Part 1 Introduction 1 Chapter 1 Introduction 2 Outline of the Book 2 The Economic Theory of Choice: An Illustration under Certainty 4 Conclusion 8 Multiple Assets and Risk 8 Questions and Problems 9 Bibliography 10 Chapter 2 Financial Securities 11 Types of Marketable Financial Securities 11 The Return Characteristics of Alternative Security Types 19 Stock Market Indexes 21 Bond Market Indexes 22 Conclusion 23 Chapter 3 Financial Markets 24 Trading Mechanics 24 Margin 27 Markets 30 Trade Types and Costs 36 Conclusion 38 Part 2 PORTFOLIO ANALYSIS 39 Section 1 Mean Variance Portfolio Theory 41 Chapter 4 The Characteristics of The Opportunity Set Under Risk 42 Determining the Average Outcome 43 A Measure of Dispersion 44 Variance of Combinations of Assets 47 Characteristics of Portfolios in General 50 Two Concluding Examples 59 Conclusion 62 Questions and Problems 62 Bibliography 64 Chapter 5 Delineating Efficient Portfolios 65 Combinations of Two Risky Assets Revisited: Short Sales Not Allowed 65 The Shape of the Portfolio Possibilities Curve 74 The Efficient Frontier with Riskless Lending and Borrowing 81 Examples and Applications 85 Three Examples 89 Conclusion 92 Questions and Problems 92 Bibliography 93 Chapter 6 Techniques for Calculating The Efficient Frontier 95 Short Sales Allowed with Riskless Lending and Borrowing 96 Short Sales Allowed: No Riskless Lending and Borrowing 100 Riskless Lending and Borrowing with Short Sales Not Allowed 100 No Short Selling and No Riskless Lending and Borrowing 101 The Incorporation of Additional Constraints 102 An Example 103 Conclusion 106 Appendix A: An Alternative Definition of Short Sales 106 Appendix B: Determining the Derivative 107 Appendix C: Solving Systems of Simultaneous Equations 111 Appendix D: A General Solution 114 Appendix E: Quadratic Programming and Kuhn-Tucker Conditions 118 Questions and Problems 121 Bibliography 122 Section 2 Simplifying The Portfolio Selection Process 125 Chapter 7 The Correlation Structure Of Security Returns--The Single-Index Model 126 The Inputs to Portfolio Analysis 127 Single-Index Models: An Overview 128 Characteristics of the Single-Index Model 133 Estimating Beta 135 The Market Model 148 An Example 149 Questions and Problems 150 Bibliography 152 Chapter 8 The Correlation Structure Of Security Returns--Multi-Index Models And Grouping Techniques 155 Multi-index Models 156 Average Correlation Models 162 Mixed Models 163 Fundamental Multi-index Models 163 Conclusion 169 Appendix A: Procedure for Reducing Any Multi-index Model to a Multi-index Model with Orthogonal Indexes 169 Appendix B: Mean Return, Variance, and Covariance of a Multi-index Model 170 Questions and Problems 172 Bibliography 173 Chapter 9 Simple Techniques for Determining The Efficient Frontier 176 The Single-index Model 177 Security Selection with a Purchasable Index 188 The Constant Correlation Model 189 Other Return Structures 192 An Example 192 Conclusion 193 Appendix A: Single-index Model--Short Sales Allowed 194 Appendix B: Constant Correlation Coefficient--Short Sales Allowed 196 Appendix C: Single-index Model--Short Sales Not Allowed 197 Appendix D: Constant Correlation Coefficient--Short Sales Not Allowed 199 Appendix E: Single-index Model, Short Sales Allowed, and a Market Asset 201 Questions and Problems 201 Bibliography 202 Section 3 Selecting The Optimum Portfolio 205 Chapter 10 Estimating Expected Returns 206 Aggregate Asset Allocation 206 Forecasting Individual Security Returns 212 Portfolio Analysis with Discrete Data 214 Appendix: The Ross Recovery Theorem--A New Approach to Using Market Data to Calculate Expected Return 215 Bibliography 218 Chapter 11 How to Select Among The Portfolios In The Opportunity Set 220 Choosing Directly 220 An Introduction to Preference Functions 221 Risk Tolerance Functions 224 Safety First 226 Maximizing the Geometric Mean Return 232 Value at Risk (VaR) 234 Utility and the Equity Risk Premium 235 Optimal Investment Strategies with Investor Liabilities 237 Liabilities and Safety-First Portfolio Selection 241 Simulations in Portfolio Choice 241 Conclusion 247 Appendix: The Economic Properties of Utility Functions 247 Relative Risk Aversion and Wealth 249 Questions and Problems 249 Bibliography 250 Section 4 Widening the Selection Universe 255 Chapter 12 International Diversification 256 Historical Background 257 Calculating the Return on Foreign Investments 257 The Risk of Foreign Securities 261 Market Integration 267 Returns from International Diversification 268 The Effect of Exchange Risk 269 Return Expectations and Portfolio Performance 270 Emerging Markets 272 Other Evidence on Internationally Diversified Portfolios 276 Sovereign Funds 278 Models for Managing International Portfolios 280 Conclusion 283 Questions and Problems 284 Bibliography 285 Part 3 Models of Equilibrium in The Capital Markets 289 Chapter 13 The Standard Capital Asset Pricing Model 290 The Assumptions Underlying the Standard Capital Asset Pricing Model (CAPM) 290 The CAPM 291 Prices and the CAPM 300 Conclusion 302 Appendix: Appropriateness of the Single-Period Asset Pricing Model 304 Questions and Problems 308 Bibliography 309 Chapter 14 Nonstandard Forms of Capital Asset Pricing Models 311 Short Sales Disallowed 312 Modifications of Riskless Lending and Borrowing 312 Personal Taxes 322 Nonmarketable Assets 324 Heterogeneous Expectations 326 Non-Price-Taking Behavior 327 Multiperiod CAPM 327 The Multi-beta CAPM 328 Consumption CAPM 328 Conclusion 330 Appendix: Derivation of the General Equilibrium with Taxes 331 Questions and Problems 333 Bibliography 334 Chapter 15 EMPIRICAL TESTS OF EQUILIBRIUM MODELS 340 The Models--Ex Ante Expectations and Ex Post Tests 340 Empirical Tests of the CAPM 341 Testing Some Alternative Forms of the CAPM Model 352 Testing the Posttax Form of the CAPM Model 353 Some Reservations about Traditional Tests of General Equilibrium Relationships and Some New Research 356 Conclusion 358 Questions and Problems 359 Bibliography 360 Chapter 16 The Arbitrage Pricing Model Apt--A Multifactor Approach To Explaining Asset Prices 364 APT--What Is It? 364 Estimating and Testing APT 369 APT and CAPM 381 Recapitulation 382 Term Structure Factor 392 Credit Risk Factor 392 Foreign Exchange [FX] Carry 393 Value Factor 393 Size Factor 393 Momentum Factor 393 Volatility Factor 394 Liquidity Factor 394 Inflation Factor 395 GDP Factor 395 Equity Risk Premium 396 Limitations of Factor Investing 396 Factor Investing Summary 397 Conclusion 397 Appendix A: A Simple Example of Factor Analysis 397 Appendix B: Specification of the APT with an Unobserved Market Factor 399 Questions and Problems 400 Bibliography 401 Part 4 Security Analysis and Portfolio Theory 409 Chapter 17 Efficient Markets 410 Early Development 411 The Next Stages of Theory 412 Recent Theory 414 Some Background 415 Testing the EMH 416 Tests of Return Predictability 417 Tests on Prices and Returns 417 Monthly Patterns 419 Announcement and Price Return 431 Methodology of Event Studies 432 Strong-Form Efficiency 437 Market Rationality 440 Conclusion 442 Questions and Problems 442 Bibliography 443 Chapter 18 The Valuation Process 454 Discounted Cash Flow Models 455 Cross-Sectional Regression Analysis 467 An Ongoing System 471 Conclusion 476 Questions and Problems 476 Bibliography 477 Chapter 19 Earnings Estimation 481 The Elusive Number Called Earnings 481 The Importance of Earnings 484 Characteristics of Earnings and Earnings Forecasts 487 Conclusion 495 Questions and Problems 496 Bibliography 496 Chapter 20 Behavioral Finance, Investor Decision Making, and Asset Prices 499 Prospect Theory and Decision Making under Uncertainty 499 Biases from Laboratory Experiments 502 Summary of Investor Behavior 505 Behavioral Finance and Asset Pricing Theory 506 Bibliography 513 Chapter 21 Interest Rate Theory And The Pricing Of Bonds 517 An Introduction to Debt Securities 518 The Many Definitions of Rates 519 Bond Prices and Spot Rates 526 Determining Spot Rates 528