Investments

MICHAEL G. MCMILLAN, CFA is Director, Ethics and Professional Standards in the Education Division of CFA Institute. Dr. McMillan joined CFA Institute in 2008 after more than a decade as a professor of accounting and finance at Johns Hopkins University's Carey Business School and The George Washington University's School of Business. He has a doctorate in accounting and finance from The George Washington University, an MBA from Stanford University, and a BA from the University of Pennsylvania. Dr. McMillan is a member of the CFA Society of Washington, DC and the East African Society of Investment Professionals. JERALD E. PINTO, CFA is Director, Curriculum Projects, in the Education Division of CFA Institute. Before coming to CFA Institute in 2002, he consulted to corporations, foundations, and partnerships in investment planning, portfolio analysis, and quantitative analysis. He has also worked in the investment and banking industries in New York City and taught finance at New York University's Stern School of Business. He holds an MBA from Baruch College, a PhD in finance from the Stern School, and earned his CFA charter in 1992. WENDY L. PIRIE, CFA is Director, Curriculum Projects, in the Education Division of CFA Institute. Prior to joining CFA Institute in 2008, she taught finance, accounting, statistics, taxation, business law, and marketing for over twenty years at both large and small, public and private universities, religious colleges, and military academies. Her work has been published in Journal of Financial Research and Journal of Economics and Finance. She holds a PhD from Queen's University in Kingston, Ontario and MBAs fromthe Universities of Toronto and Calgary. GERHARD VAN DE VENTER, CFA is Deputy Head of the School of Finance and Economics at University of Technology, Sydney. He was previously director, Curriculum Projects, in the Education Division of CFA Institute. He began his career in South Africa as a financial analyst and later as a dealer at the Bond Exchange, where he traded fixed income securities. He holds a PhD in finance from the University of Technology, Sydney. He is a member of CFA Institute and the New York Society of Security Analysts.

• Foreword xiiiAcknowledgments xvIntroduction xviiChapter 1 Market Organization and Structure 1Learning Outcomes 11. Introduction 12. The Functions of the Financial System 22.1. Helping People Achieve Their Purposes in Using the Financial System 32.2. Determining Rates of Return 82.3. Capital Allocation Efficiency 93. Assets and Contracts 103.1. Classifications of Assets and Markets 113.2. Securities 133.3. Currencies 163.4. Contracts 163.5. Commodities 223.6. Real Assets 224. Financial Intermediaries 244.1. Brokers, Exchanges, and Alternative Trading Systems 254.2. Dealers 264.3. Securitizers 274.4. Depository Institutions and Other Financial Corporations 294.5. Insurance Companies 304.6. Arbitrageurs 314.7. Settlement and Custodial Services 334.8. Summary 355. Positions 355.1. Short Positions 365.2. Levered Positions 386. Orders 416.1. Execution Instructions 426.2. Validity Instructions 456.3. Clearing Instructions 477. Primary Security Markets 477.1. Public Offerings 487.2. Private Placements and Other Primary Market Transactions 507.3. Importance of Secondary Markets to Primary Markets 518. Secondary Security Market and Contract Market Structures 518.1. Trading Sessions 518.2. Execution Mechanisms 528.3. Market Information Systems 569. Well-Functioning Financial Systems 5610. Market Regulation 5811. Summary 61Problems 63Chapter 2 Security Market Indices 73Learning Outcomes 731. Introduction 732. Index Definition and Calculations of Value and Returns 752.1. Calculation of Single-Period Returns 752.2. Calculation of Index Values over Multiple Time Periods 773. Index Construction and Management 783.1. Target Market and Security Selection 793.2. Index Weighting 793.3. Index Management: Rebalancing and Reconstitution 884. Uses of Market Indices 904.1. Gauges of Market Sentiment 904.2. Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk-Adjusted Performance 904.3. Proxies for Asset Classes in Asset Allocation Models 904.4. Benchmarks for Actively Managed Portfolios 914.5. Model Portfolios for Investment Products 915. Equity Indices 915.1. Broad Market Indices 915.2. Multimarket Indices 925.3. Sector Indices 925.4. Style Indices 936. Fixed-Income Indices 946.1. Construction 946.2. Types of Fixed-Income Indices 957. Indices for Alternative Investments 967.1. Commodity Indices 987.2. Real Estate Investment Trust Indices 987.3. Hedge Fund Indices 988. Summary 101Problems 102Chapter 3 Market Efficiency 109Learning Outcomes 1091. Introduction 1092. The Concept of Market Efficiency 1112.1. The Description of Efficient Markets 1112.2. Market Value versus Intrinsic Value 1132.3. Factors Contributing to and Impeding a Market’s Efficiency 1142.4. Transaction Costs and Information-Acquisition Costs 1173. Forms of Market Efficiency 1183.1. Weak Form 1193.2. Semistrong Form 1193.3. Strong Form 1223.4. Implications of the Efficient Market Hypothesis 1224. Market Pricing Anomalies 1244.1. Time-Series Anomalies 1254.2. Cross-Sectional Anomalies 1274.3. Other Anomalies 1284.4. Implications for Investment Strategies 1305. Behavioral Finance 1315.1. Loss Aversion 1315.2. Overconfidence 1325.3. Other Behavioral Biases 1325.4. Information Cascades 1335.5. Behavioral Finance and Efficient Markets 1336. Summary 134Problems 134Chapter 4 Portfolio Management: An Overview 139Learning Outcomes 1391. Introduction 1392. A Portfolio Perspective on Investing 1402.1. Portfolio Diversification: Avoiding Disaster 1402.2. Portfolios: Reduce Risk 1422.3. Portfolios: Composition Matters for the Risk–Return Tradeoff 1452.4. Portfolios: Not Necessarily Downside Protection 1452.5. Portfolios: The Emergence of Modern Portfolio Theory 1483. Investment Clients 1493.1. Individual Investors 1493.2. Institutional Investors 1504. Steps in the Portfolio Management Process 1564.1. Step One: The Planning Step 1564.2. Step Two: The Execution Step 1564.3. Step Three: The Feedback Step 1595. Pooled Investments 1605.1. Mutual Funds 1605.2. Types of Mutual Funds 1645.3. Other Investment Products 1676. Summary 172Problems 172Chapter 5 Portfolio Risk and Return: Part I 175Learning Outcomes 1751. Introduction 1752. Investment Characteristics of Assets 1762.1. Return 1762.2. Other Major Return Measures and Their Applications 1852.3. Variance and Covariance of Returns 1892.4. Historical Return and Risk 1922.5. Other Investment Characteristics 1973. Risk Aversion and Portfolio Selection 2003.1. The Concept of Risk Aversion 2013.2. Utility Theory and Indifference Curves 2023.3. Application of Utility Theory to Portfolio Selection 2064. Portfolio Risk 2094.1. Portfolio of Two Risky Assets 2104.2. Portfolio of Many Risky Assets 2154.3. The Power of Diversification 2165. Efficient Frontier and Investor’s Optimal Portfolio 2225.1. Investment Opportunity Set 2225.2. Minimum-Variance Portfolios 2235.3. A Risk-Free Asset and Many Risky Assets 2255.4. Optimal Investor Portfolio 2286. Summary 234Problems 234Chapter 6 Portfolio Risk and Return: Part II 243Learning Outcomes 2431. Introduction 2432. Capital Market Theory 2442.1. Portfolio of Risk-Free and Risky Assets 2442.2. The Capital Market Line 2483. Pricing of Risk and Computation of Expected Return 2563.1. Systematic Risk and Nonsystematic Risk 2573.2. Calculation and Interpretation of Beta 2594. The Capital Asset Pricing Model 2674.1. Assumptions of the CAPM 2674.2. The Security Market Line 2694.3. Applications of the CAPM 2725. Beyond the Capital Asset Pricing Model 2845.1. The CAPM 2845.2. Limitations of the CAPM 2845.3. Extensions to the CAPM 2865.4. The CAPM and Beyond 2876. Summary 287Problems 288Chapter 7 Basics of Portfolio Planning and Construction 295Learning Outcomes 2951. Introduction 2952. Portfolio Planning 2962.1. The Investment Policy Statement 2962.2. Major Components of an IPS 2972.3. Gathering Client Information 3093. Portfolio Construction 3123.1. Capital Market Expectations 3123.2. The Strategic Asset Allocation 3133.3. Steps toward an Actual Portfolio 3213.4. Additional Portfolio Organizing Principles 3254. Summary 326Problems 327Chapter 8 Overview of Equity Securities 331Learning Outcomes 3311. Introduction 3312. Equity Securities in Global Financial Markets 3323. Types and Characteristics of Equity Securities 3383.1. Common Shares 3393.2. Preference Shares 3434. Private versus Public Equity Securities 3455. Investing in Nondomestic Equity Securities 3475.1. Direct Investing 3485.2. Depository Receipts 3496. Risk and Return Characteristics of Equity Securities 3536.1. Return Characteristics of Equity Securities 3536.2. Risk of Equity Securities 3547. Equity Securities and Company Value 3567.1. Accounting Return on Equity 3567.2. The Cost of Equity and Investors’ Required Rates of Return 3618. Summary 362Problems 363Chapter 9 Introduction to Industry and Company Analysis 369Learning Outcomes 3691. Introduction 3702. Uses of Industry Analysis 3703. Approaches to Identifying Similar Companies 3713.1. Products and/or Services Supplied 3713.2. Business-Cycle Sensitivities 3723.3. Statistical Similarities 3744. Industry Classification Systems 3744.1. Commercial Industry Classification Systems 3744.2. Governmental Industry Classification Systems 3784.3. Strengths and Weaknesses of Current Systems 3804.4. Constructing a Peer Group 3805. Describing and Analyzing an Industry 3855.1. Principles of Strategic Analysis 3865.2. External Influences on Industry Growth, Profitability, and Risk 4056. Company Analysis 4126.1. Elements That Should Be Covered in a Company Analysis 4136.2. Spreadsheet Modeling 4167. Summary 417Problems 420Chapter 10 Equity Valuation: Concepts and Basic Tools 425Learning Outcomes 4251. Introduction 4262. Estimated Value and Market Price 4263. Major Categories of Equity Valuation Models 4284. Present Value Models: The Dividend Discount Model 4304.1. Preferred Stock Valuation 4344.2. The Gordon Growth Model 4364.3. Multistage Dividend Discount Models 4415. Multiplier Models 4455.1. Relationships among Price Multiples, Present Value Models, and Fundamentals 4455.2. The Method of Comparables 4495.3. Illustration of a Valuation Based on Price Multiples 4525.4. Enterprise Value 4546. Asset-Based Valuation 4577. Summary 461Problems 462Chapter 11 Equity Market Valuation 469Learning Outcomes 4691. Introduction 4692. Estimating a Justified P/E Ratio 4702.1. Neoclassical Approach to Growth Accounting 4702.2. The China Economic Experience 4722.3. Quantifying China’s Future Economic Growth 4742.4. Equity Market Valuation 4763. Top-Down and Bottom-Up Forecasting 4843.1. Portfolio Suitability of Each Forecasting Type 4853.2. Using Both Forecasting Types 4873.3. Top-Down and Bottom-Up Forecasting of Market Earnings per Share 4884. Relative Value Models 4914.1. Earnings-Based Models 4914.2. Asset-Based Models 5025. Summary 506Problems 508Chapter 12 Technical Analysis 515Learning Outcomes 5151. Introduction 5152. Technical Analysis: Definition and Scope 5162.1. Principles and Assumptions 5162.2. Technical and Fundamental Analysis 5183. Technical Analysis Tools 5203.1. Charts 5203.2. Trend 5303.3. Chart Patterns 5323.4. Technical Indicators 5443.5. Cycles 5624. Elliott Wave Theory 5635. Intermarket Analysis 5666. Summary 568Problems 570Glossary 575References 589About the Authors 595About the CFA Program 601Index 603