Investments (Bodie, Kane & Marcus) deel 1

Inhoudsopgave
Chapter 1: Investment environment
Chapter 2: Asset Classes and Financial Instruments
Chapter 3 Trading Securities
Chapter 4: Mutual funds and other investment companies
Chapter 5 History of interest rates and risk premiums
Chapter 6 Risk and Risk Aversion
Chapter 7 Optimal risky portfolio
Chapter 8 Indeling
Chapter 9 CAPM
Chapter 10: Arbitrage pricing theory and multifactor models of risk and return
Chapter 11 The efficient market hypothesis
Chapter 12 behavioral finance and technical analysis
Chapter 13 Empircal evidence on security returns
Chapter 14 Bond Prices and Yields
Chapter 15 The term structure of interest rates
Chapter 16 Managing Bond portfolios
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 1: Investment environment

Real vs financial assets
The capacity to produce is defined by the real assets of the economy,
for example land, buildings, machines and knowledge. These real
assets ultimately determine the material wealth of a society. Financial
assets, in contrast to real assets, are the means by which individuals
can claim real assets, in other words, the claims on the income
generated by real assets. Financial assets therefore allocate income
or wealth among investors. As such, the financial assets of
households are the liabilities of the issuers of those assets or
securities. Ultimately, when aggregating the entire economy, these
claims will cancel out, leaving only the real assets. These real assets
are then the net national wealth, consisting of equipment, goods and
land. This book almost exclusively treats financial assets.
Financial assets
We can distinguish between three types of financial assets:
1. Fixed-income or debt securities entail either a fixed stream of
income or a stream of income determined by a formula. Therefore
they are not strongly tied to the financial condition or performance
of the issuer. These financial assets range from the money
market, short term and low risk, to the capital market, long term
and higher risk.
2. Equity, or common stock, represents a share of ownership in a
corporation. The owners of equity are therefore not promised
anything beforehand. The performance is directly tied to the
success of the firm and its real assets. Risk is therefore much
higher.
3. Derivative securities are determined by the performance and
prices of other assets. So, the value of options and futures are
based on the prices of stocks and bonds. Derivatives are now
widely used to hedge risk or to transfer risk to other parties. They
can be used to speculate, sometimes resulting in big losses.
Derivatives will however stay very important in the financial
system.
Financial markets
The ability for a firm to attract investor capital depends on the
financial markets. Financial markets therefore play a crucial role in
the allocation of resources. In the end, the financial markets decide
which companies can survive and which ones cannot. Stock prices
represent the collective judgment on the performance or perspectives
of a firm.
Financial markets also play a crucial role in the timing of consumption
by households. By storing wealth in financial assets, individuals can
postpone the expenditure of their wealth.
Moreover, capital markets give the possibility to choose a level of risk
appropriate to the level of risk aversion of the individual. The ones
willing to bear a lot of risk are enabled to do so through capital
markets. It also serves the companies that try to finance investments
by raising capital.
A possibly large number of owners of financial assets, acquired
through the capital markets, elect the management of the company.
This separation between ownership and management, they are two
different parties, results in a stable decision-making structure. Some
 Samenvatting: Investments (Bodie, Kane & Marcus)

agency problems might arise however. The agency issue is the fact
that the management of a company might not always act in the
interests of the investors. Such agency conflicts can be countered by
several instruments. First of all, often the compensation for
executives is tied to the performance of the firm, the value of the
stock. Also, the board of directors and external institutions can play
an important role in controlling the executives. Lastly, there is the
chance that bad performers will be taken over by others.
However, to make financial markets function, a certain quality of
corporate governance and corporate ethics is necessary. As such, an
acceptable level of transparency needs to be existent, to enable
investors to make well-informed decisions.
The process
The portfolio of an investor is simply his collections of financial
assets, such as stocks, bonds, real estate, commodities, etc. The
investment choice between such broad classes of assets is called the
asset allocation decision. The choice for particular securities within
these classes is called the security selection decision.
A top down approach starts with the asset allocation decision, while a
bottom up strategy approaches the issue the other way around.
Security analysis is the valuation of particular securities that might be
included in the portfolio.
Competition
Financial markets are highly competitive markets and therefore
investors should not expect easy wins. This high level of competition
results in the so called risk-return trade-off.
Because investors cannot predict future returns precisely, there is
always a risk involved in an investment. The assets with the highest
expected return also entail a high level of risk. If this would not be the
case, investors would collectively ask for these assets and thereby
drive up the price. The assets will be less attractive.
To manage the risk of their total investment, investors try to diversify
their portfolio. This means that the set of assets hold in a portfolio
together, limit the risk of one of the assets. Modern portfolio theory is
the knowledge gathered on this topic.
The efficient market hypothesis is the hypothesis that financial
markets are capable of processing all available information about a
security quickly and efficiently and that therefore the price of a
security accurately reflects the value of the security. Accordingly,
when any new piece of information comes available, the stock price
will adjust immediately.
Investors have the choice to passively or actively manage their
portfolio. Passive management means holding a highly diversified
portfolio without attempting to improve its performance in other ways.
Active management entails attempts to improve its performance in
multiple ways. If the efficient market hypothesis is fully true, active
portfolio management would only mean wasting resources on the
analysis of securities. In reality however, we observe an almost
efficient market, in which profit opportunities still exist.
Players
On a macro level there are three main players on the financial
markets:
1. firms need to raise capital to invest and are therefore net
borrowers.
2. Household are however net savers
 Samenvatting: Investments (Bodie, Kane & Marcus)

3. Governments can be both net savers and net borrowers.

Their position depends on the relation between the level of
government spending and the level of taxation. When the
government needs to cover a budget deficit, it is a net
borrower.
Financial intermediaries play a crucial role on the financial markets.
Financial intermediaries are financial institutions that stand between
the issuer and the ultimate owner of a security. Financial
intermediaries include banks, insurance companies, investment
companies or credit unions. They issue their own securities to be able
to purchase the securities of other corporations. Their primary
function is to channel savings of households to the business sector,
usually by pooling the resources together. Moreover, they can
substantially diversify risk and accumulate valuable expertise on
asset management. Economies of scale is an important reason for
the profitable existence of for example investment companies.
Investment bankers, that specialize in the assistance of firms when
they issue new stock, offer their services and expertise to many
corporations and lower the cost. For companies it is therefore much
more affordable to deal with such an investment banker than to have
an in-house security issuance division. Investment bankers in this
role are called underwriters. They give advise and moreover they
market the new securities in both the primary, first offer to the public,
and secondary market, intermediaries trading among themselves.
Financial crisis of 2008
Before the financial crisis of 2008, the worst one since the Great
Depression, the financial markets seemed to be in optima forma. The
apparent success of monetary policy over the last few decades was
called the Great Moderation. Low interest rates and a stable economy
leaded to an historic boom in the American housing market. Also,
since the 1970s a new system for financing housing had come into
place. Now securitization, the process of pooling claims on mortgages
and selling them as mortgage-backed securities, became most
prevalent. Credit agencies had highly underestimated the risks of this
securitization process and the trade in complicated derivative
products. This financial system was full of systemic risk, which means
that problems in one market would quickly spillover to other markets
and lead to a potential breakdown of the entire system. The crisis of
2008 brought the financial system close to a full systemic breakdown.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 2: Asset Classes and Financial Instruments

In this chapter we will discuss the variety of securities traded on
financial markets, making a distinction between those on the money
market and the ones on the capital market.
Money market
The money market consists of trading short-term debt securities.
Small investors can enter the market by buying mutual funds. We
present here the most important financial assets that are traded on
the money market, usually the ones that are highly marketable and
have low credit risk.
2. Treasury bills
Treasury bills are the most marketable and liquid product on
the money market. Issuing treasury bills (and treasury notes
and bonds) is one of the most important ways in which the
government raises capital. The public buys the bills from the
government at a certain discount price. At the maturity of the
bill (4, 13, 26 or 52 weeks) the investor will earn the face value
minus the purchase price.
3. Certificates of deposit (CD)
CDs are the most common bank deposit made by the
costumers of a bank. At the end of a chosen time interval, the
bank pays interest to the investor. The investor must hold the
deposit until maturity. He can cash it before by trading the
deposit to another investor.
4. Commercial papers (CP)
With this financial product large companies can make their
own short-term debt notes to raise capital, instead of
borrowing a large sum from banks. These assets are only
fairly safe, because often firms issue CPs intending to roll it
over at maturity. This means that they issue new CPs to pay
the old ones, which make the deal riskier.
5. Bankers’ acceptance
Accepting a “bankers’ acceptance” claimed by a bank
costumer, the bank takes the responsibility to pay the holder
of the contract on a future fixed date. In between, the contract
can be traded on secondary markets.
6. Eurodollars
Eurodollars are dollar-denominated deposits. These contracts
are made with foreign banks. It’s a way to avoid the Federal
Reserve regulation in the USA.
7. Repos and reverses
Repos are government securities sold by dealers to investors
on an overnight payback policy. For reverse repos, the dealer
buys government securities from investors, agreeing to sell
them back on a “future date/higher price” policy.
8. Federal funds
Banks have their own deposits at a Federal Reserve bank. It
is the way in which banks fix their reserves. The magnitude of
these reserves is regulated by Fed and it depends on the
bank’s costumers total deposits.
The bond market
The bond market involves long-term borrowing or long-term debt
products.
9. Treasury notes and bonds
 Samenvatting: Investments (Bodie, Kane & Marcus)

As said above, these belong to the main instruments for

government to borrow funds. They differ with respect to their
maturity (up to 10 years for the notes, 10-30 years for the
bonds). Both of them make semi-annual interest payments.
The ask price is the price the investor is willing to pay to the
dealer for the asset. The bid price is the lowest price you
receive when selling the asset to a dealer. The yield to
maturity is the annual rate of return if you hold the asset until
maturity.
10. Inflation-protected treasury bonds (TIPS)
TIPS provide constant income in real dollars, by adjusting
rates of return according to the Consumer Price Index.
11. Federal agency debt
Bonds issued by a government-backed agency. Those
agencies aim to give credit to certain sectors of the economy
that are believed to not receive sufficient credit from private
sources. This kind of debt is not ensured by the federal
government, but commonly government will help agencies
near default.
12. Municipal bonds
State and local governments can issue their own bonds. They
are used to finance particular projects, also private-purpose
ones. This bonds allow firms to take advantage of
municipality’s possibility to borrow at tax-exempt rates.

To compare between taxable and tax-exempt bonds, let be the

rate on municipal bonds. The after-tax rate on the taxable bond is
easy to compute: calling the federal plus local marginal tax
bracket and the total before-tax rate of return on the taxable
bond, the after-tax rate is . With small calculus, the investor
can compute, given , the interest rate of return the taxable bond
should have to be indifferent to the tax-exempt one, which is:

or, given , the tax bracket that equate the after-tax rate to the tax-
exempt one:
.
It is clear that the ratio between the two rates determines the
attractiveness of municipal bonds.
 Corporate bonds
These bonds allow private firms to borrow money from the public.
For investors corporate bonds are riskier than treasury
ones,because the default probability is higher, but they work in the
same way, paying semi-annual coupons and so on. The default
risk can be handled with secured bonds, which are backed also in
case of bankruptcy, and with subordinates debentures, also
backed but with lower priority. Unsecured bonds (debentures)
have none of these collaterals.
 Mortgages and mortgage-backed securities
Conventional mortgages are written on the long term, with a fixed
interest rate and equal fixed monthly payments. There are also
adjustable-rate mortgages, which split between banks and
costumers the risk of fluctuations in interest rates. Mortgage-
backed securities are a type of asset-backed securities that are
 Samenvatting: Investments (Bodie, Kane & Marcus)

secured by a mortgage, or a pool of them.

Equity securities
Common stock, or equity, represents shares of ownership in a
corporation. With these shares the owner can participate in the
decisionmaking process of the corporation, apropriate to the number
of shares the investor holds. Shareholders vote for the board of
directors (each year) and thesw directors select the managers who
run the corporation. This separation between ownership and control is
sometimes a problem, because stakeholders and managers can have
different aims.
Stocks are characterized by its residual claim. In case of a liquidation
of a firm, stockholders will only receive the assets that will be left after
all other crediters have claimed their parts (taxation, employees,
suppliers etc.). Moreover, management decides what to do with the
residual, to reinvest it or to pay dividends to stakeholders. Common
stock can have a limited liability feature, when stakeholders cannot
claim anything in case of failure of the corporation.

The “numbers” to consider are:

 The daily closing price of the stock and its change from the
previous trading day;
 The volume of stocks traded for that day;
 The highest and the lowest price for which the stock has been
traded during the last 52 weeks;
 The dividend payment per share, ignoring prospective capital
gains or losses driven by the future prices;
 The price-earning ratio (P/E), i.e. the ratio of the current stock
price to last year earnings per share. In other words, the P/E
ratio tells us how much needs to be spent on the stock to
receive one dollar of dividends.
Preferred stocks are similar to perpetual bonds, because they give a
fixed amount of income each year. Moreover, like a bond, they do not
give the possibility to vote the board of directors. Like for common
stocks, the firm decides to pay dividends or not. On the other hand,
the firm has a contractual obligation to make interest payments on the
debt. Finally, preferred stocks have a lower priority than bonds in
case of bankruptcy. This higher risk results in higher yields than in the
case of the less risky bonds.
Stock market indexes
Indexes measure the stock market performances. We discuss here
the most important ones.
1. Dow Jones Averages
This index is calculated by averaging the stock prices of
30, large, “blue chip” corporations, by storing that value for
each day. The percent change of the index from the day
before represents the rate at which a portfolio made of one
stock for each of the 30 corporations rises or falls. Such a
portfolio is then price-weighted, holding the same number
of stocks for each corporation, so the money invested in
each of those is proportional to their stock prices.
Nowadays this index is adjusted to the fact that
corporations can pay dividends, which can result in a
misrepresented stock price.
2. Standard & Poor’s indexes
This index involves 500 corporations, so it is better able to
 Samenvatting: Investments (Bodie, Kane & Marcus)

track the stocks market than the Dow Jones index.

Moreover, it is weighted based on the market-value. This
means that it takes the absolute value of a stock into
account and not only the changes over time. Therefore,
when computing the value of the index, a corporation that
sells shares at 100$ per share is ten times more important
than a stock selling for 10$ per share. In other words, the
index tracks the rate of return of an investor’s portfolio
using a number of stocks proportional to the market value
of each of the 500 corporations.
3. Equally weighted indexes
These indexes measure market performances by an
equally weighted average of the returns of each stock. It
corresponds to a portfolio investing equal dollar values in
each stock. This result in a portfolio that can change
quickly. A change in the value of a stock due to a price
movement will change the weight given to that corporation
in the index. So, such a portfolio is not a buy-and-hold one.
4. Bond market indicators
As for stocks, there are many indexes that try to track the
performances of the bond market. But often those indexes
are not reliable, because the true rate of return for bonds is
difficult to compute considering the timehorizon.
Derivative markets
A derivative is an asset whose value is derived from the values of
other assets. Trading in derivatives can get very complicated. Here
we only discuss options and futures contracts.
There are two kinds of options:
 Call option
This derivative gives to the holder the right (not the obligation)
to buy an asset at a given price (strike price) on (or before) a
given expiration date. Then, if before that day the market price
of the stock grows, the holder can profit by buying the stock
for the strike price and selling it at the market price. On the
contrary, if the price falls down, the holder will let the option
expire.
 Put option
This option is the opposite of a call option and it gives the
holder the right to sell an asset at a given price on (or before)
a given expiration date. Clearly, if the price falls down, the
owner will use the call option, while if the price grows up he
will let expire the option.
Futures contracts call for the delivery of an asset on a given future
date and for a predetermined price. The long position is the one of the
investor who will buy the asset, while the asset owner has the short
position. Futures may seem to be very similar to options, but there is
an important difference. A future contract obliges one part to buy and
the other to sell the asset. For example, if an investor has a long
futures position on an asset and the price goes down, he is obliged to
buy it anyway but he will be losing money. This is the reason why
futures contracts are costless and options are not (you pay a
premium price): options give you the possibility to hedge risks, while
futures do not give that possibility.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 3 Trading Securities

In this chapter we will see how securities are marketed to the public
for the first time and how they are traded between investors. We
focus also on the specific trading arenas and the specific way of
trading that each of them entails. We will see how these stockmarkets
compete between each other to attract investors.
How firms issue securities
The Primary market is the market where new issues of securities are
brought to the public.
Once they have been sold, they can be traded among investors in the
secondary market, so the total amount of securities does not change.
On the primary market we find Initial Public Offerings (IPOs), which
are stocks offered by a company that is entering the market for the
first time, and Seasoned equities, when a company who is already on
the market wants to augment the volume of its offered stocks.
Concerning bonds, there are two kind of issues: public offering and
private placement. Once bought you can trade the first kind of bonds
on the secondary market, while you must keep the second one until
maturity.
Investment banking
Investment bankers (here called underwriters) have the role to market
bonds and stocks of a firm on the primary market. First, these issues
have to be checked and registered by the Securities and Exchange
Commission (SEC), which means that a statement must be filled and
its final approved form is called prospectus. This process is not
costless. On average it costs 7% of the funds raised. After the
registration, the price offered to the public is announced: investment
bankers buy the issues and sell them to the public at a higher price.
They earn money from this price spread or from a given commission.
Sometimes they may also receive shares of the firm.
Private placements
If the firm does not want to enter the public market, it is possible to
sell securities in private placement offerings, which means to a small
group of investors. A clear consequence is that the volumes of traded
securities is much smaller. At the same time, this kind of placement is
cheaper than the public one, because SEC allows the firm to skip the
expensive registration/validation phase. These private placements
cannot be traded on the secondary market.
Initial public offerings
Once the prospectus is ready investment bankers travel around the
country to publicize the firms intentions. These road shows are the
way in which firms create interest for their offers. So, depending on
the magnitude of demand, they can adjust the selling price per share
of the IPO. This process of pooling potential investors’ information is
called bookbuilding.
This price and the total amount of shares offered, is often revised
responding to the feedback from the investing community. The higher
the potential demand is, the higher the price will be. As a
consequence potential investors can profit from a smaller price hiding
their intentions to buy. To avoid this, the firm is forced to reward in
some way the investors, hoping to obtain a truthful picture of the
situation. The main strategy is to offer them the securities at a bargain
price.
 Samenvatting: Investments (Bodie, Kane & Marcus)

In any case, despite such efforts, obtaining perfect information is

impossible and often IPOs are underpriced compared to the price at
which they could be marketed. The biased information will lead to an
outstanding performance of the new securities in the beginning and a
worse one on the long term.
It can be very difficult to find a buyer for the assets you want to sell, or
the other way around, without an organized information network. This
is why financial markets have come to existence.
Types of Markets
We can differentiate four types of markets, ordered by increasing
level of organization:
1. Direct search markets: The least organized type. Some
example are advertisementnewspapers or Craiglists. Through
such channels supply and demand can find each other
directly, without an intermediary.
2. Brokered markets: In these markets brokers are the
intermediaries who earn money by providing matchingservices
to buyers and sellers. An example is the primary market,
where investment banks play this role.
3. Dealer markets: These markets are more appropriate when
the trading activities increase in volume. Here dealers buy
securities for themselves, they create their own inventory, and
they sell them later. The spread between the bid and ask price
over time generates their profits. Holding such an inventory
can be risky though, and that is why these markets need to be
dynamic and large. Most bonds are traded in those markets.
4. Auction markets: This is the most integrated type. Buyers and
sellers come together in the same place. In this way they are
able to spend as little on searching activities as possible.
Obviously these markets require very intens and frequent
trading to maintain themselves. A famous auction market is
the NYSE (New York Stock Exchange).
Types of orders
Now we can differentiate between the different types of trades you
can find on these markets.
 Market orders: Orders that are to be executed immediately at
the current market prices. The broker provides the investor
with the best bid and ask prices. This may not be easy,
because bid and ask quotes are linked to specific bounds on
the number of securities traded. When the trades go beyond
those limits multiple prices for one order can arise. Moreover
the price may change before the order arrives, or another
trader may beat the initial quote, whose investor will then
receive a worse price.
 Price-contingent orders: The investor decides the maximum
price for which he wants to buy and the minimum for which he
would be willing to sell. These oreders are called limit orders.
Afterwards he sends the order to the broker, who follows the
given trading strategy. While waiting to be handled, these limit
orders float on the limit order book, which basically is a table
storing the price, the size and the date of the order.
Bids are sorted from the more expensive to the less expensive
ones, vice versa for Asks. The highest buying price and the
lowest selling price on the table are called inside quotes. Stop
orders instruct the broker to a certain trade only if the stock
 Samenvatting: Investments (Bodie, Kane & Marcus)

hits specified price limits. Here we distinguish stop-loss

orders, an order to sell if the price goes below a stipulated
threshold, from stop-buy orders, stop to buy if the price rises
above a stipulated threshold. These orders are clearly meant
to limit potential losses.

Trading mechanisms
In each type of trading system different trading operations are
allowed.
1. Dealer markets: in this OTC (over the counter) market
thousands of brokers are registered through SEC as security
dealers. Dealers can then quote their bid/ask prices. Let us
take NASDAQ (National Association of Securities Dealers
Automatic Quotation System) as an example. NASDAQ
represents the computer network system through which
brokers can scan bid/ask prices and choose the dealer.
Nowadays the majority of trades are executed electronically.
2. Electronic communication networks (ECNs): these networks
provides a limit-order book where investors can place limit
orders. Trading in such a network is not costless, but it is
cheaper than paying the bid/ask price spread and the absence
of dealers increases the speed of trading.
3. Specialist markets: in these markets brokers can trade only
through specialists, who represent firms. They act as brokers
who take care of executing tradings with other brokers for
specific firms’ issues. They can also buy/sell for their own
inventory, as a proper dealer. As a consequence, specialists
earn their income through firms commissions on managing
orders and the bid/ask price spread. Basically, a specialist is a
facilitator.
The New York Stock Exchange
The New York Stock Exchange is the largest stock exchange in the
United States. Here investors send orders to brokerage firms, that
have the task of managing the investor’s or firm’s communication.
Small orders are traded automatically while bigger ones, if negotiation
is needed, are sent to a floor broker, who contacts the relative
specialist.
Block shares
Larger block transations (10000+ shares) are no longer managed by
specialists. In this case we have Block houses to handle the problem
of matching offer and demand. If, for example, a buyer cannot be
found, a block house may purchases part of the sale for its own
account, trading them later to public.
Electronic trading on the NYSE
Today, due to computer lines, brokerage firms can send orders
directly to the specialist. The electronic system managing this for the
NYSE is called SuperDot. NYSE has also implemented a fully
automated trade-execution system, called Direct+. This system can
match orders and bid/ask prices in fractions of seconds. The majority
of NYSE trades are now executed in this way.
Electronic communication networks
The large majority of all trades executed belongs to such electronic
markets (as NASDAQ, ArcaEx, and others). These networks link
buyers and sellers directly and are completely electronic. These
features speed up trading execution time so substantially that is
 Samenvatting: Investments (Bodie, Kane & Marcus)

possible to execute trades in 0.0025 seconds or less. This is subject

to concern among market regulators, because with such a speed a lot
of foggy operations are allowed.
Bond trading
When marketing bonds dealers can set up big inventories, because
unlike stocks, those markets are “thin”. This means that it is harder to
match demand and supply and therefore the dealer runs more risk.
This slow speed of transactions results in liquidity risk.
Trading costs
We can make a distinction between the explicit and the implicit costs
of trading.
 Explicit costs: the main example is the commission the broker
asks. This commission can vary a lot, because investors have the
possibility to trade with different kinds of brokers:
1. Full service brokers: these brokers can help
investors in making decisions, because they
have a research staff that studies the market
and tries to forecast its future behavior.
Sometimes clients have so much confidence in
their broker that they allow him to make
decisions on their behalf. The broker gets a
discretionary account to make the operations.
The risk for the client is that the broker mainly
trades to generate a higher commission for
himself.
2. Discount brokers: these brokers provide no
more than basic services, which means buying
and selling securities, scanning the market
quotes, offering margin loans etc.
 Implicit costs: these costs are for example the spread between
the bidprice and the askprice of the dealer, or the price concession an
investor may be forced to make for trading quantities greater than the
quotes.
Buying on margin
An investor is buying on margin if he borrows a part of the capital he
wants to invest in an asset from his broker. This source of debt
financing is called broker’s call loans.
The steps are the followings: the investor borrows part of the
purchase price from a broker; the broker borrows money from banks
at a certain interest rate to finance the purchase; he then charges his
client the bank’s cost and to one for his trading service. The margin is
then the portion of the investment contributed by the investor.

The Board of Governors of Federal Reserve System bounded the

minimum margin to be above 50%.
With a bit of calculus it is easy to understand that buying on margin
uses the leverage effect to spread out performances of the
investment. The investor can earn a bigger rate of interest in case of
the best scenario (compared with a normal investment) and lose a lot
more in case of the worst one. The broker, on the other hand, must
be guaranteed in case of big losses: sometimes the margin of a bad
investment can become negative, which means that the investor
cannot pay his debt to the broker by selling the asset. To get it back,
the broker sets a maintenance margin. When the margin falls below
this threshold the broker will issue a margin call, asking the investor
 Samenvatting: Investments (Bodie, Kane & Marcus)

to put more cash/equities on the table to increase the margin.

If the investor does not act, the broker sells the stocks until the
margin is above the maintenance level.
Short sales
An investor is short selling if he sells stocks he do not possess: he
borrows stocks from a broker, and sells these shares. Later he must
purchase the stock to give it back to the broker (the investor is
covering the short position). Clearly, short selling is profitable if the
price of the stocks sold goes down (you sell at a certain price and buy
at a lower one).
Also in this case margin calls exist, when the price increases too
much. If the margin falls below the maintenance level, the short seller
will receive a margin call. The investor can also set up a stop buying
order to limit his losses: he chooses the maximum buying price he
wants to pay if the price rises. In other words he fixes the maximum
loss he I willing to take
Regulation of securities markets
The major laws that regulate trading in securities are the following:
1. 1933: the security act imposes firms to clearly highlight their
financial prospect before entering the market (i.e., to make the
prospectus mentioned above)
2. 1934: the security exchange act empowers SEC to register
and regulate tradings, brokers, dealers, etc.
3. The CFTC (Commodity futures trading commission) regulates
trading in futures market
4. The Federal reserve sets margin requirements on stocks and
stock options, and regulate bank lending to security market
actors
5. 1970: the SIPC (Securities Investor Protection Corporation) is
established to protect investors if their brokerage firms fail.
6. Securities trading is also subject to state laws.
Inside trading
Inside trading is prohibited by law and regulation. Inside trading is
making profits from non-public information. Generally, using
some private information is legal, for example a supplier can
forecast the situation of the client. But it is not clear where to
draw the line between legal and illegal private information.
Therefore inside trading is difficult to trace.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 4: Mutual funds and other

investment companies
Investment companies
Investment companies collect funds from investors, pool them and
reinvest these funds in a potentially wide range of other assets.
These companies function as financial intermediaries. They perform
several important functions:
- Record keeping and administration
- Diversification and divisibility
- Professional management
- Lower transaction costs
Investors buy shares in such an investment company and the value of
each share is called the net asset value (NAV):

There are various kinds of investment companies.

Unit investment trusts invest their funds in a portfolio that is fixed for
the lifetime of the fund. The shares sold are called redeemable trust
certificates. There is little management involved since the portfolio
composition is fixed.
Managed investment companies are able to manage the portfolios
they have. There is a difference between open-end funds and closed-
end funds. The former enables investors to sell their shares back to
the fund. The latter does not and obliges the investor who wants to
sell his shares on the market. Consequently there exists a market for
such shares, often traded by brokers. The price often diverges widely
from the net asset value, but this remains a great puzzle.
Other investment organizations are for example commingled funds,
similar to open-end mutual funds, or Real Estate Investment Trusts
(REITs), similar to a closed-end fund with loans secured by real
estate. Of the latter (REITs) there exist two kinds: equity trusts and
mortgage trusts. Hedge funds are vehicles that allow private investors
to pool assets. They are constructed as private partnerships and
therefore are subject to minimal regulation. They often request lock-
ups that allow them to invest in illiquid assets without worrying about
the demands for redemption of funds.
Mutual funds
Mutual funds are the common name for open-end investment
companies. Each mutual fund has its own investment policy,
described in the prospectus. Management companies manage a
family, or complex, of mutual funds. The following groups exist:
4. Money market funds
5. Equity funds
6. Sector funds
7. Bond funds
8. International funds (global, regional or emerging market for
example)
9. Balanced funds (covering an individual’s entire investment
 Samenvatting: Investments (Bodie, Kane & Marcus)

portfolio
10. Asset allocation and flexible funds (holding both stocks and
bonds)
11. Index funds (trying to match the performance of a market index.
Mutual funds are either directly sold either through brokers acting on
behalf of. It is important to realize that brokers have a conflict of
interest due to revenue sharing. This might lead them to recommend
mutual funds on the basis of criteria other than the best interest of
their clients.
Costs of mutual funds
Investors in mutual funds often have to bear several costs, such as
management fees. Operating expenses include administrative
expenses, advisory fees, but also marketing and distribution costs. A
front-end load is charged when shares are purchased by the investor.
Back-end loads are similar but charged when the investor wants to
sell the shares. Another category of costs is 12b-1 charges, used to
pay for distribution costs.
East investor must choose the best combination of fees.
Knowledgeable investors might not need these services, but many
investors are willing to pay for advice.
The rate of return on an investment in a mutual fund is the following:
Rate of return = (NAV1 - NAV0 + Income and capital gain
distributions) / NAV0
Fees can have a big effect on performance, but it is often difficult to
measure the true expenses accurately. This is due to the use of so-
called soft dollars, being a kind of credit with a brokerage firm on the
basis of which the broker can pay for other expenses.
Late trading refers to the practice of accepting to trade in orders after
the market closes and the NAV is determined. This enables investors
to buy them and redeem them the next day.
In the US only the investor is asked to pay taxes, not the fund itself.
When you invest through a fund, you however lose the ability to
engage in tax management. A fund with a high portfolio turnover rate
can be particularly tax inefficient. The turnover is the ratio of the
trading activity of a portfolio to the assets of the portfolio.
Exchange traded funds
These ETFs are offshoots of mutual funds that allow investors to
trade index portfolios just as they do with shares of stock. These
ETFs offer various advantages over normal mutual funds. Firstly the
price of an ETFs is continuously known, instead of published once a
day. Secondly they can be sold short or purchased on margin. They
can moreover provide tax advantages over mutual funds. ETFs are
also cheaper than mutual funds.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Performance
Because investors delegate portfolio management to investment
professionals, they can only choose the percentages of the portfolio
that should be invested in equity, bonds or other assets. A good
performance measure for mutual funds is needed. But what should be
the proper benchmark against which the investment performance
ought to be evaluated.
Many studies are done to find out if superior performance in a
particular year is due to luck, and therefore random, or due to skill,
and therefore consistent. Empirical data show that at least part of a
fund’s performance is determined by skill.
Information on mutual funds is first and foremost to be found in its
prospectus. The Statement of Additional Information of the
prospectus includes a list of the securities in the portfolio at the end of
the fiscal year, audited financial statements, a list of the directors etc.
The SAI is however not often used. Other comparative sources are
the Wiesenberger Investment Companies, and Morningstar’s Mutual
Fund Sourcebook.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 5 History of interest rates and risk

premiums

In this chapter we will discuss the historical performance of the major

asset classes. We will use a risk free asset as a benchmark to
evaluate that performance. The risk free asset is the Treasury Bill or
T-Bill because it is regarded as the safest asset, the main reason for
this is that the US government issues these bills and maintains its
credit worthiness via the tax payers money. We will start with a review
of the determinants of the risk free rate, the rate available on T-bills
and we will focus on the important distinction between real and
nominal returns. Second we will discuss the measurement of the
expected returns and volatility of risky assets, and show how
historical data can be used to construct such estimates. The purpose
of this is that we will construct on optimal investment portfolio and in
order to construct it we need some idea how risk can be measured.
Finally we will review the historical record of several portfolios of
interest to provide some insight how different portfolios have
performed over time.

Determinants of the level of interest rates

Forecasting interest rates is very difficult, But we do however have a
good understanding of the fundamental determinants of the level of
interest rates:

1. The supply of finds from savers, primary households

2. The demand for funds from businesses to be used to finance
investments in plant, equipment and inventories.
3. The government’s net supply of or demand for funds as
modified by actions of the Federal Reserve Bank.

Real versus Nominal risk

Now we will focus on the important distinction between real and
nominal returns. The real rate of interest is the nominal rate of interest
minus the expected rate of inflation. In general, we can observe only
the nominal interest rates. From these nominal interest rates we can
derive expected real rates using inflation forecasts. The equilibrium
expected rate of return on any security is the sum of the equilibrium
real rate of interest, the expected rate of inflation and a security-
specific risk premium.

Real versus nominal interest rates an example:

General
Fisher effect: Approximation
nominal rate = real rate + inflation premium
R = r + i or r = R – i

Example
 Samenvatting: Investments (Bodie, Kane & Marcus)

r = 3%, i = 6%
R = 9% = 3% + 6% or 3% = 9% - 6%

Fisher effect: Exact

r = (R - i) / (1 + i)
2.83% = (9%-6%) / (1.06)

The empirical relationship is that inflation and interest rates move

closely together.

The holding period return:

- +
HPR = P1 P 0 D1
P0

HPR = Holding Period Return

P0 = Beginning price
P1 = Ending price
D1 = Dividend during period

This holding period return is always uncertain. The expected rate of

return is a probability weighted average of the rates of return in each
scenario. P(s) is the probability of each scenario, and r(s) is the HPR
in each scenario:

To quantify the volatility of this HPR, the risk, the standard deviation
(square root of the variance) is used as a measure:

An investment decision first of all depends on the expected reward,

which is the difference between the expected HPR (E(r)) and the risk
free rate, which is the rate of return on a risk free asset, such as
Treasury bills. This difference is called the risk premium.

Excess return is the actual difference between the risk free rate of
return and the actual rate of return of a risky asset. The risk premium
is therefore the expected value of the excess return.

Investors are said to be risk averse, which means that they always
want to be compensated by a premium for taking risk.

A single period example:

Ending Price = 48
Beginning Price = 40
Dividend = 2
 Samenvatting: Investments (Bodie, Kane & Marcus)

HPR = (48 - 40 + 2 )/ (40) = 25%

Time series
The probability distributions of these rates of return must be inferred
from the data at hand, historical data. The average rate of return can
be calculated in two ways:
1. The Arithmetic average of rates of return, giving an unbiased
estimate of the expected rate of return:

2. The geometric average (g) is a time-weighted average return:

An estimate of the variance is usually based on the estimate of the

expected return, the arithmetic average ( ). Using historical data the
estimated variance looks like this:

This estimate needs to be compensated for the degrees of freedom

bias, which is the result of the estimation error resulting from using .
It is resolved by multiplying it with n/(n-1):

which is the standard deviation.

The trade off between reward and risk is important and represented
by the sharpe ratio:

Assuming that expectations are rational, the actual rates of return

should be normally distributed around the expectations. Because the
normal distribution is symmetric, stable and binary, this assumption is
very practical in investment and portfolio management.

Deviations from normality are so common, that we cannot leave it

undiscussed. Skew is a measure of symmetry:

(cubing these deviations ensures that the sign is maintained.

Kurtosis is a measure of fat tails:

Historical returns on stock have more frequent large negative

deviations from the mean than would be predicted from a normal
distribution.
 Samenvatting: Investments (Bodie, Kane & Marcus)

The lower partial standard deviation (LPSD) of the actual distribution

quantify the deviation from normality. The LPSD, instead of the
standard deviation, is sometimes used by professionals as a
measurement of risk. A more widely used measurement of risk is
value at risk (VaR). VaR measures the loss that will be exceeded with
a specified probability such as 5%. The VaR does not add new
information when returns are normally distributed. When negative
deviations from the average are larger and more frequent than the
normal distribution, the 5% VaR will be more than 1.65 standard
deviations below the average return.

A global view of the historical record

Historical rates of return over the twentieth century in developed
capital markets suggest the US history of stock returns is not an
outlier compared to other countries. The arithmetic average of the risk
premiums on stocks over the period 1926-2002 is arguably too
optimistic as a forecast for the long term as we can see on page 155
of BKM figures 5.8 and 5.9. Some evidence suggests returns over the
later half of the twentieth century were unexpected high, and hence
the full-century average is upward biased. Another argument is that
the arithmetic average returns may five upward biased estimates of
long-term cumulative return. Long-term forecasts require
compounding at an average of the geometric and arithmetic historical
means, which reduces the forecast.

Long term investments

A compounding portfolio with a terminal value has a strong positive

skew. It converges to a lognormal rather than a normal distribution. In
a lognormal distribution the logarithms of a variable are normally
distributed. For example, if an investment has low rates of returnmm
the expected rate of return of the continuously compounded
investment is close to the normal rate: . This
changes however if it concerns longer periods or hinger r’s.

Chapter 6 Risk and Risk Aversion

In this chapter we will discuss three themes in portfolio theory, all of
them centering around risk. The first theme is that investors avoid risk
and demand a reward for engaging in a risky investment. The reward
is taken as a risk premium, the difference between the expected rate
of return and that rate of return on a risk free investment. The second
theme allows us to quantify investor’s personal trade-offs between
portfolio risk and expected return. To do this we introduce the utility
function which assumes that investors can assign a welfare/benefit or
“utility” score to any investment portfolio depending on its risk and
 Samenvatting: Investments (Bodie, Kane & Marcus)

return. Finally, the third theme is that we cannot evaluate the risk of
an asset separate from the portfolio of which it is a part; that is the
proper way to measure the risk of an individual asset is to assess its
impact on the volatility of the entire portfolio of investments. Taking
this approach, we find that seemingly risky securities may be portfolio
stabilizers and actually low risk assets. In appendix A of this chapter
we will describe the theory and practice of measuring portfolio risk by
variance or standard deviations of returns. In Appendix B we will
discuss the classical theory of risk aversion.

Risk and Risk aversion

One definition of speculation is: the assumption of considerable

business risk obtaining commensurate gain. With commensurate gain
we mean a positive risk premium, that is, an expected profit greater
than the risk-free alternative.
By considerable risk we mean that risk is sufficient to affect the
decision. Gambling is to bet with an uncertain outcome. If you
compare this definition to that of speculation, you will see that the
central difference is the lack of commensurate gain. Economically
speaking, a gamble is the assumption of risk for no purpose but
enjoyment of risk itself, whereas speculation is undertaken in spite of
risk involved because one perceives a favourable risk return trade off.
Hence, risk aversion and speculation are not necessarily inconsistent.

A prospect that has a zero risk premium is called a fair game.

Investors who are risk averse reject investment portfolios that are fair
games or worse. Risk averse investors are willing to consider only
risk free or speculative prospects with a positive risk premium. In a
certain way risk-averse investors penalizes the expected rate of
return of a risky portfolio to account for the risk involved. We can
formalize the notion of a risk penalty system. In order to do so, we will
assume that each investor can assign a welfare or utility, score to
competing investment portfolios based on the expected return and
risk of those portfolios.

We can formulate this concept into a formula:

Utility Function

A is the insexof the investor’s risk aversion

Investors can have three different views of risk:

 risk averse: investor will consider risky portfolios only if they

provide compensation for risk via a risk premium.
 risk neutral: investor finds the level of risk irrelevant and
considers only the expected return of risk prospects.
 risk seeking: is willing to accept lower expected returns on
 Samenvatting: Investments (Bodie, Kane & Marcus)

prospects with higher amounts of risk.

The utility function weighs the return and the risk, taking the risk
aversion of the investor into account. Based on comparing the utility
values of different scenarios an investor can make a profound
decision. Simply said, portfolio A dominated B if its expected return is
higher and if the risk is lower. Using this utility function, indifference
curves can be drawn, comparing all possible portfolios.

Because we can compare utility values to the rate offered on risk-free

investments when choosing between a risky portfolio and a safe one,
we may interpret a portfolio’s utility value as its “certainty equivalent
”rate of return to an investor. That is, the certainty equivalent rate of a
portfolio is the rate that risk-free investments would need to offer with
certainty to be considered equally attractive as the risky portfolio.

Figure 6.1. on page 193 describes the trade-off between risk and
return of a potential investment portfolio. We can see expected return
E(r) on the y-axis and risk represented as variance on the x-axis). We
say that this is the mean variance criterion. When we plot different
mean variance combinations we can draw a line which results into the
indifference curve as graphed in figure 6.2. on page 173.

Capital allocation across risky and risk-free portfolios

Shifting funds from the risky portfolio to the risk-free asset is the
simplest way to reduce risk. Other methods involve diversification of
the risky portfolio and hedging. In allocating capital across risky and
risk free portfolios we consider T-bills the risk free asset and stocks
as the risky asset. Issues we need to examine are risk versus return
trade-off. We will demonstrate how different degrees of risk aversion
affect allocation between risk free and risky assets.

The risk free asset

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 other assets such as long-term
bonds and common stocks, so for the purpose of our analysis we
consider T-bills as the risk-free asset. Money market funds hold, in
addition to T-bills, relatively safe obligations such as CP and CDs.
These entail some default risk, but again, the additional risk is small
relative to most other risky assets. For convenience, we often refer to
money market funds as risk-free assets.

Portfolio’s
So investors compose complete portfolios containing both risky
investments and low-risk, even risk-free, assets. Only the government
can issue default-free bonds. Although such treasury bills are in fact
not entirely risk-free, it is common sense to use the rates of return of
treasury bills as the risk-free rate.
 Samenvatting: Investments (Bodie, Kane & Marcus)

The rate of return of a complete portfolio is calculated as follows:

You can take expectations of this portfolio rate of return.

It can be rearranged to:

Concerning the volatility, only the standard deviation of the risky asset
is relevant, and its weight:

Using that y is the division of both standard deviations, the

relationship between the expected rate of return of the complete
portfolio and the risk is as follows:

S is the slope of the capital asset allocation line (CAL). (see page
200, figure 6.4) This line represents all the risk-return combinations
available to the investor. The slope (S) is called the reward-to-
volatility ratio. Other things equal, an investor would prefer a
steeper-sloping CAL, because that means higher expected return for
any level of risk. If the borrowing rate is greater than the lending rate,
the CAL will be "kinked" at the point of the risky asset.

Risk tolerance and asset allocation

The investor's degree of risk aversion is characterized by the slope of
his or her indifference curve. Indifference curves show, at any level of
expected return and risk, the required risk premium for taking on one
additional percentage of standard deviation. More risk-averse
investors have steeper indifference curves; that is, they require a
greater risk premium for taking on more risk.
The optimal position, y*, in the risky asset, is proportional to the risk
premium and inversely proportional to the variance and degree of risk
aversion:

In other words, when we look at the optimal position of the risky asset
shown as y* we can see that this is also strongly depended on A or in
other words the level of risk averseness of the investor. Recall that A
= 0 means a risk neutral investor and A > 0 are risk averse investors.
The next step is to look for the optimal portfolio for a given level of
risk aversion. To fully understand the level of risk aversion we need to
construct a indifference curve to graphically plot the indifference
curve for the level of risk aversion. An example of how an indifference
curve can be plotted can be seen on page 208 in table 7.2. and figure
7.5, where we can see several indifference curves for a given several
given levels of risk aversion. The next step is to find the optimal
complete portfolio by using indifference curves. This can be
graphically seen in figure 7.6 on page 209 where the tangent line of
the indifference curve and the CAL depicts the optimal complete
 Samenvatting: Investments (Bodie, Kane & Marcus)

portfolio, this is also shown in table 7.3.

Passive strategies: the capital market line

A passive investment strategy disregards security analysis, targeting
instead the risk-free asset and a broad portfolio of risky assets such
as the S&P 500 stock portfolio. We call it a passive strategy because
it describes a portfolio decision that avoids any direct or indirect
security This can also be conceptually be drawn, this line is
comprised by a 1-month T-bills and a broad index of common stocks
and is called the capital market line (CML). There are several reasons
why an investor would choose a passive strategy. The first reason is
that an active strategy is not free, in involves for example research
costs, analysing the different securities and buying or selling these
securities, transaction costs. The second reason is the free-rider
benefit. If markets work perfectly there is no need to try to outperform
the market, better to hold a well diversified portfolio that represents
the market, in other words if you can beat them, join them. The box
on page 213 describes that passive strategies outperform active
strategies.

Chapter 7 Optimal risky portfolios

In this chapter we explain how to construct that optimal risky portfolio.
We begin with a discussion of how diversification can reduce the
variability of portfolio returns. After establishing this basic point we
examine efficient diversification strategies at the asset allocation and
security selection levels. We start a simple example of asset
allocation that excludes the risk-free asset. To that effect we use two
risky mutual funds: a long-term bond fund and a stock fund. With this
example we investigate the relationship between investment
proportions and the resulting portfolio expected return and standard
deviation. We then add a risk-free asset to the menu and determine
the optimal asset allocation. We do so by combining the principals of
optimal allocation between risky assets and risk-free assets with the
risky portfolio construction methodology. Moving from asset allocation
to security selection, we first generalize asset allocation to a universe
of many risky securities. We show how the best attainable capital
allocation line emerges from the efficient portfolio algorithm, so that
portfolio optimalization can be conducted in two stages, asset
allocation and security selection. We examine in two appendixes
common fallacies relating the power of diversification to the insurance
principal and to investing for the long run.

Diversification and portfolio risk

The reduction of risk to very low levels in the case of independent risk
sources is sometimes called the insurance principal, because of the
notion that an insurance company depends on the risk reduction
achieved through diversification when it writes insurance policies
insuring against many independent sources of risk, each policy being
 Samenvatting: Investments (Bodie, Kane & Marcus)

a small part of the company’s overall portfolio.

The risk that remains even after extensive diversification is called

market risk, risk that is attributable to market-wide risk sources. Such
risk is also called systematic risk, or non-diversifiable risk. In
contrast, the risk that can be eliminated by diversification is called
unique risk, firm-specific risk, non-systemic risk or diversifiable risk.

Portfolios of two risky assets

We will now move on and study efficient diversification, whereby we
construct risky portfolios to provide for the lowest possible risk for any
given level of expected return. We will start with considering a
portfolio of two risky assets because they are relatively easy to
analyze and illustrate the principal and considerations that apply to
portfolios of many assets.

Return
We will consider a portfolio of two risky assets. We can formalize this
as:

this is the return on such a portfolio.

Wd = Proportion of funds in Security 1

We = Proportion of funds in Security 2
rd = Expected return on Security 1
re = Expected return on Security
n

and the weights need to add up to 1: w 1

i 1
i
Risk

The risk of the portfolio with two risky assets can also be formalized
as:

= Variance of Security 1
= Variance of Security 2

= Covariance of returns for Security 1 and Security 2

This covariance is calculated by using the correlation between

security 1 and 2:

= Correlation coefficient of returns

= Standard deviation of returns for Security 1
= Standard deviation of returns for Security 2

The correlation between the two risky assets is important. Because it

tells us in what way these two risky assets move together. When the
securities are positively correlated they will move together. When they
are negatively correlated they will move the opposite way of each
 Samenvatting: Investments (Bodie, Kane & Marcus)

other.

Portfolios of less than perfectly correlated assets always offer better

risk-return opportunities than the components on their own. This is
because the standard deviation is less than the weighted average of
both components, as the expected return actually is. Here the
diversification opportunities arise. A minimum-variance portfolio has a
standard deviation that is smaller than that of either of the individual
component assets. This is the effect of diversification. . In the extreme
case of perfect negative correlation, there is a perfect hedging
opportunity and it would be possible to construct a zero-variance
portfolio.

Portfolios with different correlations:

We use assets with different correlations to reduce the risk of the
overall portfolio. The correlation effects can b summarized as:
The relationship depends on correlation coefficient.
-1.0 <  < +1.0
The smaller the correlation, the greater the risk reduction potential.
If r = +1.0, no risk reduction is possible

Range of values for  1,2

+ 1.0 > r> -1.0
If r= 1.0, the securities would be perfectly positively correlated
If r= - 1.0, the securities would be perfectly negatively correlated

The relationship of expected return and standard deviation in relation

to different levels of correlation can be seen in the graph below. This
graph is also called the portfolio opportunity set. Here we can clearly
see the different levels of expected return associated with different
levels of correlation between the two risky assets. A correlation of r =
1 achieves a lower expected return than a r = -1.

E(r)

 = .3
P=1
=
1

12 20 St. Dev
Figure 1: portfolio opportunity set % %
 Samenvatting: Investments (Bodie, Kane & Marcus)

Asset allocation with stocks, bonds and bills

This is our next step in our refinement process of understanding
portfolio selection. In the previous section we have looked at the
simplest asset allocation decision. That involves the choice of how
much of the portfolio to leave in risk-free money market securities
versus in a risky portfolio. We will now take it a bit further by
specifying the risky portfolio as comprised of a stock and bond fund.
We will investigate this more refined selection of the risky part of the
portfolio in this section.

Optimal risky portfolio with two risky assets and a risk-free asset
We will start our analysis with plotting two different capital allocation
lines for two different portfolios. This can be seen in figure 7.6 on
page 234 where the opportunity set of the debt and equity funds and
two feasible CALs are shown. By calculating the different sharp ratios
we can see which Cal dominates the other, when we calculate this we
can see that portfolio B dominates portfolio A.

The next step is to think why do we stop here? We can continue to

create the optimal portfolio. We do this by plotting the optimal CAL
which is tangent to the opportunity set of risky assets, which is shown
in figure 7.7 on page 236. P in this graph is the optimal portfolio. In
practice, the process of creating an optimal risky portfolio is done with
more than two risky assets we do this in a spread sheet or another
computer program.

A numerical example of creating a optimal complete portfolio can be

seen in examples 7.2 and 7.3 on pages 236-237 of the book. In
general, we take the following steps to arrive at the complete
portfolio:
`
1. Specify the return characteristics of all securities (expected
returns, variances, covariances)
2. Establish the risk portfolio:
a. Calculate the optimal risky portfolio using the following
formula:
W1 = σ1^2 - Cov(r1r2) / σ1^2 + σ2^2 – 2COV(r1,r2)

W2 = 1-W1
b. Calculate the properties of Portfolio P using the
weights we have calculated.
3. Allocate funds between the risky portfolio and the risk-free
asset:
a. Calculate the fraction of the complete portfolio
allocated to Portfolio P (the risky portfolio) and to T-
bills (the risk-free asset)
b. Calculate the share of the complete portfolio invested
in each asset and in t-bills.
 Samenvatting: Investments (Bodie, Kane & Marcus)

The Markowitz portfolio selection model

Security selection
In general, we can divide the security selection problem in three
phases. First, we identify the risk-return combinations available from
the set of risky assets. Second, we identify the optimal portfolio of
risky assets by finding the portfolio weights that result in the steepest
CAL. And third and finally, we choose an appropriate complete
portfolio by mixing the risk-free asset with the optimal risky portfolio.

Harry Markowitz (1952), published a formal model of portfolio

selection embodying diversification principals. For his work he
received the nobel prize in 1990. His model is precisely step one of
portfolio management: identification of the efficient set of portfolios or
as we have seen and named the efficient frontier of risky assets. The
critical idea behind the frontier set of risky portfolios is that, for any
risk level, we are interested only in that portfolio with the highest
expected return. An alternative we can view the frontier as asset of
portfolios that minimize the variance of any target expected return.

In more detail, the first step is to determine the risk-return

opportunities available to the investor. These are summarized by the
minimum-variance frontier of risky assets. This is a graph of the
lowest possible variance that can be attained for a given portfolio
expected return. With data about expected returns, variances, and
covariances we can calculate the minimum-variance portfolio for any
targeted expected return. The plot of the minimum variance frontier of

E(r)

Efficient
frontier

Global Individua
minimum assets

variance Minimum
portfolio variance
frontier

risky assets can be seen in the graph below (fugure 2).

Figure 2: The minimum variance frontier of risky assets

All the portfolios that lie on the minimum variance frontier from the
global minimum variance portfolio are candidates for the optimal
portfolio. The part of the frontier that lies above the global minimum-
 Samenvatting: Investments (Bodie, Kane & Marcus)

variance portfolio is therefore called the efficient frontier of risky

assets. The second step of the optimization plan involves the risk-free
asset. As we can see in figure 7.11 on page 240 we can see that the
portfolio P is tangent with the efficient frontier. Portfolio P is clearly
the optimal portfolio. The final step, is where the individual investor
chooses the optimal mix between the risky portfolio P and T-bills as
we can see in figure 7.8 on page 238.

Optimal portfolios with restrictions on the risk-free asset

In this section we briefly describe how we can create an optimal

portfolio with a spread sheet program like MS excel. This we can do
with a data set as shown in table 7.4 and the section describes how
we can plot an efficient frontier as shown in figure 7.13 with excel with
the dataset.

Capital allocation and the separation property

Let us assume that we now have established the efficient frontier with
excel. The next step is to introduce the risk-free asset. Whatever the
preference of the client, the client will always choose portfolio P,
because it is the optimal risky portfolio. The assumption with this
conclusion is that the risk-free asset is available and that the input
lists are identical for every investor. This result is called a separation
property.

The separation property tells us that the portfolio choice problem may
be separated into two tasks.

5. determination of the optimal risky portfolio which is a

purely technical part. Given the manager’s input list (list of
securities), the best risky portfolio is the same for all
clients, regardless of risk aversion.
6. allocation of the complete portfolio to T-bills versus risky
portfolio depends on personal preferences in this part of
the task the client is the decision maker.

The critical point is that the optimal portfolio P that the manager offers
is the same for all clients. This result makes professional
management more efficient and hence less costly. In practice
however the differentiating factor of great portfolio managers and the
rest is the quality of security analysis in other words the input list
analysis as the universal rule also applies here garbage in is garbage
out. This is the factor that makes great versus poor portfolio
managers.

Asset allocation and security selection

We have seen that the that the theories of asset allocation and
security selection are identical. So the next logical question is: Why
do we make a distinction between asset allocation and security
selection? There are three reasons:
 Samenvatting: Investments (Bodie, Kane & Marcus)

5. There is a great need and ability to save (pensions,

healthcare, college etc.), the demand for sophisticated
investment management has increased enormously.
6. The widening spectrum of financial markets and financial
instruments has put sophisticated investment beyond the
capacity of many amateur investors.
7. There are strong economies of scale in investment analysis.
The result is that the size of a competitive investment
company has grown with the industry, and efficiency in
organization has become an important issue.

Long term risk diversification

Risk pooling is the collection of uncorrelated assets in one portfolio.

This is widely seen as the insurance principle, but it is based on the
misunderstanding that adding several bets would reduce the risk.
Despite the fact that risk pooling benefit from uncorrelatedness, it
does not reduce risk by itself. Risk only increases less than
proportionally to the number of securities. The probability of loss
however does diminish.

Risk sharing is selling shares in an attractive risky portfolio to limit risk

an yet maintain the profitability of the resultant position. Risk sharing
combined with risk pooling is the key to the insurance industry.
Adding insurance policies increases the sharpe ratio, or the
profitability, and steadily reduces the risk to each shareholder.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 8 Indexing
Single-factor model
This chapter introduces index models that simplify estimation of
the covariances and greatly enhances analysis if risk premiums.
Risk is explicitly decomposed in systematic and unsystematic
risk. This simplifies the analysis because positive covariances
among security returns arise from common economic forces
that affect the fortunes of most firms, for example business
cycles, interest rates or natural resources. Covariances and
correlations are more easily estimated now.

We assume in the single factor security market that just one

variable drives the normally distributed returns. Statistical
implications of this normality assumption give the following
model:

Whereas,
 is rate of return on security i,

 is the expected rate of return on security i,

 is the unexpected component of the rate of return on

security i,

 is a parameter measuring macroeconomic

components, unanticipated macro surprises,

 is the sensitivity coefficient of the specific security i

(relating to a specific firm, some respond differently to m
than others).

This beta coefficient gives the sign of the systemic risk. Cyclical
firms for example respond greater to the market, resulting in a
higher beta.

Total risk of security i is given by a composition of beta and

standard deviations:

Also the covariance between a pair of securities is determined

by its beta’s:
 Samenvatting: Investments (Bodie, Kane & Marcus)

Single-index model
The single index model uses the market index to estimate the
common macroeconomic factor. Since the model is linear, the
beta coefficient of a security can be estimated using single-
variable linear regression. The basis is regressing the excess
return of a security i on the excess return of the market index
using historical data (from for example the S&P500):

Whereas,
 is the excess return of a security i

 is the expected excess return when the market excess

return is zero,

 is the security’s sensitivity to the market index,

 is the excess return of the market index,

 is the residual, the estimation error, with .

Taking expectations of this model results in the following:

The first term (alpha) on the right hand side is the nonmarket
risk premium. The second part, derived from the market risk
premium, is the systemic risk premium.

This model simplifies the analysis because less separate

coefficients need to be estimated. This model also enables
specialization of effort in the analysis. The model however
simplifies the World of risks, dividing them into a Sharp
dichotomy: market versus firm-specific risk.

Estimating the model

Page 283 until 289 describe the simplified estimation process of
the model using six large corporations. The regressions of the
rate of returns of these (six in total) corporations describe the
security characteristic line (SCL), drawn through a scatter
diagram. (basic econometrics)

This regression is complemented by an analysis of the variance

(ANOVA), the estimate of the alpha, the estimate of the beta,
and the covariance and correlation matrix.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Portfolio Construction
In the context of portfolio Construction the alpha term is crucial.
The beta’s are widely known and standardized. A sound
estimation of the alpha however tells the manager if the security
is good or bad. Intuitively: a positive alpha provides a premium
on top of the premium that would result from following
macroeconomic movements.

To optimize a portfolio, the goal is to maximize the Sharpe ratio.

The procedure is summarized as follows:
1. Compute the initial position of the securities in weights:

2. Scale them:

3. Compute the alpha of the active portfolio:

4. Compute the residual variance of the active portfolio:

5. Compute the initial position of the active portfolio:

6. Compute the beta of the active portfolio:

7. Adjust the initial position in the active portfolio:

8. The optimal portfolio now has weights: and

9. Calculate the premium of the optimal portfolio from the

premium of the index portfolio and the alpha of the active
portfolio:

10. Compute the variance of the optimum:

 Samenvatting: Investments (Bodie, Kane & Marcus)

Practical aspects
The full Markowitz model would be a better model in principle,
since all necessary estimations would have to be made.
However the great number of possible estimation errors
cumulatively could account for a major failure. The single-index
framework has a clear practical advantage.

Another practical issue is the estimation of betas. betas seem to

drift toward 1 over time, meaning that estimating a beta based
on past betas is usually not the best option. Forecasting models
have been developed that use regression to estimate the beta’s
from various variables, such as variance of earnings, market
capitalization, and dividend yield or debt-to-asset ratio.

Beta capture is the procedure of constructing a tracking

portfolio which has the same beta as the portfolio of interest.
This tracking portfolio captures the systemic risk. Buying this
tracking portfolio short combined with the portfolio of interest
long, the systemic risk is cancelled out. This is characteristic for
many hedge funds.

Chapter 9 CAPM
The capital asset pricing model (CAPM) is the core of modern
finance. It provides a prediction of the relationship between risk
and expected return that should be observed. As such it is a
benchmark and it provides ground for educated guesses on
non-traded securities.

The model
The model is based on six assumptions:
1. Perfect competition: there are many investors with each
a small fraction of the total endowments, which implies
that they are price takers.

2. Investors show myopic behavior: they plan for one

identical holding period.

3. They can only invest in publicly traded Financial assets.

They may borrow at a fixed risk-free rate.

4. No taxes or transaction costs exist.

5. All investors are rational mean-variance optimizers,

using the Markowitz portfolio selection model.
 Samenvatting: Investments (Bodie, Kane & Marcus)

6. Homogeneous expectations: all investors have identical

estimates of the probability distributions.

Although these assumptions are often not realistic, they provide

insight in many real-world complexities.

These assumptions will result in the following equilibrium:

 All investors will choose to hold a risky portfolio in the
same proportions as the market portfolio (M) is
composed. M is on the efficient frontier. This results
logically from the assumptions above, since if all
investors have identical information and identical
analytical tools, they will hold the same portfolio.
Consequently this has to be M.

 The capital market line (CML) is the best capital

allocation line (CAL).

 The risk premium on M will be proportional to its risk and

the risk aversion of the investor:
where is the average degree of risk aversion, and is
the variance of the market portfolio (or in this case the
systemic risk of the universe).

 The risk premium on individual assets will be

proportional to the risk premium on M. Beta measures
the extent to which returns on the stock and the market
move together: . So the risk premium on
individual securities is:
.

The mutual fund theorem is the result that the passive

strategy of investing in a market index portfolio is efficient. If this
is true, it would imply that attempts to beat the passive strategy
only generates trading and research costs with no offsetting
benefits. However, in the real world, investors do choose
different portfolios from M.

The market price of risk is the extra return that investors

demand to bear portfolio risk. It is represented by the following
ratio:
 Samenvatting: Investments (Bodie, Kane & Marcus)

A basic principle of equilibrium is that all investments should

offer the same reward-to-risk ratio, otherwise trading a
rearranging would be beneficial. That is why the reward-to-risk
ratio of an individual security needs to equal the market price of
risk.

Rearranging terms results in the expected return-beta

relationship:

In which is the ratio that measures the contribution of this

individual security to the variance of the market portfolio as a
fraction of the total variance of the market portfolio:
.

If this holds for every i, this would have to hold for the entire
portfolio.
This expected return-beta relationship can graphically be
represented by the security market line (SML), see figure 9.2
on page 317. The SML graphs the individual asset risk
premiums as a function of asset risk. Relevant in this case is
the contribution of the asset to the portfolio variance, measures
by beta. The capital market line (CML) in contrast graphs the
risk premiums of efficient portfolios as a function of portfolio
standard deviation.

Practicality of CAPM
Testing the implication of CAPM is difficult. First of all because
all traded risky assets would need to be considered, which is
immense. Second, the CAPM implies relationships among
expected returns and such expected values are never actually
observed.

A model, consisting of assumptions, logical/mathematical

manipulation of these assumptions, and predictions, can be
tested normatively and positively. Normative tests test the
assumptions, positive tests test the predictions. Few models
can pass the normative test. In case of the CAPM the positive
test implies testing the efficiency of the market portfolio and the
accurateness of security market line. The principle problem with
testing these, is that the market portfolio M is unobservable.
 Samenvatting: Investments (Bodie, Kane & Marcus)

This leaves us with empirical tests of the expected return-beta

relationship, but the CAPM miserably fails these tests.

Despite its empirical shortcomings, the CAPM is the accepted

norm in the US and other developed countries. The first reason
is that the theoretical decomposition of systematic risk from
firm-specific risk is compelling. Second, there is impressive
evidence that the central conclusion of CAPM, which is the
efficiency of M, may be close to truth.

Extensions of CAPM
Greater accuracy could be gained by adding complexity to the
model.

Zero-beta model
Efficient frontier portfolios have some interesting implications:
 A combination of two efficient frontier portfolios is in itself
efficient.

 The expected return of any asset can be expressed as

an exact linear function of the expected return on any
two efficient-frontier portfolios P and Q:

 Every portfolio on the efficient frontier has a companion

portfolio (the zero-beta portfolio) on the inefficient half
of the frontier, which is uncorrelated. Choosing M and its
zero-beta companion Z, then :

which resembles the SML of CAPM.

Labor income
Two important assets are not traded, human capital and
privately held businesses. Such capital is less portable across
time and thus may be more difficult to hedge with using traded
securities. Such facts may put pressure on security prices and
results in departures from CAPM.

Multiperiod model
Robert C. Merton has relaxed the assumption of myopic
investors. He envisions investors who optimize a lifetime
consumption or investment plan and who adapt their decisions
to changes. His model however predicts the same expected
return-beta relationship when the only source of risk is the
 Samenvatting: Investments (Bodie, Kane & Marcus)

uncertainty about portfolio returns. Other sources of risk could

be changes in the parameters such ask the risk-free rate or
expected returns. Another possibility would be the prices of
consumption goods, inflation risk for example. All these risks
would require hedging activities, highly complicating the model.

Consumption based CAPM

It might be useful to center the model on consumption,
assuming that an investor would try to optimally smooth
maximum consumption. In a lifetime consumption plan, he must
in each period balance the allocation of current wealth between
today’s consumption and the savings and investment that will
support future consumption. When optimized, the utility value
from an additional dollar of consumption today must be equal to
the utility value of the expected future consumption that can be
financed by that additional dollar of wealth.
Investors will value additional income more highly during
difficult economic times. An asset will therefore be viewed as
riskier in terms of consumption if it has positive covariance with
consumption growth. Equilibrium risk premiums will be greater
for assets that exhibit higher covariance with consumption
growth.

Liquidity
The liquidity of an asset is the ease and speed with which it can
be sold at fair market value. Illiquidity is measures by the
discount that a seller must accept if the asset is to be sold
quickly. Liquidity is increasingly seen as an important
determinant of prices. Investors are likely to act on expected
liquidity constraints or changes in such constraints. Liquidity
premises might change unexpectedly as well. Therefore,
investors may demand compensation for their exposure to
liquidity risk.

Chapter 11 The efficient market hypothesis

Random walk & EMH
The efficient market hypothesis (EMH) is the notion that stocks
already reflect all available information. As market participants
try to anticipate on all available information, in principle stock
prices should contain all information that could possibly be used
to predict them. Consequently stock prices that respond to
information must move unpredictably. Prices should follow a
random walk.
 Samenvatting: Investments (Bodie, Kane & Marcus)

The weak-form of the EMH asserts that stock prices already

reflect all information that can be derived by examining market
trading data. The semi strong-form states that all publicly
available information regarding the prospects of a firm must be
reflected already in the stock price. The strong-form of the
hypothesis, the most extreme position, claims that all
information relevant to a firm is reflected.

Implications
The EMH implies that technical analysis is of no merit.
Technical analysis is the search for recurrent and predictable
patterns in stock prices. Well-known concepts of such technical
analysis are resistance levels and support levels, respectively
probable upper and lower levels of stock prices.
Fundamental analysis uses earnings and dividend prospects of
the firm, expectations of future interest rates, and risk
evaluation of the firm to determine proper stock prices. Just as
technical analysis, most fundamental analysis is useless
following the reasoning of EMH. The trick is to identify firms that
are better than everyone else’s estimate.

Proponents of the EMH are advocates of passive investment

strategy, because the costs of active management is unlikely to
be compensated by benefits. Such passive management simply
aims for a well-diversified portfolio of securities. One common
strategy is creating an index fund, designed to replicate the
performance of a broad-based index.

Even in an efficient market there is a role for portfolio

management. Optimal positions depend on such things as tax,
risk aversion and employment. The role of the portfolio
manager is to adjust the portfolio to these factors, not to beat
the market.

Event studies
An event study is empirical financial research to assess the
impact of a certain event on a firm’s stock price. The general
approach commences with an estimate of the stock price if the
event would not have occurred. The abnormal return is then the
difference between the actual return and this benchmark.
Index models are widely used to estimate these abnormal
returns. Rewriting the mathematical formula for stock return (
) gives the following equation to estimate:
 Samenvatting: Investments (Bodie, Kane & Marcus)

Whereas
 is the part of a security’s return resulting from firm-
specific events,

 is the actual rate of return of this stock,

 is the return on the market portfolio,

 is the sensitivity of this particular stock to market

return,

 is the average rate of return the stock would realize in

a period with a zero market return.

This model can be easily upgraded to include all kinds of

sophisticated factors. Estimation of the parameters a and b is a
delicate issue. The standard estimate of abnormal return is
easily complicated by leakage of information. The cumulative
abnormal return is a better measure in such a case. Event
studies are widely used nowadays.

Efficiency
EMH has never been widely accepted on Wall Street. Three
important issues are important: the magnitude issue, the
selection bias issue and the lucky event issue. With these in
mind, we can discuss the empirical test of EMH.

Weak-form tests
One way of finding trends in stock prices is measuring the serial
correlation of returns. This reflects the tendency of returns to be
related to past returns. Broad market indexes only reflect very
weak serial correlation. There seems to be a stronger
relationship across specific sectors.
Some studies have shown the predictive power of particular
easily collected variables. On the one hand this could imply the
violation of the EMH. On the other hand, such variables
probably account for variation in market return.

Semi strong-form
Fundamental analysis is always in line with the semi strong-
form of the hypothesis, since fundamental analysis uses
publicly available information to clarify and predict stock prices.
Examples of such fundamental analysis and its findings are the
small-firm effect, the neglected-firm effect, the book-to-market
effects, and the post-earnings-announcement price drift.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Strong-form
It is very common sense that insiders are able to make superior
profits trading in their own stock. This practice is regulated and
limited. This however implies that the strong-form of the
hypothesis is not very likely to appear.

Anomalies
Lots of literature has been produced on the anomalies of the
financial markets. Are these markets just inefficient? Some
argue that the anomaly effect named above are actually in line
with efficiency and just reflect manifestations of risk premiums.
The opposite interpretation is also provided, claiming that these
effects are proof of inefficiency.

Prices can also lose their grounding in reality. Such bubbles

show prices that depart from any semblance of intrinsic value.
These bubbles are usually only acknowledged in retrospect.

Market professionals
Can market professionals outperform the passive index funds?
This provides a short discussion of the professionals, stock
market analysts and mutual fund managers.

Stock market analysts recommend investment positions based

on their analysis. Only the relative performance of these
analysts is really of interest. Literature suggests that they add
some value, but ambiguity remains. The same accounts for
mutual fund managers, who actually manage portfolios.

Chapter 12 behavioral finance and technical

analysis
Behavioral finance is a relatively new school in finance, arguing
that the literature on finance strategies has overlooked the most
important point: the correctness of security prices. Conventional
financial theory ignores how people really make decisions.
Behavioral finance starts with the assumption that investors
might not be rational. Irrationalities fall into two categories:
people do not always process information correctly, and people
make often inconsistent decisions.
1. Information processing: this leads to misestimating of
probabilities. Four important biases have been identified.
 Samenvatting: Investments (Bodie, Kane & Marcus)

a. Investors make forecasting errors.

b. Investors tend to overestimate their own insights

and abilities.

c. Investors are slow in updating their beliefs in

response to new evidence (conservatism)

d. Investors to quickly trust information inferred from

relatively small samples (representativeness).

2. Behavioral biases

a. Decisions are affected by the framing of an issue.

b. Mental accounting: investors treat cases

differently or separately per case.

c. Investors experience greater regret when they

failed in some unconventional case.

d. Prospect theory modifies the analytic description

of rational risk averse investors found in standard
financial theory.

3. The above biases would not lead to inefficient markets if

some rational arbitrageurs would operate. For the
following reasons, such arbitrage is limited:

a. There is always a degree of fundamental risk.

b. Implementation costs limit possibilities.

c. There is always a risk in trusting on models.

d. Even the law of one price is in some cases

violated (see pages 416 to 418)

Behavioral finance is not uncontroversial yet. It does make

important points on the limits of rationality. It however does not
provide investment opportunities based on its insights, for
example. Some believe that the behavioral critique is too
unstructured.

Technical analysis
Technical analysis attempts to exploit recurring and predictable
 Samenvatting: Investments (Bodie, Kane & Marcus)

patterns in stock prices to generate superior investment

performance. This section discusses the relation between
technical analysis and behavioral finance. Technical analysis
reflects all kinds of behavioral biases.

Technical analysis mostly uncovers trends. Dow theory is one

of the oldest of trend analysis. According to Dow, three major
trends influence stock prices:
1. Primary trend: long term

2. Secondary or intermediate trend: short term deviations,

usually corrected.

3. Tertiary or minor trend: daily fluctuation of little

importance.

This model is built on the notion of predictability. EHM argues

however that in this case investors would exploit these
possibilities, affecting the prices and resulting in a self-
destructing strategy. These trends are thus only observed after
the fact.

Two other measures are (1) the moving average, and (2) the
breadth, a measure of the extent to which movements in the
market index are reflected widely in the price movements of all
the stocks in the market.

There are three indicators of the investor’s sentiment to be

named here:
1. Trin statistic: when rising prices go with rising volumes,
technicians consider the market advances to be
favorable. The trin statistic is such a measure:

2. Confidence index is the ratio of the average yield on 10

top-rated corporate bonds divided by the average yield
on 10 intermediate-grade corporate bonds.

3. Put/call ratio is the ratio of outstanding put options to

outstanding call options. Because put options do well in
falling markets while for call options it’s the other way
around, deviations of the ratio from historical data are
considered to be a signal of market performance.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 13 Empirical evidence on security

returns
The index model and the single-factor APT
The mostly tested implication of the CAPM and APT models is the
expected return-beta relationship of a security:

To test this condition 3 steps are necessary:

1. Setting up the sample data: first determine a sample period
(e.g., 5 years), divide it in subperiods (e.g. months), and for
each of them you collect the rate of return of a chosen number
of stocks ( ). Over the sample period you store also a
market-portfolio proxy, e.g. S&P 500 ( and 1-month risk-
free T-bills ( ).
2. Estimating the SCL: interpret the equation above as a security
characteristic line. For each stock you estimate the beta
coefficient as the slope of the first-pass regression (there will
be a second one later):

then you compute the following statistics for the next step:

.
3. Estimating the SML: interpret the equation above as a security
market line. Here you estimate coefficient for the second-pass
regression:

You should find the conclusion that, if the CAPM is valid, this
last estimated coefficient should satisfy
and
Myller and Scholes constructed this test using annual data on 631
NYSE stocks for 10 years. The results were inconsistent with CAPM.
It turns out that there were several difficulties with this approach.
Firstly, the extreme volatility of stock returns make any test of
average return problematic and less precise. Another source of errors
is that the market index used is not the market portfolio of the CAPM.
Moreover, the second-pass regression uses coefficients estimated on
the first-step regression, having substantial sampling errors.
Now we investigate the implications of these problems.
The market index
Richard Rolled pointed out that the usual CAPM test is a test of the
mean-variance efficiency of a market proxy and therefore tests of the
linearity of the expected return-beta relationship cannot be transferred
to validate the CAPM model.
Measurement error in beta
 Samenvatting: Investments (Bodie, Kane & Marcus)

Scholes made new tests to overcome the measurement problem

described above. He decided to use portfolios rather than individual
securities to estimate the betas. Those betas were then estimated
with more precision, because combining securities into portfolios
cancels out most of the specific-firm part of the return on the portfolio
of securities.
The negative consequence is that this process reduces the number of
observations for the second-pass regression (e.g.: if you combine 100
stocks in 5 portfolios, then you’ll have 5 observation for the second
step).
Therefore, a good trade-off must be set to have reliable results. One
way is to construct portfolios with the largest possible dispersion of
the beta coefficients. If we have a great dispersion of market returns,
we have more chance on properly estimating the effect of a change in
the market return on the return of the stock.
This test, in the end, provides mixed evidence on the validity of the
theory:
1. The expected rate of return increases linearly with beta
2. The expected rate of return is not affected by non-systematic
risk.
The bottom line is that the CAPM model seems qualitatively correct,
but empirical tests do not validate its quantitative predictions.
The EMH and the CAPM
Roll also pointed out that the return-beta relationship follows directly
from the efficiency of the market portfolio. You need to test if the
market is efficient, because CAPM and APT depend on this attribute.
The only (weak) proof of the efficiency of the market is that S&P500
and the NYSE index have shown to be difficult to beat by professional
investors.
Accounting for human capital and cyclical variations in asset betas
The above mentioned tests have two important deficiencies:
1. They do not take into account human capital (which is a non-
traded asset)
2. They do not take into account that betas are cyclical
For these reasons, conventional first-pass estimates of security betas
are affected by big errors. They do not capture cyclicality of stock
returns and thus they are less accurate in measuring the systematic
risk of stocks.
However, it may be possible to replace the simple betas with better
estimates of systematic risk and transfer the explanatory power of
instrumental variables such as size and the default premium to the
index rate of return.
Tests of multifactor CAPM and APT
Multifactor CAPM and APT models are including which factors ought
to result in risk premiums. There are three stages to test this
hypothesis:
1. Specification of risk factors
2. Identification of portfolios that edge the chosen risk factors
3. Test of explanatory power and risk premiums of the hedge
portfolios
The regression steps are made just as in the single factor model.
The Fama-French three-factor model
The systematic factors of this model are firm size, book-to-market
ratio and the market index.
To make the model operational we take two steps:
 Samenvatting: Investments (Bodie, Kane & Marcus)

 We measure the risk factor in each period as the differential

return on small firms versus large ones. This is the SMB
(small minus big) factor.
 The other extra-market factor is measured as the return of
dfirms with high book-to-market ratios minus that on firms with
a low ratio. This is the HML (high minus low) factor.
This is the three-factor asset-pricing Fama-French model:

The coefficients , and are the betas on each factor. They are
called factor loadings.
In the end, if the arbitrage pricing model is correct, the return should
be fully explained by factors, and thus the intercept of the equation
should be zero. To test this, Fama and French form nine portfolios
with a range of sensitivities to each factor. They sorted the firms into
three size group (small, medium, large) and three book-to-market
groups (high, medium, low).
Their results were the following:
1. The intercepts were small and in general statistically
insignificant
2. Large R-squared, which shows that the three factors explain
the rates of return well
3. Large t-statistics on size and value, which shows that these
factors contribute significally to explanatory power.
Consumption-based asset pricing and the equity premium puzzle
The “puzzle” refers to a lack of consensus among economists on why
the demand for bonds is so high, given the small return they provide
with respect to stocks. An intuitive answer could be that stocks are
much more risky than bonds. This is correct, but insufficient to explain
the disparity between the two returns (i.e. the equity risk premium),
which implies a level of risk aversion beyond reason.
Proposed explanation
Here we list a number of proposed explanations to this puzzle

1. Survivorship bias: the US market was the most successful stock

market in the 20th century. Other countries displayed lower long-
run returns. Picking the best observation (US) from a sample
leads to biased estimates of the premium. Moreover, other
countries’ markets are weaker than the US one, and firms can
come and go before the end of the study. It is essential to take
this risk into account to have a truly unbiased and explanatory
model.
2. Fama and French show that the puzzle emerges because of
excess returns on the last 50 years.
3. The puzzle exists because the common practice of computing
risk does not properly account for liquidity risk, only for the
volatility of returns.
4. Behavioral explanation: the puzzle is an outcome of irrational
investor behavior. In experimental settings it was observed that
investors value every risk they take in isolation, i.e. without
considering if a correlation between them exists. therefore, they
require a higher risk premium.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 14 Bond Prices and Yields

We will start with analysing debt securities. A debt security is a
claim on a specified periodic stream of income. Debt securities
are often called fixed-income securities, because they promise
a (fixed) stream of income that is determined according to a
specified formula. These securities have the advantage of being
relatively easy to understand because the payment formulas
are specified in advance. Risk considerations are minimal as
long as the issuer of the security is sufficiently creditworthy.

The bond is the basic debt security. We will start with an

overview of the universe of bond markets. This includes
Treasury, corporate, and international bonds. We next turn to
bond pricing, showing how bond prices are set in accordance
with market interest rates and why bond prices change with
those rates. Given this background we compare the different
measures of bond returns such as yield to maturity, yield to call,
holding-period return or realized compound yield to maturity.
We show how bond prices evolve over time. Finally we consider
the impact of default or credit risk on bond pricing and look at
the determinants of credit risk and the default premium built into
bond yields.

Bond characteristics
A bond is a security that is issued in connection with a
borrowing arrangement. The borrower issues (i.e., sells) a bond
to the lender for some amount of cash; the bond is a “IOU” of
the borrower. The arrangement obligates the issues to make
specified payments to the bondholder on specified dates. A
typical coupon bond obligates the issuer to make semiannual
payments of interest to the bondholder for the life of the bond.
These are called coupon payments. When the bond matures,
the issuer repays the debt by paying the bondholder the bond’s
par value another word for par value is face value. The coupon
rate of the bond serves to determine the interest payment: the
annual payment is the coupon rate times the bond’s par value.
The coupon rate, maturity date, and par value of the bond are
part of the bond indenture, which is the contract between the
issuer and the bondholder.

Bonds are usually issued with coupon rates set high enough to
induce investors to pay par value to buy the bond. Sometimes,
however, zero-coupon bonds are issued that make no coupon
payments. In this case, investors receive par value at the
 Samenvatting: Investments (Bodie, Kane & Marcus)

maturity date but receive no interest payment until then. The

bond has a coupon of zero. This type of bond is issued at
priced considerably below par value, and the investor’s return
comes solely from the difference between issued price and the
payment of par value at maturity.

Treasury bonds and notes

Figure 14.1 on page 468 is an excerpt from the listing of
treasury issues of the Wall Street Journal. Aside from the
differing initial maturities, the only major distinction between T-
notes and T-bonds is that in the past, some T-bonds were
callable for a given period. The US treasury no longer issues
callable bonds, but some previously issued callable bonds still
outstanding. Page 468 explains how to read a bond price quote
in the Wall Street Journal (WSJ).

Accrued interest and quoted bond prices. The bond prices that
you see quoted in the financial pages are not the actual prices
that investors pay for the bond. This is because the quoted
price does not include the interest that accrues between coupon
payment dates.

In general, the formula for the amount of accrued interest

between two dates is:

Accrued interest = (Annual coupon payment / 2 ) × (days since

last coupon payment/ daysseparating coupon payments)

Corporate bonds. These are bonds issued by corporations. An

example is given in figure 14.2 on page 451 here you can a
sample from the WSJ.

 Call provisions on Corporate bonds. The US treasury no

longer issues callable bonds, some corporate bonds are
issued with call provisions allowing the issuer to
repurchase the bond at a specified call price before the
maturity date. The option to call the bond is valuable to
the firm, allowing it to buy back the bond and refinance at
lower interest rates when market rates fall

 Convertible bonds. These bonds give bondholders an

option to exchange each bond for a specified number of
shares of common stock of the firm. The conversion ratio
is the number of shares for which each bond may be
exchanged.
 Samenvatting: Investments (Bodie, Kane & Marcus)

 Puttable bonds. While the callable bond gives the issuer

the option to extend or retire the bond at the call date,
the extendable or put bond gives this option to the bond
holder.

 Floating-rate bonds. These bonds make interest

payments that are tied to some measure of current
market rates.

Preferred Stock. Although preferred stock strictly speaking is

considered to be equity, it often is included in the fixed-income
universe. This is because like bonds preferred stock promises
to pay a specified stream of cash in the form of dividends.

Other Issuers. There are also other issuers of bonds. For

example local governments and federal agencies as discussed
in chapter 2.

International Bonds. International bonds can be divided into

two categories: foreign bonds and Eurobonds. Foreign bonds
are issued by a borrower from a country other than the one in
which the bond is sold. The bond is denominated in the
currency of the country in which it is market. Foreign bonds sold
in the US are called Yankee bonds, for example German BMW
issues a bond in dollars in the US are called Yankee bonds.
Foreign bonds in Japan are called Samurai bonds and foreign
bonds in the UK are called bulldog bonds.

Innovation in the bond market. Below we will describe some

innovations in the bond market:

 Inverse floaters. These are similar to the floating bonds,

except that the coupon rate on these bonds falls when
the general level of interest rises. Investors in these
bonds suffer doubly when rates rise.

 Asset-backed Bonds. An example BMW has issued

bonds with coupon rates tied to the financial
performance of the firm. This is what is meant with asset
backed bonds.

 Catastrophe bonds. An example Winterthur (the insurer)

has issued a bond whose payment depend on whether
there has been a sever hailstorm in Switzerland. The
bond is a way to transfer “catestrophe risk” from the firm
to the capital markets.
 Samenvatting: Investments (Bodie, Kane & Marcus)

 Indexed Bonds. Indexed bonds make payments that are

tied to a general price index or the price of a particular
commodity. For example Mexico has issued 20-year
bonds with payments that depend on the price of oil.

Bond pricing
A bond’s coupon and principal payment all occur months or
years in the future, the price an investor would be willing to pay
for a claim to those payment depends on the value of dollars to
be received in the future compared to dollars in hand today.
This sort of present value calculation depends in turn on market
interest rates. The nominal risk-free interest rate equals: 1) a
real risk-free rate of return 2) a premium above the real rate to
compensate for expected inflation. In addition a premium
reflects bond specific characteristics such as default risk,
liquidity, tax attributes, call risk etc. To value a security we
discount its expected cash flows by the appropriate discount
rate.

Bond value = Present value of coupons + Present value of par

value

T
ParValue T
PB = å (1+Cr )
t =1
t
T
+
(1+ r )
T

PB = price of the bond

Ct = interest or coupon payments
T = number of periods to maturity
y = semi-annual discount rate or the semi-annual yield
to maturity

An example:

What is the price of the bond?

We know:
10 year bond
Face value or Par value 1000
8% Coupon
20
1 1000
Calculations: P = 40
å t =1 (1.03)
t
+
(1.03)
20

P = $1,148.77
 Samenvatting: Investments (Bodie, Kane & Marcus)

Ct = 40 (SA)
P = 1000
T = 20 periods
r = 3% (SA)

An important insight is that with a higher interest rate, the

present value of the payments to be received by the bondholder
is lower. Therefore, the price of the bond will fall as market
interest rates rise. This illustrates a crucial general rule in bond
valuation. When interest rates rise, bond prices must fall
because the present value of the bond’s payments are obtained
by discounting at a higher interest rate.

Figure 14.3 on page 476 explains the inverse relationship

between bond prices and yields. The price of an 8% coupon
bond with 30-year maturity making semiannual payments. An
important insight from this figure is that the shape of the curve
implies that an increase in the interest rate results in a price
decline that is smaller than the price gain resulting from a
decrease of equal magnitude in the interest rate. This property
of bond prices is called convexity because of the convex shape
of the bond price curve. This curvature reflects the fact that
progressive increases in the interest rate result in progressively
smaller reductions in the pond price. Therefore, the price curve
becomes flatter with higher interest rates. Prices and Yields
(required rates of return) have an inverse relationship

We can say that when yields get very high the value of the bond
will be very low. When yields approach zero, the value of the
bond approaches the sum of the cash flows.

A general rule in evaluating bond price risk is that, keeping all

other factors the same, the longer the maturity of the bond, the
greater the sensitivity of price to fluctuations in the interest rate.
This is also the reason why short-term Treasury securities such
as T-bills are considered to be the safest. They are free not only
of default risk but also largely of price risk attributable to interest
rate volatility.

Bond yields
We would like a measure to rate of return that accounts for both
current income and the price increase or decrease over the
bond’s life. The yield to maturity is the standard measure of
 Samenvatting: Investments (Bodie, Kane & Marcus)

total rate of return. The yield to maturity is defined as the

interest rate that makes the present value of a bond’s payments
equal to its price.

In Formula:
T

PB = å C t T + ParValue T

(1+ r )
T
t =1 (1+ r )

An example:

20
35 1000
950 = å +
(1+ r ) (1+ r )
t T
t =1

10 yr Maturity Coupon Rate = 7%

Price = $950
Solve for r = semiannual rate

Answer: r = 3.8635%

The financial press reports on an annualized basis, and

annualizes the bond’s semiannual yield using simple interest
techniques, resulting in an annual percentage rate, or APR.
Yields annualized using simple interest are also called “bond
equivalent yields”. Therefore, the semiannual yield would be
doubled and reported in the newspaper as a bond equivalent of
6%. The effective annual yield of the bond, however, accounts
for compound interest. If one earns 3% interest every 6 months,
then after 1 year, each dollar invested grows with interest to
$1 X (1,03)^2 = $ 1,0609, and the effective annual interest rate
on the bond is 6,06%.

Yield to maturity is different from the current yield of a bond,

which is the bond’s annual coupon payment divided by the
bond price.

A general rule is that for premium bonds (bonds selling above

par value), coupon rate is greater than current yield, which in
turn is greater than yield to maturity. For discount bonds (bonds
selling below par value), these relationships are reversed.
Some numeral examples:

Bond Equivalent Yield

7.72% = 3.86% x 2
Effective Annual Yield
(1.0386)2 - 1 = 7.88%
 Samenvatting: Investments (Bodie, Kane & Marcus)

Current Yield
Annual Interest / Market Price
$70 / $950 = 7.37 %

Bond prices over time

A bond sell at par value when its coupon rate equals the market
interest rate. We shall now discuss the Yield to maturity versus
holding-period return. The difference between yield to maturity
and holding period return is that yield to maturity depends only
on the bond’s coupon, current price and par value at maturity.
All of these values can de observed today, so it is relatively
easy to calculate. In other words we can see the yield to
maturity as a measure of the average rate of return if we hold
the bond until the bonds maturity. The holding-period return is
the rate of return over a particular investment period and
depends on changes in rates affects returns, reinvestment of
coupon payments and change in price of the bond.

Zero coupon bonds. Original issue discount bonds are less

common than coupon bonds issued at par. There are bonds
that are issued intentionally with low coupon rates that cause
the bond to sell at a discount from par value. An extreme
example are zero-coupon bonds, which carries no coupons and
provides all its return in the form of price appreciation. Zeros
provide only one cash flow to their owners, on the maturity date
of the bond.

Default risk and bond pricing

Although bonds generally promise a fixed flow of income, that
income stream is not risk less unless the investor can be sure
the issuer will not default on obligation. Bond default risk, is
usually called credit risk, this risk is measured by rating
agencies such as Moody’s, Fitch and Standard and Poor. They
give a bond a rating such as in figure 1.8 on page 472.

To determine the safety of a bond we can use some ratios to

analyze. We will discuss five of them briefly:

4. Coverage ratio. Ratios of company earnings and fixed

costs.
5. Leverage ratios. Debt-to equity ratios
6. Liquidity ratio. Two common liquidity ratios are:
a. Current ratio (asset/current liability)
b. Quick ratio (current assets excluding
inventories/current liabilities)
 Samenvatting: Investments (Bodie, Kane & Marcus)

7. Profitability ratios. Measures of rates of return on assets

or equity.
8. Cash flow to debt ratio. This is the ratio of cash flow to
outstanding debt.

Bond indentures.
A bond is issued with an indenture, which is the contract
between the issuer and the bondholder. Part of the indenture is
a set of restrictions that protect the rights of bondholders. To
make sure the bond issuer does not come into a cash flow
problem the firm agrees to establish a sinking fund to spread
the payment burden over several years. The sinking fund may
operate in one of two ways:

1. The firm may repurchase a fraction of outstanding bonds in

the open market each year.
2. The firm may purchase a fraction of the outstanding bonds at
a special call price associated with the sinking fund provision.

The firm has an option to purchase the bonds at either the

market price or the sinking fund price, whichever is lower. To
allocate the burden of the sinking fund call fairly among
bondholders, the bonds chosen for the call are selected at
random based on serial number. Other issues are subordination
of further debt in case of liquidation, dividend restrictions and
collateral.

Bonds with a relatively high risk of default yield lower prices

and consequently its rate of return will rise. Following the same
reasoning implies that collateralized bonds usually yield a lower
rate of return, because the risk of losses in case of default is
smaller. The default premium is the compensation that
corporate bonds offer for the possibility of default. The
development over time of these default premiums on these
risky bonds is sometimes called the structure of interest rates.

A credit default swap (CDS) is in short an insurance on the

default risk of an investment. By using such a CDS a highly
risky bond can be repackaged as a very safe investment. These
CDSs have widely been used to speculate, resulting in the
credit boom that led to the financial crisis of 2008.

Another example of such a financial product dealing with risk

mitigation is the Collateralized Debt Obligation (CDO). A
separate legal financial institution would first raise funds, collect
different kinds of debt obligations, pool them togehter, and
 Samenvatting: Investments (Bodie, Kane & Marcus)

resell the total in small ‘slices’ or ‘tranches’ in different priority-

scales varying in the risk they would entail.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 15 The term structure of interest

rates
Until now we have assumed for the sake of simplicity that the
same constant interest rate is used to discount cash flows of
any maturity. In the real world this is rarely the case. In this
chapter we explore the pattern of interest rates for different-
term assets. We will try to identify the factors that account for
that pattern and determine what information may be derived
from an analysis of the so called term structure of interest rates,
the structure of interest rates for discounting cash flows of
different maturities. We will show how traders use the term
structure to compute forward rates that represent interest rates
on “forward” or deferred loans, and consider the relationship
between forward rates and future interest rates. Finally, we give
an overview of some issues involved in measuring the term
structure.

The term structure under certainty

We could conclude that longer-term bonds usually offer higher
yields of maturity because longer-term bonds are riskier and
that the higher yields are evidence of a risk premium that
compensates for interest rate risk. Another reason is that at
these times investors expect interest rates to rise and that the
higher average yields on long-term bonds reflect the
anticipation of high interest rates in the latter years of the
bond’s life.

Bond pricing. The interest rate for a given time interval is called
the short interest rate for that period. Table 15.1 on page 509
shows the Interest rates on 1-year bonds in coming years.
Expected one-rear rates in coming Years:

Year Interest Rate

0 (today) 8%
1 10%
2 11%
3 11%

The interest rates are the expected interest rates in the future
from today. We can price a bond using these expected interest
rates with the following formula:
1
PVn =
(1 + r1 )(1 + r2 )...(1 + rn )
 Samenvatting: Investments (Bodie, Kane & Marcus)

PVn = Present Value of $1 in n periods

r1 = One-year rate for period 1
r2 = One-year rate for period 2
rn = One-year rate for period n

We use this table to calculate the prices and yields of zero

coupon bonds
Time to Maturity Price of Zero* Yield to Maturity
1 $925.93 8.00%
2 841.75 8.995
3 758.33 9.660
4 683.18 9.993
* $1,000 Par value zero

. An important note is that the yield to maturity on zero-coupon

bonds is sometimes called the spot rate that prevails today for a
period corresponding to the maturity of the zero.

Interest rate uncertainty and forward rates

The forward interest rate is the interest rate that is inferred from
the growth rate of the observed interest rates of the years
before. Consequently, and since future interest rates are
uncertain, this forward interest rate does not need to equal the
interest rates that will actually prevail. With the following formula
we can calculate the forward rates from the observed rates.
(1 + yn ) n
(1 + f n ) =
(1 + yn -1 ) n -1

fn = one-year forward rate for period n

yn = yield for a security with a maturity of n
(1 + yn ) n = (1 + yn -1 ) n -1 (1 + f n )

An example as explained in the BKM: How to calculate a

forward?

4 yr = 9.993 3yr = 9.660 fn = ?

(1.0993)^4 = (1.0966)^3 (1+fn)
(1.46373) / (1.31870) = (1+fn)
fn = .10998 or 11%

Note: this is expected rate that was used in the prior example.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Downward Sloping Spot Yield Curve

Zero-Coupon RatesBond Maturity

12% 1
11.75% 2
11.25% 3
10.00% 4
9.25% 5

1yr Forward Rates downward sloping yield curve

1yr [(1.1175)2 / 1.12] - 1 = 0.115006

2yrs [(1.1125)3 / (1.1175)2] - 1 = 0.102567
3yrs [(1.1)4 / (1.1125)3] - 1 = 0.063336
4yrs [(1.0925)5 / (1.1)4] - 1 = 0.063008

Theories of the term structure

In general there are three theories concerning term structure:

4. Expectations
5. Liquidity Preference (Upward bias over expectations)
6. Market Segmentation / Preferred Habitat

We will explain each theory briefly:

1. Expectations theory
This is the simplest theory of the term structure. A common
version of this hypothesis states that the forward rate equals the
market consensus expectation of the future short interest rate.
The assumptions of this theory are:

4. Observed long-term rate is a function of today’s short-

term rate and expected future short-term rates.
5. Long-term and short-term securities are perfect
substitutes.
6. Forward rates that are calculated from the yield on long-
term securities are market consensus expected future
short-term rates. An upward-sloping curve would be clear
evidence that investors anticipate increases in interest
rates.

2. Liquidity preference:
This theory states that the forward rate exceeds expected future
interest rates. It assumes that 1) Long-term bonds are more
risky. 2) Investors will demand a premium for the risk
associated with long-term bonds. 3) The yield curve has an
 Samenvatting: Investments (Bodie, Kane & Marcus)

upward bias built into the long-term rates because of the risk
premium. 4) Forward rates contain a liquidity premium and are
not equal to expected future short-term rates.

3. Market segmentation theory / preferred habit theory:

This is the theory that long- and short-maturity bonds are traded
in essentially distinct or segmented markets and that prices in
one market do not affect those in the other. It assumes that 1)
Short- and long-term bonds are traded in distinct markets. 2)
Trading in the distinct segments determines the various rates.
3) Observed rates are not directly influenced by expectations.
4) Investors will switch out of preferred maturity segments if
premiums are adequate.

Interpreting the term structure

A common version of the expectations hypothesis holds that

forward interest rates are unbiased estimates of expected future
interest rates. However, there are good reasons to believe that
forward rates differ from expected short rates because of a risk
premium know as a liquidity premium. A liquidity premium can
cause the yield curve to slope upward even if no increase in
short rates is anticipated.

The existence of liquidity premiums makes it very difficult to

infer expected future interest rates from the yield curve. Such
an inference would be made easier if we could assume the
liquidity premium remains reasonable stable over time.
However, both empirical and theoretic; considerations cast
doubt on the constancy of that premium.

A pure yield curve could be plotted easily from a complete set

of zero-coupon bonds. In practice, however, most bonds carry
coupons, payable at different future times, so that yield-curve
estimates are often inferred from prices of coupon bonds.
Measurement of the term structure is complicated by tax issues
such as tax timing options and the different tax brackets of
different investors.

Forward rates as forward contracts

Forward rates are market interest rates in the important sense

that commitments to forward (deferred) borrowing or lending
arrangements can be made at these rates. Even though the
forward rates eventually won’t equal the realized interest rates
in the future.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Chapter 16 Managing Bond portfolios

In this chapter we will discuss several strategies bond portfolio
managers can pursue. We make the following distinction
between these strategies. Active and passive bond strategies.
Active strategies are strategies that trade on interest rate
predictions and trade on market inefficiencies. In contrast,
passive strategies focus on control risk and balance risk and
return. We will start with discussing interest rate risk and the
important concept of duration. Second, we will move to
convexity. Third, passive bond management. Fourth, active
bond management and finally interest rate SWAPS.

Interest rate risk

We have seen in the previous chapter that there is an inverse

relationship between bond prices and yields, and we know that
interest rate fluctuate. As we can imagine the sensitivity of bond
prices to changes in market interest rates is obviously of great
concern to investors. Six propositions underlie this sensitivity:
1. Bond prices and yields are inversely related: as yields
increase, bond prices fall; as yields fall, bond prices rise.
2. An increase in a bond’s yield to maturity results in a
smaller price change than a decrease in yield of equal
magnitude.
3. Prices of long-term bonds tend to be more sensitive to
interest rate changes than prices of short-term bonds.
4. The sensitivity of bond prices to changes in yields
increases at a decreasing rate as maturity increases . In
other words, interest rate risk is less than proportional to
bond maturity.
5. Interest rate risk is inversely related to the bond’s coupon
rate. Prices of high-coupon bonds are less sensitive to
changes in interest rates than prices if low-coupon
bonds.
6. The sensitivity of a bond’s price to a change in its yield is
inversely related to the yield to maturity at which the
bond currently is selling.

Duration
We need a measurement as guide to the sensitivity of a bond to
interest rate changes, because the price sensitivity tends to
increase with time to maturity. This measurement is called
duration.
Duration is the effective measure of the duration of a bond.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Duration is shorter than maturity for all bonds except zero

coupon bonds. Duration is equal to maturity for zero coupon
bonds.
For three reasons duration is a usefull concept for fixed-income
portfolio management. First it is a simple summary statistic of
the effective average maturity of the portfolio. Second, it is a
useful tool to immunize portfolios from interest rate risk. Third, it
is a measure of interest rate sensitivity.

In formula duration:
wt = éëCF t (1 + y ) ùû Pr ice
t

T
D= å t ´w
t =1
t
CFt = Cash Flow for period t

An example to calculate duration

8% time Payme PV of
bond years nt CF(10%) Weight C1*C4
0,5 40 38.095 0.395 0.0197
1 40 36.281 0.0376 0.0376
1,5 40 34.553 0.357 0.537
2 1040 855.611 0.8871 17.742
Sum 964.540 1 18.852 Duration

Duration price relationship

CPrice change is proportional to duration and not to maturity.

P/P = -D x [(1+y) / (1+y)
D* = modified duration
D* = D / (1+y)
P/P = - D* x y
Note the convexity of this function. The price-yield relationship
is a convex relationship. Convexity is the rate of change of the
slope of the curve as a fraction of the bond price:

Rules for duration

Rule 1: the duration of a zero-coupon bond equals its time to

maturity.
Rule 2: holding maturity constant, a bond’s duration is higher
when the coupon rate is lower.
Rule 3: holding the coupon rate constant, a bond’s duration
generally increases with its time to maturity.
Rule 4: holding other factors constant, the duration of a coupon
bond is higher when the bond’s yield to maturity is lower.
Rules 5: the duration of a level perpetuity is equal to: (1 + y )
y
 Samenvatting: Investments (Bodie, Kane & Marcus)

Different sort of durations:

Duration. A measure of the average life of a bond, defined as
the weighted average of the times until each payment is made,
with weights proportional to the present value of the payment.
Macauly’s duration. Effective maturity of bond, equal to
weighted average of the times until each payment, with weights
proportional to the present value of the payment.
Modified duration. Macauly’s duration divided by 1 + yield to
maturity. Measures the sensitivity of the bond.
Effective duration. Percentage change in bond price per
change in the level of market interest rates.

Convexity
As a measure of interest rate sensitivity, duration is a critical
tool in fixed-income portfolio management. But the duration rule
for the impact of interest rates on bonds is only an
approximation. The duration rule is a good approximation for
small changes in bond yield, but it is less accurate for large
changes. This point is illustrated in figure 16.4 on page 532.
The true price-yield relationship is a curvature. Curves with
shapes such as the price-yield relationship are said to be
convex, and the curvature of the price-yield curve is called the
convexity of the bond. As figure 16.4 shows we want to
compensate for the convex curvature of the bond. We do this
with the following formula:
1 n
é CFt ù
Convexity =
P ´ (1 + y ) 2
å ê (1 + y ) t
(t 2 + t ) ú
t =1 ë û

If we correct the formula for convexity we get:

DP
= - D * Dy + 1 [Conveixity ´ (Dy ) 2 ]
P 2

Investors think that convexity is a desirable characteristic of a

bond. The reason is that bonds with greater curvature gain
more in price when yields fall than they lose when yields rise.
Although convexity is desirable it is not available for free,
investors have to pay more and accept lower yields on bonds
with greater convexity.

Passive bond management

Passive fixed-income portfolio management has two broad
categories, indexing and immunization strategies.
 Samenvatting: Investments (Bodie, Kane & Marcus)

Bond indexing basically composes a portfolio that mirrors the

broad market and is similar to stock market indexing. Some
differences exist however. It is for example much more
complicated to keep track of the owners of bonds, and the
bonds available at the market change continuously. A cellular
approach is used to solve such practical problems.
Immunization strategies attempt to render the individual of firm
immune from movements in interest rates. This may take the
form of immunizing net worth or instead immunize the future
accumulated value if a fixed income portfolio. We can
accomplish immunization by matching the durations of assets
and liabilities. If we want to maintain an immunized position we
need to rebalance the portfolio over time, the reason is that as
time passes interest rates pass as well.
This classical approach to immunization also depends on
parallel shifts in a flat yield curve. Given that this assumption is
unrealistic, immunization generally will be less than complete.
To solve this problem, multifactor duration models can be used
to allow for variation in the shape of the yield curve. A more
direct form of immunization is dedication or cash flow matching.
If the portfolio is perfectly matched in cash flow with projected
liabilities, rebalancing will not be needed.

Active bond management

Active bond management could be divided in two broad
categories. First there is interest rate forecasting, when
managers use techniques to adjust their portfiolios to
movements across the markets. An example of such a
technique is horizon analysis, adjusting its strategies based on
a particular holding period.
The second categorie is searching for relative mispricing within
the fixed-income market. Interest rate swaps are common
techniques of active bond management:
Interest rate swaps are major recent developments in the fixed
income market. In these deals parties trade the cash flows of
different securities without actually exchanging any security
directly. This is a useful tool to manage the interest-rate
exposure of a portfolio. Five categories of swaps can be
identified:
4. Substation swaps (temporarily), using identical
substitutes.
5. Intermarket spread swaps (temporarily), when two
markets are temporarily out of line.
6. Rate anticipation swaps, closely linked to interest rate
forecasting.
7. Pure yield pickup swaps, just to increase returns
 Samenvatting: Investments (Bodie, Kane & Marcus)

8. Tax swaps, to exploit tax advantages.