Chapter 1: Introduction Investment: commitment of current resources in the expectation of deriving greater resources in the future Assets:

o Real: assets used to produce goods and services (ie land, equipment, building, knowledge) [determines the wealth of an economy]

o Financial: claims on real assets or the income generated by them (ie stocks and bonds) [represents claims on real assets]

Debt (fixed income or debt securities): pay a specified cash flow over a specific period Money market: short-term, highly marketable, and generally of very low risk (US T-bills, bank

certificates of deposit (CDs)) Capital market: long-term securities such as T-bonds, bonds issued by federal agencies, state and

local municipalities, and corporations; bonds risk ranges from default (T securities) to relatively risky (high-yield or “junk” bonds)

Equity: an ownership share in a corporation Equityholders are not promised any particular payment, but are paid dividends which is

dependent on the success of the firm Derivatives: securities providing payoffs that depend on the values of other assets (options and futures

contracts) Commodity and derivative markets allow firms to adjust their exposure to various business risks

Financial markets:o Informational roleo Consumption timingo Allocation of risko Separation of ownership and management

Avoiding agency problems: conflicts of interest between managers and stockholders Compensation plan Board of directors can force out underperforming management teams Outsiders monitor firms (security analysts and large institutional investors such as pension funds) Bad performers are subject to threats of takeover (shareholders changing board of directors)

o Corporate governance and corporate ethics Sarbanes-Oxley Act

Investment processo Asset allocation: allocation of an investment portfolio across broad asset classeso Security allocation: choice of specific securities within each asset class

Security analysis: analysis of the value of securitieso Strategies:

“top-down”: starts with the asset allocation decision – the allocation of funds across broad asset classes – and then progress to more specific security-selection decisions

“bottom-up”: constructed from the securities that seem attractively price without as much concern for the resultant asset allocation

The Market (no-free-lunch proposition)o Risk-return trade-off: assets with higher expected returns entail greater risko Efficient markets: the security price usually reflects all the information available to investors concerning the value

of the security in a quick and efficient manner Passive management: buying and holding a diversified portfolio without attempting to identify mispriced

securities Active management: attempting to identify mispriced securities or to forecast broad market trends

Players in the Financial Marketo Firms

Net demanders of capital Raise capital now to pay for investments in plant and equipment Income generated by those real assets provides the returns to investors who purchase the securities

issued by the firmo Household

Typically, suppliers of capital Purchase the securities issued by firms that need to raise funds

o Governments Borrowers or lenders, depending on relationship between tax revenue and government expenditures Has to borrow if they need to cover budget deficits (issuance of T-bills, notes and bonds)

o Financial intermediaries: institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers

pooling the resources of many small investors, they are able to lend considerable sums to large borrowers; by lending to many borrowers, intermediaries achieve significant diversification, so they can accept loans that individually might be too risky; intermediaries build expertise through the volume of business they do and can use economies of scale and scope to assess and monitor risk

investment companies: firms managing funds for investors; may manage several mutual fundso Investment bankers: firms specializing in the sale of new securities to the public, typically by underwriting the

issue Primary market: a market in which new issues of securities are offered to the public Secondary market: previously issued securities are traded among investors

o Venture capital and private equity Venture capital: money invested to finance a new firm Private equity: investments in companies that are not traded on a stock exchange

Chapter 5: Risk and Return Rates of return

o Holding-period return (HPR): rate of return over a given investment period

HPR= ending price−beginning price+cash dividendbeginning price

=dividend yield+capital gains yield

Assumption: dividends paid at the end of the holding period Dividend yield: the percentage return from dividends, cash dividends/beginning price

o Arithmetic average: the sum of returns in each period divided by the number of periodso Geometric average: the single-per-period return that gives the same cumulative performance as the sequence of

actual returnso Dollar-weighted average: the internal rate of return of an investment

APR and EARo Annual percentage rate (APR): annualizing per-period rates using a simple interest approach, ignoring

compounding interestAPR=per−period rate × periods per yearo Effective annual rate (EAR): compounded

EAR=(1+rate per period )n−1=(1+ APRn )

n

−1

o Conversion:Typeequationhere .

Expected return: the mean value of the distribution of HPR

E (r )=∑s=1

s

p ( s )r (s)

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

o Probability distribution [p(s)]: list of possible outcomes with associated probabilities Kurtosis: measure of the fatness of the tails of a probability distribution relative to that of a normal

distribution. Indicates likelihood of extreme outcomes Skew: measure of the asymmetry of a probability distribution

Variance:

Var (r )=σ2=¿ Standard deviation:

SD (r )=σ

Properties of investment management when returns are normally distributed:o The return on a portfolio comprising two or more assets whose returns are normally distributed also will be

normally distributedo The normal distribution is completely described by its mean and standard deviation. No other statistic is needed to

learn about the behavior of normally distributed returnso The standard deviation is the appropriate measure of risk of a portfolio of assets with normally distributed returns.

In this case, no static can improve the risk assessment conveyed by the standard deviation of a portfolio Value at risk (VaR): measure of downside risk. The worst loss that will be suffered with a given probability, often 5% Risk premium and aversion

o Risk-free rate: the rate of return that can be earned with certaintyo Risk premium: an expected return in excess of that on risk-free securitieso Excess return: rate of return in excess of the risk-free rateo Risk aversion: reluctance to accept risko Price of risk: the ratio of portfolio risk premium to variance

Sharpe (risk-to-volatility) ratio: ratio of portfolio risk premium to standard deviation

S= portfolio risk premiumstandard deviationof portfolio excess return

=E (r p )−r f

σ p

Mean-variance analysis: ranking portfolio by their Sharpe ratiosChapter 6: Diversification

Chapter 7: CAPM

Chapter 8: Efficient Market Hypothesis

Random walk: the notion that stock price changes are random and unpredictable Efficient market hypothesis (EMH): the hypothesis that prices of securities fully reflect available information about

securitieso Weak-form EMH: the assertion that stock prices already reflect all information contained in the history of past

trading Returns over short horizon: measuring serial correlation of stock market returns

Momentum effect: tendency of poorly performing stock and well-performing stocks in on period to continue that abnormal performance in following periods

Returns over long horizon Reversal effect: tendency of poorly performing stocks and well-performing stocks in one period

to experience reversals in the following periodo Semistrong-form EMH: the assertion that stock prices already reflect all publicly available information o Strong-form EMH: the assertion that stock prices reflect all relevant information, including inside informationo Implications:

Technical analysis: research on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market

Resistance level: a price level above which it is supposedly unlikely for a stock or stock index to rise

Support level: a price level below which it is supposedly unlikely for a stock or stock index to fall Fundamental analysis: research on determinants of stock value, such as earnings and dividends prospects,

expectations for future interest rates, and risk of the firmo Issues:

Magnitude Selection bias Lucky event

Portfolio management:o Passive investment strategy: buying a well-diversified portfolio without attempting to search out mispriced

securities

Index fund: a mutual fund holding shares in proportion to their representation in a market index such as the S&P 500

o