Chapter Summaries and Short Explanatory Notes for Investments by Bodie, Kane and Marcus
Prof. P.V. Viswanath, 1997


Chapter 1: The Investment Environment

The distinction between real and financial assets; our course will deal mainly with financial assets.

Real assets are net income-generating assets for society, whereas financial assets define the allocation of income among investors or members of society. Real assets only appear on the assets side of the balance sheet, whereas financial assets can appear on both sides of the balance sheet. In fact, if a financial asset appears on the asset side of one entity's balance sheet, it will appear on the liability side of the balance sheet of another entity. Examples of real assets are houses, plant & equipment, land, consumer durables, human knowledge. Examples of financial assets are stocks, bonds, mortgages, options.

The household sector, on net, holds financial assets, while the business sector, on net, issues financial assets. The main role of the government sector is to regulate the financial environment, although it, too, can hold and issue financial assets.

The material wealth of an economy is primarily determined by its real assets. Its financial assets are important in facilitating exchange of those assets and the income flow from those assets between people. Hence, the role of financial assets is secondary, though hardly unimportant. Given this distinction, it should be clear that , we should first look at real factors in trying to explain economic phenomena, and then at financial or nominal factors.

Problem 1, 2, 3, 4.

The financial environment responds to the needs of the different clienteles that comprise the economy.

Problem 7.

Different kinds of markets also come into being in response to investor and issuer needs:

New trends:

Problem 8, 9, 10.


Chapter 2: Markets and Instruments

The Money Market: Markets for Short Term Borrowing and Lending

Problems 2, 3, 4, 6.

The Fixed-Income Capital Market: Longer-term Borrowing Markets

Equity Securities

Stock and Bond Market Indexes

Problems 8, 9.

Derivative Markets

  • Options
    Webnotes on Options
  • Futures Contracts

    Problems 13, 14, 15, and 17.

  • Other Related links


    Chapter 3: How Securities are Traded

    How firms issue securities

    Problem 1

    Types of orders

    Problems 2, 3, 4.

    Alternative Trading Systems

    Problems 6, 7.

    Buying on Margin

    Webnotes on Margin Purchases
    Problems 11, 12.

    Short Selling

    Webnotes on Short Selling
    Problems 13, 14.

    Related Links


    Chapter 5: Interest Rates and Risk Premiums

    Interest Rates

    Interest rates reflect the price that an investor is paid for the use of his

    money over time. If r is the interest rate per period, then a riskless investment of $1 today will yield $(1+r) in one year. Consequently, the price that an investor will be willing to pay today for $1 in one year is 1/(1+r).

    It is easy to see that the interest rate will affect the price of assets, defined as cashflow generating machines. The other important element in the pricing of risky assets is the price of risk. We will first discuss interest rates (reflecting the price of riskless cashflows) and then the price of risk.

    Determinants of Interest Rates:

    Interest rates have two components, a reward for postponing consumption (real rate of interest), and a compensation for expected changes in the value of money (inflation) itself. We can write: r ; R - i, where r is the real rate of interest, R is the nominal rate of interest, and i is the inflation rate. If prices are expected to increase by 10%, then a nominal rate of interest of 15% implies a real rate of interest (rate of return measured in consumption goods, rather than in dollars) of 15 - 10 or 5%.

    The real interest rate is determined by

    As usual, the higher the reward for saving/cost of borrowing (real interest rate), the higher the supply of funds (upward sloping supply curve), and the lower the demand for funds (downward sloping demand curve). The intersection determines the equilibrium real interest rate. The Federal Reserve Bank can affect supply by an expansionary (increase supply of funds) or restrictive (decrease supply of funds) monetary policy.

    The equilibrium nominal interest rate is equal to the equilibrium real interest rate plus the expected rate of inflation.

    Problems 2, 3, 11.

    Risk and Return

    Define holding period return.

    We can now talk about the reward for bearing risk. Risk means uncertainty about future rates of return. This uncertainty is usually quantified as the variance of returns. Historically, classes of securities with higher return variances have yielded higher average returns as well.

    Problems 4, 5, 15, 16.

    However, the riskiness of a security has to be considered in the context of the portfolio in which the security is held. Sometimes movements in the value of a given security are offset by movements in the value of other securities. This reduces the uncertainty of a portfolio containing both those securities. Hence investors will be compensated only for certain kinds of risk (called non-diversifiable risk). We will see later how risk is properly defined and how we can define the relationship between risk and return.

    Problem 17.

    Arbitrage

    Another concept that is important in the pricing of assets is that of arbitrage. Arbitrage is the pricing of an asset at one price and simultaneously selling it (or its equivalent) at a higher price. Obviously, arbitrage possibilities cannot exist in a well-functioning market. This is another concept that is used in asset pricing. For example, the cash flows from stock options can be replicated by portfolios of stocks and bonds. Clearly, this implies that the option can be priced off the stocks and the bonds.


    Chapter 6: Risk and Risk Aversion

    We start out looking at risk from an individual's point of view and the end up in Chapter 8 with a look at risk and return from a market point of view.

    Problem 1.

    We saw in chapter 4 that risk can be measured by variance of return. The reward for bearing this variance risk is a higher return on average. Depending on one's aversion to risk, some investors might demand a higher expected return and others, not so high an expected return for a given level of risk. If we assume that a higher expected return is a good and variance uncertainty is a bad, we can score the desirability of an investment portfolio using utility functions (5.1).

    Problem 2.

    The notion of indifference curves. The y-intercept of a given indifference curve can be thought of as the certainty equivalent of all the portfolios located on that indifference curve.

    Problems 3, 7, 8, 9.

    Asset risk versus portfolio risk. Example with two risky investments: a consumer of sugar, and a producer of sugar.
    Covariance measures the degree to which two assets move together.

    Problems 13, 14 and 15.


    Chapter 7: Capital Allocation Between the Risky Asset and the Risk-Free Asset

    In the last chapter, we learnt about risk and return. Ultimately, we will systematize our understanding of the relationship between risk and return. Before going on, however, we need to develop some portfolio mathematics. Fortunately, we can also learn about asset-allocation while we are about it.

    Capital Allocation across risky and risk-free portfolios.

    We know that investing in stocks is can be risky. However, we can reduce the risk somewhat by investing in riskfree securities. How do we figure out the optimal amount to invest in risky stocks as opposed to the riskfree asset?

    Definition of portfolio weights

    Portfolios of one risky asset and one riskfree asset

    Problems 1, 2, 19, 20
  • Generation of the capital allocation line
    Problems 3, 4
  • The choice of optimal portfolio weights
    Problems 5, 6, 7
  • The arguments for a passive investment strategy

    Problems 8, 9

    The Capital Market Line

    Computer Exercises

    Classroom Project: Portfolio Analysis with two assets

    Webnotes on Capital Allocation Between a Risky Asset and a Riskless Asset


    Chapter 8: Optimal Risky Portfolios

    Diversification and Portfolio Risk

    Problems 15, 16 and 17

    Portfolios of Two Risky Assets

    Portfolios of Two Risky Assets and One Riskless Asset

    Problems 6, 7, 21.

    Portfolios consisting of all risky assets

    How to construct a portfolio of risky assets.

    Webnotes on Techniques for Constructing Efficient Portfolios
    Excel file demonstrating how to compute an optimal portfolio with > 2 assets

    Computer Exercises

    Classroom Project: Portfolio Analysis with more than two assets.

    Webnotes on Optimal Risky Portfolios


    Chapter 9: The Capital Asset Pricing Model

    The CAPM gives us an equilibrium relationship between risk and expected return. Two things should be noted regarding this relationship:

    An integrated presenation of the equilibrium relationship between risk and return starting with the concept of probability can be found in my Webnotes on Determination of the Discount Rate for Risky Assets.

    Assumptions of the CAPM:

    Implications of the CAPM:

    Discussion of the CAPM

    Webnotes on the Capital Asset Pricing Model
    Demonstration of CAPM (in Excel)

    Problems 3, 5, 6-12, 22, 23, 24.

    Computer Exercises

    Classroom Project: Beta Computation
     

    Chapter 14: Bond Prices and Yields

    A brief discussion of the issues and concepts below can be found in my Webnotes on Bonds: Description and Introduction to Pricing. Note that these notes are in Rich Text Format (RTF). Can be read with Word for Windows and many other word-processing programs, such as WordPad.

    What is a bond?

    Types of bonds

    Problem 22, 26.

    Bond Pricing

    Webnotes on Valuing Bonds

    Problems 2, 3, 5, 7, 9, 16, 19

    Bond Prices over time


    Chapter 15: The Term Structure of Interest Rates

    An integrated description of bonds, their pricing, the term structure of interest rates, and bond portfolio management can be found in my Webnotes on Bond Pricing, Term Structure of Interest Rates, and Interest Rate Management. Note that this is in Word format. Click here for information on downloading.

    Bond Pricing

    Problems 5, 6, 13,

    Measuring the term structure

    Computer exercise
    Excel file on estimating forward rates

    Interest Uncertainty and forward rates

    Problems 2, 3, 17.


    Chapter 16: Fixed-Income Portfolio Management

    A detailed discussion of Fixed-Income Portfolio Management can be found in my Webnotes.

    Interest rate risk

    Problems 1, 2, 6, 7

    Immunization

    Problems 11, 12, 13, 14

    Active Bond Management Strategies

    Problem 17, 18.


    Chapter 18: Equity Valuation Models

    Much of the material for this chapter is taken from Aswath Damodaran's book on Corporate Finance, Chapter 23, titled Basics of Valuation. A more detailed version of these notes can be found in My Webnotes on Equity Valuation. A simpler, more introductory approach to Stock Valuation can be found in my Webnotes on Valuing Stocks.

    There are two basic approaches to Valuation:

    However, one must recognize that all valuation is ultimately relative, and there are elements of relative valuation in discounted cashflow valuation as well, although this may sometimes be implicit.

    Discounted Cash-flow Valuation

    The value of any asset is the present value of its expected cash flows.

    Equity Valuation vs. Firm Valuation

    The value of equity is the value of the equity stake in a business. In the context of a publicly traded firm, it is the value of the common stock in the firm.

    The value of the firm is the total value of debt and equity in a business.

    Equity Valuation Models:

    Dividend Discount Model:

    The value of stock is the present value of dividends per share through infinity.

    A certain pattern of dividends has to be assumed before this general model can be implemented to estimate the value of equity.

    The most common assumption is that dividends will have a period of extraordinary growth followed by stable growth forever. This model needs four inputs:

    Expected dividends during the high growth period can be estimated by first estimating expected earnings and then the dividend payout ratio; expected dividends are the product of the two. Expected earnings can be estimated by three appproaches:

    FCFE Valuation Model:

    This model estimates the value of euqiyt as the present value of the expected free cashflows to equity over time.

    FCFE = Net Income + Depreciation - Capital Expenditure - Change in Non-cash Working capital - Principal Repayments + New Debt issues.

    As in the dividend discount model, there are four basic inputs to the model. A two-stage model similar to the dividend model is used here as well.

    The FCFE Valuation method will provide identical estimates to the Dividend discount model when:

    Often, the FCFE estimate is higher; the difference can provide valuable information about the firm's investment, financing and dividend policy.

    FCFF (Free cash flow to the firm) Valuation Model:

    The FCFF can be estimated as:

    FCFF = Free cash flow to Equity + Interest expense (1 - tax rate) + Principal repayments - New debt issues + Preferred dividends.

    FCFF = EBIT(1-tax rate) + Depreciation - Capital Expenditure - change in working capital

    A two stage model similar to the FCFE model is used, except that the free cash flows are discounted at the firm's weighted average cost of capital. The growth rate in the FCFE model is usually greater than the growth rate in the FCFF model because of the existence of financial leverage.

    The value of equity can be computed as the firm value less the value of debt less the value of preferred stock.

    Discounted Cash-flow estimation may be difficult or impossible to use in the following circumstances:

    Relative Valuation

    The value of an asset is derived from the pricing of "comparable" assets, standardized using a common variable such as earnings, cash flows, book value, or revenues.

    Ways of using multiples

    Multiples can be misused because of the difficulty of finding comparables.


    Chapter 24: Portfolio Performance Evaluation

    A more detailed discussion of these issues can be found in my Webnotes on Portfolio Evaluation.

    Measuring Investment Returns

    Conventional Performance Evaluation

    Performance Attribution Procedures

    Components of Investment Performance

    Market Timing


    Learning Objectives:

    Chap What you should know after completing the chapter 
    Warning! This is not an exhaustive listing
    1: Differences between real and financial assets 
    the relationships between different market sectors 
    Markets and securities evolve to meet the needs of the different sectors. 
    2 the different financial instruments available to the investor 
    the interpretation, composition and calculation of different market indexes 
    the basics of options and futures contracts 
    3 How securities are traded on the primary and secondary markets 
    the mechanics, risk and calculations involved in margin and short trading. 
    What are mutual funds? 
    5 The determinants of real and nominal interest rates 
    The effect of inflation on nominal interest rates 
    Computation of expected return and standard deviation for various investment alternatives. 
    The law of one price and the implications for arbitrage opportunities. 
    6 Risk and Risk aversion 
    Risk, speculation and gambling 
    Risk aversion and utility values 
    Asset risk versus portfolio risk 
    The statistical measure of portfolio risk 
    7 Risk reduction and the risk-free asset 
    portfolios of one risky and one risk-free asset 
    risk tolerance and asset allocation 
    Passive investment strategies using the capital market line 
    8 Diversification and portfolio risk 
    Creating Optimal Portfolios Using the Markowitz security selection algorithm 
    The separation property of asset allocation 
    9 The theory of the Capital Asset Pricing Model 
    Construction and use of the security market line 
    Extensions of the CAPM to allow for liquidity differences across stocks 
    14 Pricing, characteristics and risk determinants of bonds 
    Calculation of yields and prices of different kinds of bonds 
    15 The term structure of interest rates under certainty and under uncertainty 
    The three term structure hypotheses. 
    16 Duration and bond price sensitivity 
    Passive and Active Bond Portfolio strategies: their uses and their limitations. 
    18 Dividend Discount Model (DDM) 
    Gordon Growth Model 
    Combining P/E ratio forecasts and the DDM 
    25 The different measures of portfolio evaluation 
    Factors affecting portfolio performance: risk, timing, asset allocation, and security selection.Different ways of computing portfolio returns 
    28 Evaluation of the market timing ability of portfolio managers 
    Treynor-Black model of efficient security analysis 
    Security analysis in multifactor security models. 

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