying and holding a diversified portfolio without attempting
to identify mispriced securities
Active management: attempting to identify mispriced securities or to forecast broad
market trends
Players in the Financial Market
o Firms
Net demanders of capital
Raise capital now to pay for investments in plant and equipment

Income generated by those real assets provides the returns to investors who
purchase the securities issued by the firm
o Household
Typically, suppliers of capital
Purchase the securities issued by firms that need to raise funds
o Governments
Borrowers or lenders, depending on relationship between tax revenue and
government expenditures
Has to borrow if they need to cover budget deficits (issuance of T-bills, notes and
bonds)
o Financial intermediaries: institutions that connect borrowers and lenders by accepting
funds from lenders and loaning funds to borrowers
pooling the resources of many small investors, they are able to lend considerable
sums to large borrowers; by lending to many borrowers, intermediaries achieve
significant diversification, so they can accept loans that individually might be too
risky; intermediaries build expertise through the volume of business they do and can
use economies of scale and scope to assess and monitor risk
investment companies: firms managing funds for investors; may manage several
mutual funds
o Investment bankers: firms specializing in the sale of new securities to the public, typically
by underwriting the issue
Primary market: a market in which new issues of securities are offered to the public
Secondary market: previously issued securities are traded among investors
o Venture capital and private equity
Venture capital: money invested to finance a new firm
Private equity: investments in companies that are not traded on a stock exchange
Chapter 5: Risk and Return
Rates of return
o Holding-period return (HPR): rate of return over a given investment period

HPR=

ending pricebeginning price+ cash dividend

=dividend yield + capital gains yield
beginning price

Assumption: dividends paid at the end of the holding period

Dividend yield: the percentage return from dividends, cash dividends/beginning price
o Arithmetic average: the sum of returns in each period divided by the number of periods
o Geometric average: the single-per-period return that gives the same cumulative
performance as the sequence of actual returns
o Dollar-weighted average: the internal rate of return of an investment
APR and EAR
o Annual percentage rate (APR): annualizing per-period rates using a simple interest approach,
ignoring compounding interest

APR =per period rate periods per year

o

Effective annual rate (EAR): compounded

n

n
APR
EAR=( 1+rate per period ) 1= 1+
1
n

Conversion:

Type equation here .

Expected return: the mean value of the distribution of HPR

s

E ( r )= p ( s ) r ( s)
s=1

Scenario analysis [r(s)]: process of devising a list of possible economic scenarios and
specifying the likelihood of each one, as well as the HPR that will be realized in each case

Probability distribution [p(s)]: list of possible outcomes with associated probabilities

Kurtosis: measure of the fatness of the tails of a probability distribution relative to
that of a normal distribution. Indicates likelihood of extreme outcomes
Skew: measure of the asymmetry of a probability distribution
Variance:
o

Var ( r )= 2 =

Standard deviation:

SD ( r ) =

S=

Properties of investment management when returns are normally distributed:

o The return on a portfolio comprising two or more assets whose returns are normally
distributed also will be normally distributed
o The normal distribution is completely described by its mean and standard deviation. No
other statistic is needed to learn about the behavior of normally distributed returns
o The standard deviation is the appropriate measure of risk of a portfolio of assets with
normally distributed returns. In this case, no static can improve the risk assessment
conveyed by the standard deviation of a portfolio
Value at risk (VaR): measure of downside risk. The worst loss that will be suffered with a given
probability, often 5%
Risk premium and aversion
o Risk-free rate: the rate of return that can be earned with certainty
o Risk premium: an expected return in excess of that on risk-free securities
o Excess return: rate of return in excess of the risk-free rate
o Risk aversion: reluctance to accept risk
o Price of risk: the ratio of portfolio risk premium to variance
Sharpe (risk-to-volatility) ratio: ratio of portfolio risk premium to standard deviation

E ( r p ) r f
portfolio risk premium
=
standard deviation of portfolio excess return
p

Mean-variance analysis: ranking portfolio by their Sharpe ratios

Chapter 6: Diversification

Chapter 7: CAPM

Chapter 8: Efficient Market Hypothesis

Random walk: the notion that stock price changes are random and unpredictable
Efficient market hypothesis (EMH): the hypothesis that prices of securities fully reflect available
information about securities
o Weak-form EMH: the assertion that stock prices already reflect all information contained in
the history of past trading
Returns over short horizon: measuring serial correlation of stock market returns
Momentum effect: tendency of poorly performing stock and well-performing
stocks in on period to continue that abnormal performance in following
periods
Returns over long horizon
Reversal effect: tendency of poorly performing stocks and well-performing
stocks in one period to experience reversals in the following period
o Semistrong-form EMH: the assertion that stock prices already reflect all publicly available
information
o Strong-form EMH: the assertion that stock prices reflect all relevant information, including
inside information
o Implications:
Technical analysis: research on recurrent and predictable stock price patterns and on
proxies for buy or sell pressure in the market

Issues:
Magnitude
Selection bias
Lucky event
Portfolio management:
o Passive investment strategy: buying a well-diversified portfolio without attempting to search
out mispriced securities
Index fund: a mutual fund holding shares in proportion to their representation in a
market index such as the S&P 500
o

Resistance level: a price level above which it is supposedly unlikely for a stock
or stock index to rise
Support level: a price level below which it is supposedly unlikely for a stock or
stock index to fall
Fundamental analysis: research on determinants of stock value, such as earnings and
dividends prospects, expectations for future interest rates, and risk of the firm