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PART ONE1

BACKGROUND1

1 Introduction to Modern Investment Theory1

PART ONE1

BACKGROUND1

1 INTRODUCTION TO MODERN INVESTMENT THEORY1

CHAPTER 1 The Function of Financial Markets1

Savings-Investment Foundation1

Efficiency of Financial Markets2

THE DEVELOPMENT OF MODERN INVESTMENT THEORY2

Stages of Efficiency3

Financial Assets3

WHY SHOULD YOU LEARN MODERN INVESTMENT THEORY?4

The Role of Financial Intermediaries5

2 SECURITIES AND MARKETS6

Bank Discount Rate6

2 Securities and Markets6

Government Bonds7

SECURITIES7

Disintermediation and Securitization8

Financial Innovation9

Country Efficiency9

The Catalyst for Change10

Types of Innovations11

The Implications of Savings11

Corpotate Fixed Income Securities11

Sensitivity of Price to Various Properties12

Degrees of Moneyness13

Interest Rates and Arbitrage Efficiency14

Corporate Stock14

Summary15

Selected References15

The Structure of the System17

CHAPTER 2 The Flow-of-Funds System17

Sectoring18

The Preparation of a Matrix and Its Use20

Forwrd and Futures Contracts20

Options and Warrants20

Federal Reserve Flow-of-Funds Data21

The Shares of Investment Companies and Mutual Funds22

Credit Flows23

Market Pressure to Assume Equilibrium Prices24

The Difference Between Primary and Secondary Markets24

THE FINANCIAL MARKETS24

Implications of Analysis25

Organizde Exchanges for Common Stock and Bonds25

Summary27

Organized Exchanges for Futures Contracts27

Organized Exchanges for Options27

Selected References28

The Individual Choice29

The Interest Rate in an Exchange Economy29

CHAPT ER 3 Foundations for Interest Rates29

The Over-the -Counter Market30

Computerized Trading Techniques30

Optimum with Exchange31

Combined Effect33

SUMMARY34

Market Equilibrium35

3 Some Statistical Concepts38

3 SOME STATISTICAL CONCEPTS38

Behavior of Individual Economic Units39

Interest Rates in a World with Risk39

THE SIMPLE OR MARGINAL PROBABILITY DISTRIBUTION39

The Population Expected Value and Variance40

The Sample Mean and Variance40

Utility for Financial Assets40

THE JOINT PROBABILITY DISTRIBUTION42

Utility for Other Assets42

Utility for Financial Liabiliues42

The Sample Covariance43

Market Equilibrium43

Maximizing Utility for the Economic Unit44

The Action of All Economic Units45

Summary46

The Population Covariance46

Appendix：The Equilibrium Prices of Financial Assets47

The Correlation Coefficient48

Market Equilibrium：Two Economic Units50

The Coefficient of Detemination50

THE RELATIONSHIP BETWEEN A STOCK AND THE MARKET PORTFOLIO51

Market Equilibrium：Multiple Financial Assets51

The Charaeteristie Line52

The Beta Factor53

Selected References53

Residual Variance54

CHAPTER 4 Prices and Yields for Bonds and Money Market Instruments55

Review of Present Values55

Present Value When Interest Is Compounded More Than Once a Year56

Annuities56

SUMMARY57

Coupons and Principal Payments57

The Price of a Bond57

Continuous Compounding57

Price When Next Coupon Payment Is Less Than Six Months Away58

Zero-Coupon Bonds60

Yield Calculations for Bonds60

Holding Period Return61

Current Yield61

Implicit Reinvestment Rate Assumption61

Yield for Perpetuilies62

Yield-to-Maturity for Zero-Coupon Bonds62

Money Market Instrument Returns63

Summary64

Implications64

Selected References65

CHAPTER 5 Inflation and Returns66

PART TWO66

PORTFOLIO MANAGEMENT66

4 COMBINING INDIVIDUAL SECURITIES INTO PORTFOUOS66

The Historical Record in Brief66

4 Combining Individual Securities into Portfolios66

PORTFOLIO MANAGEMENT66

PART TWO66

THE RISK AND EXPECTED RETURN OF A PORTFOLIO68

The Portfolio s Rate of Return68

The Portfolio s Expected Rate of Return69

The Nature of Inflation Premiums69

Unanticipated Inflation70

The Portfolio s Variance70

COMBINATION LINES72

The Fisher Effect72

Nominal Interest Rates and Inflation, Theoretically73

Empirical Evidence on Nominal Interest Rates74

Problems in Empirical Testing74

Testing for the Effect of Inflation75

The Cases of Perfect Positive and Negative Correlation75

The Fisher Effect More Directly77

A Summing Up77

Nominal Contracting Effects77

Debtor-Creditor Claims78

Depreciation78

Inventories78

The Mechanics79

Inflation Indexed Bonds79

Empirical Testing79

Corporate Value79

Other Aspects80

Summary80

Borrowing and Lending at a Risk-Free Rate80

SUMMARY81

Selected References81

APPENDIX1：FORMULAS FOR THE EXPECTED RATE OF RETURN AND VARIANCE OF A PORTFOLIO82

Definition of Term Structure83

CHAPTER 6 The Term Structure of Interest Rates83

The Pure Expectations Theory84

Forward Rates of Interest85

Substitutability of Maturities86

Technical Problems87

Arbitruge and Market Efficiency88

Uncertainty and Term Premiums89

Market Segmentation90

5 FINDING THE EFFICIENT SET92

Term Structure Implications92

General Equilibrium Notions92

5 Finding the Efficient Set92

Cox-Ingersoll-Ross Theory92

THE MINIMUM VARIANCE AND EFFICIENT SETS93

Other Models of the Term Structure93

Multifactor Models94

FINDING THE EFFICIENT SET WITH SHORT SELLING94

Lattice-Type Models95

The Isoexpected Return Lines96

Summary97

Empirical Evidence97

Selected References98

The Isovariance Ellipses99

The Critical Line101

The Coupon Effect101

CHAPTER 7 Price Volatility, Coupon Rate, and Maturity101

The Duration Measure and Its Changing Behavior103

Relationship between Duration and Maturity105

FINDING THE MINIMUM VARIANCE WITHOUT SHORT SELLING106

Relationship between Duration and Changes in Interest Rates106

Relationship between Duration and Coupon Payment106

Volatility Duration108

Modified Duration Formula109

Convexity109

TWO IMPORTANT PROPERTIES OF THE MINIMUM VARIANCE SET109

The Convexity Measure110

Illustration of Price-Change Estimates Using Modified Duration and Convexity111

Further Observations on Convexity112

Immunization of Bond Portfolios113

Immunization with Coupon Issues114

An Illustration114

Fisher-Weil Duration116

Mapping the Stochastic Process116

Testing for Immunization Effectiveness117

Additional Immunization Considerations118

Equilibration between Coupon and Noncoupon Bond Markets118

Coupon Stripping119

SUMMARY119

Term Structure of Pure Discount Bonds120

APPENDIX2：A THREE-DIMENSIONAL APPROACH TO FINDING THE EFFICIENT SET120

Arbitrage Efficiency between the Markets120

Summary122

Selected References123

CHAPTER 8 The Default-Risk Structure of Interest Rates125

Promised, Realized, and Expected Rates125

Distribution of Possible Returns126

APPENDIX3：USING LAGRANGIAN MULTIPLIERS TO FIND THE MINLMUM VARIANCE SET128

Empirical Evidence on Default Losses128

APPENDIX4：PROOF OF PROPERTY II130

Credit Ratings and Risk Premiums131

Some Studies of Bond Ratings132

Cyclical Behavior of Risk Premiums133

APPENDIX5：UTILITY AND RISK AVERSION134

The Market Segmentation Effect135

Issuers and Use in Acquisitions137

Development of the Market137

Speculative-Grade（Junk）Bonds137

Risk versus Return138

Event Risk139

Empirical Evidence141

Risk Structure and the Term Structure141

Summary143

Selected References144

Introduction to Contract146

CHAPTER 9 Derivative Securities：Interest-Rate Futures146

Features of Futures Markets148

Margin Requirements148

Money Market Instruments148

Quality Delivery Options149

Longer-Term Instruments149

Marking-to-Market and Price Movements149

Hedging and Speculation151

Some Hedging Fundumentals151

Futures and Spot Prices152

Long Hedges152

6 FACTOR MODELS152

6 Factor Models152

FACTOR MODELS TO ESTIMATE VOLATILITY OF RETURN153

The Single -Factor Model153

Hedge Rations154

Short Hedges155

Basis Pisk155

The Single-Factor Model s Simplified Formula for Portfolio Variance155

More on Basis Risk156

Sources of Basis Risk158

Market Efficiency158

Possible Reasons for Deviation of Forward and Futures Rates159

Summary160

An Example Where the Single-Factor Model Works160

Selected References161

An Example of a Potential Problem with the Single-Factor Model163

CHAPTER 10 Derivative Securities：Options163

Option Valuation163

Expiration Date Value of an Option164

Multifactor Models165

Valuation Prior to Expiration165

Estimating Portfolio Variance Using a Multifactor Model：An Example167

Hedging with Options168

Black -Scholes Option Model169

MODELS FOR ESTIMATING EXPECTED RETURN171

Debt Options172

Features of Futures Options172

Use of Debt Options173

Caps, Floors, and Collars174

Valuation of Debt Options175

Firm Characteristics（Factors）That Induce Differentials in Expected Returns176

Yield Curve Options177

Estimating and Projecting Factor Payoffs178

Debt Plus Option Characteristic179

Conversion Price/Ratio179

Convertible Securities179

A Test of the Accuracy of Expected Return Factor Models180

Value of Convertible Securities180

Premiums181

Simulating the Performance of the Expected Return Factor Model182

Summary183

Other Reasons for Premiums183

SUMMARY184

Appendix A：Put-Call Parity184

Appendix B：Application of Option Pricing Concepts to Valuing Convertible Securities186

Selected References190

CHAPTER 11 Derivative Securities：Swaps192

Swap Features192

An Illustration193

Valuation Issues194

Comparative Advantage194

Completing Markets195

Default Risk195

PART THREE196

7 THE CAPITAL ASSET PRICING MODEL196

RISK，EXPECTED RETURN，AND PERFORMANCE MEASUREMENT196

Skirting Tax Laws and Regulations196

PART THREE196

RISK，EXPECTED RETURN，AND PERFORMANCE MEASUREMENT196

7 The Capital Asset Pricing Model196

THE ASSUMPTIONS OF THE CAPITAL ASSET PRICING MODEL197

AssumptionⅠ：Investors Can Choose Between Portfolios on the Basis of Expected Return and Variance197

Credit Risk, Maturity, and Systemic Risk197

Swap Valuation：A Summing Up197

Default Provisions198

Value at Risk199

Secondary Market Values200

Assumption Ⅲ：There Are No Frictions in the Capital Market201

AssumptionⅡ：All Investors Are in Agreement Regarding the Planning Horizon and the Distributions of201

Summary201

Swaptions201

The Capital Market Line202

THE CAPITAL ASSET PRICING MODEL WITH UNLIMITED BORROWING AND LENDING AT A RISK-FREE RATE202

Selected References202

Option-Adjusted Spreads203

CHAPTER 12 Embedded Options and Option-Adjusted Spreads203

An Illustration204

The Basic Methodology204

The Nature of the Call Feature205

Forms of the Provision206

The Relationship Between the Risk of an Asset and Its Expected Rate of Return206

Putable Bonds207

Redemption versus Callability207

The Call Featrure s Valuation208

The Positioning of Characteristic Lines under the Capital Asset Pricing Model208

Interest-Rate Expectations209

The Positions of Individual Assets in Expected Return, Standard Deviation Space209

The Call Feature and Convexity210

Valuation in an Option Pricing Context211

Empirical Evidence on Call Valuation212

The Sinking Fund212

Characteristics of the Provision213

Value of the Sinking Fund214

Empirical Evidence215

Summary215

Selected References216

THE CAPITAL ASSET PRICING MODEL WITH NO RISK-FREE ASSET217

CHAPTER 13 Mortgage Securities and Prepayment Pisk217

Some Features of Mortgages217

Mortgage Pass-Through Security218

Agency Pass-Throughs218

Nonagency Pass-Throughs219

Mortgage Derivatives219

THE CAPITAL ASSET PRICING MODEL WHEN A RISK-FREE ASSET EXISTS BUT WE CAN T SELL IT220

Collateralized Mortgage Obligations（CMOs）220

Floaters and Inverse Floaters221

Stripped Mortgage-Backed Securities221

Planned Amortization Class（PAC）and Targeted Amorization Class（TAC）Securities221

Prepayment Option and Its Valuation222

Prepayment and Convexity222

SUMMARY222

Measures of Prepayment223

Coupon Rate and Age224

Additional Factors Explaining Prepayment225

Modeling Prepayment Experience226

Prepayment Behavior of Certain Derivatives227

Planned Amortization Class Securities227

Optiion-Adjusted Spread Approach227

Other Asset-Backed Securities230

Summary230

Selected References231

8 Empirical Tests of the Capital Asset Pricing Model232

8 EMPIRICL TESTS OF THE CAPITAL ASSET PRICING MODEL232

Risk and Return form Foreign Investment233

The Black Jensen, and Scholes Test（1972）233

CHAPTER 14 Controlling Currency Risk233

EARLY TESTS OF THE CAPITAL ASSET PRICING MODEL233

Exchange Rate Risk Management234

Forward Exchange Market235

The Fama-MacBeth Study（1974）235

Illustration of Spot and Forward Exchage Rates236

A Single European Currency（Euro）236

Underlying Relationships238

The Law of One Price238

Purchasing Power Parity238

ROLL S CRITIQUE OF TESTS OF THE CAPITAL ASSET PRICING MODEL238

Previous Tests as Tautologies239

Interest -Rate Parity240

Interest-Rate Parity Approximation242

Covered Interest Arbitrage242

Can the Capital Asset Pricing Model Ever Be Tested?243

Empirical Evidence Concerning Interest-Rate Parity（IRP）243

Currency Options244

Currency Futures244

Other Ways to Shift Risk244

Currency Swaps245

THE OTHER SIDE OF THE ISSUE245

Tautologies Can t Prediet the Future245

Valuation Implications246

Currency/Interest-Rate Swaps246

Can You Reject the CAPM if You Find No Efficient Portfolios with Positive Portfolio Weights?247

The Amount to Hedge248

The Cost of Curreucy Hedging248

Sensitivity Analysis to Alernative Market Indices248

MORE RECENT TESTS OF THE CAPM248

Testing a Contained CAPM248

Black s Universal Hedging249

Closing Thoughts249

Currency-Option and Multiple-Currency Bonds250

Some Institutional Characteristics250

Euro and Foreign Bonds250

Summary251

Selected References252

SUMMARY254

CHAPTER 15 The Influence of Taxes254

Tax Treatment of Capital Gains255

Original Issue Discount（OID）Bonds255

Capital Gains Treatment for Taxable Coupon Bonds256

The De Minimis Rule257

Capital Gains Treatment for Municipal Bonds257

Tax Timing Options257

9 The Arbitrage Pricing Theory258

9 THE ARBITRAGE PRICING THEORY258

Municipal Bonds and the Taxation of Interest Income258

The Nature of the Municipal Market259

Taxable versus Tax-Exempt Yields259

DERIVING THE ARBITRAGE PRICING THEORY259

The APT with an Infinite Number of Securities260

Value of the Tax Exemption Feature261

Variation of Implied Tax Rate262

The Effect of Tax Reform and Supply263

Implied Tax Rate and Maturity263

Preferred-Stock Taxt Effects264

Straight Preferred-Stock Investments264

Auction-Rate Preferred Stock265

The APT with a Finite Number of Securities265

Summary266

Selected References266

EMPIRICAL TESTS OF THE APT267

Intial Empirical Tests267

The Issues Involved268

CHAPTER 16 The Social Allocation of Capital268

Is the APT Testable in Principle?268

Ceilings on Borrowing Costs269

The Effect of Usury Laws270

THE CONSISTENCY OF THE APT AND THE CAPM270

The Negatives of Interest-Rate Ceilings271

SUMMARY271

Government Guarntees and Insurance272

The Transfer of Underlying Risk273

Interest-Rate Subsidies274

Option-Pricing Valuation274

The Effect of the Subsidy274

Effectiveness of the Subsidy275

Financial Intermediation Through Borrowing and Relending276

The Situation Illustrated277

Regulations Affecting Investor and Borrowet Behavior278

The Effect of Government Intermediation278

The Effectiveness of This Approach279

The Costs to Society279

Qualificatiion for Tax-Exempt Financing280

10 THE TRACKING POWER OF MARKOWITZ PORTFOLIO OPTIMIZATION281

10 The Tracking Power of Markowitz Portfolio Optimization281

Policy Implications281

Benefits, Costs, and Externalities281

CONDITIONS REQUIRED FOR THE EFFICIENCY OF CAP-WEIGHTED PORTFOLIOS282

WHEN CAP-WEIGHTED PORTFOLIOS ARE EFFICIENT282

Summary283

Selected References284

WHEN CAP-WEIGHTED PORTFOLIOS ARE INEFFICIENT284

What If We Disagree?284

Index285

What If Some of Us Can t Sell Short?285

Tax Avoidance286

Foreign Investors287

Human Capital287

The Benefits of Portfolio Optimization287

Interest Only（IOs）, Principal Only (POs), and Residual Class Securities288

A SIMPLE TEST OF THE EFFICIENCY OF THE CAP-WEIGHTED INDEX288

TRACKING TARGETS WITH STOCK PORTFOLIOS291

Tracking Targets with Factor Models293

Tracking a Target with the Markowitz Bullet294

TRACKING THE RATE OF INFLATION WITH THE MARKOWITZ BULLET297

SUMMARY299

APPENDIX 6：FINDING THE PORTFOLIO WITH THE MINIMUM VOLATILITY OF DIFFERENCES300

11 Measuring Portfolio Performance305

11 MEASURING PORTFOLIO PERFORMANCE305

MEASURING THE RATE OF RETURN TO A PORTFOLIO306

THE NEED FOR RISK-ADJUSTED PERFORMANCE MEASURES307

RISK-ADJUSTED PERFORMANCE MEASURES BASE D ON THE CAPITAL ASSET PRICING MODEL309

The Jensen Index311

The Treynor Index314

The Sharpe Index315

Misspecifying the Market Pricing Structure317

PITFALLS IN MEASURING PERFORMANCE WITH THE JENSEN, TREYNOR, AND SHARPE INDICES317

Misspecification of the Market Index321

MEASURING PERFORMANCE USING THE ARBITRAGE PRICING THEORY324

MEASURING PERFORMANCE WITHOUT THE USE OF AN ASSET PRICING MODEL327

SUMMARY330

PART FOUR341

INTEREST RATES AND BOND MANAGEMENT341

PART FOUR341

INTEREST RATES AND BOND MANAGEMENT341

12 The Level of Interest Rates341

12 THE LEVEL OF INTEREST RATES341

THE REAL AND NOMINAL RATES OF INTEREST342

INTEREST RATES AND THE SUPPLY AND DEMAND FOR MONEY343

The Transactions Demand for Money343

The Speculative Demand for Money344

The Total Demand for Money346

The Supply of Money and the Equilibrium Interest Rate348

INVESTMENT, SAVING, AND NATIONAL INCOME350

THE INTEREST RATES353

A Tax Cut355

THE EFFECT OF A CHANGE IN FISCAL POLICY355

Monetizing the Deficit359

SUMMARY360

13 THE TERM STRUCTURE OF INTEREST RATES367

13 The Term Structure of Interest Rates367

THE NATURE AND HISTORY OF THE TERM STRUCTURE368

DRAWING THE TERM STRUCTURE371

METHODS OF COMPUTING THE YIELD TO MATURITY375

The Arithmetie Mean Yield to Maturity375

The Geometric Mean Yield to Matruity376

The Internal Yield to Maturity376

A BRIEF OVERVIEW OF THE THREE THEORIES OF THE TERM STRUCTURE376

THE MARKET EXPECTATIONS THEORY OF THE TERM STRUCTURE377

THE LIQUIDITY PREFERENCE THEORY OF THE TERM STRUCTURE380

THE MARKET SEGMENTATION THEORY OF THE TERM STRUCTURE383

DERIVING THE MARKET S ORECAST OF FUTURE INTEREST RATES FROM THE TERM STRUCTURE386

Finding the Market s Forecast from Arithmetic Mean Yields386

Finding the Market s Forecast with Internal Yields388

SUMMARY392

APPENDIX 7：AVERAGING MULTIPLE RATES OF RETURN393

14 Bond Portfolio Management407

14 BOND PORTFOLIO MANAGEMENT407

ESTIMATING THE EXPECTED RETURN OF A BOND FOR PORTFOLIO ANALYSIS408

Forecasting Expected Returns on Treasury Bonds408

Forecasting Expected Returns on Corporate Bonds411

A DURATION-BASED APPROACH TO ESTIMATING THE RISK OF A BOND PORTFOLIO413

A MARKOWITZ APPROACH TO BOND RISK MANAGEMENT414

DIVIDING THE PORTFOLIO BETWEEN BONDS AND STOCK416

SUMMARY416

15 INTEREST IMMUNIZATION422

15 Interest Immunization422

CASH MATCHING AND INTEREST IMMUNIZATION423

ALTERNATIVE MEASURES OF DURATION425

Macaulay s Duration425

Fisher-Weil Duration426

Duration and Yield Elasticity426

Duration and the Response of the Value of a Stream of Payments or Receipts to a Change in Discount R427

Cox, Ingersoll, Ross Duration430

IMMUNIZING WITH MACAULAY S DURATION：THE CASE OF A SINGLE-PAYMENT LIABILITY431

The Effect of Interest Rate Changes on Present Values432

The Effect of Interest Rate Changes on Terminal Values433

COMPUTING THE MACAULAY DURATION AND INTERNAL YIELD OF A BOND PORTFOLIO435

Combination Lines for Internal Yield and Duration439

IMMUNIZING WITH THE MACAULAY DURATION：THE CASE OF A MULTIPLE-PAYMENT LIABILITY439

A TEST OF THE RELATIVE EFFECTIVENESS OF THE THREE DURATION MEASURES441

SUMMARY445

16 EUROPEAN OPTION PRICING454

THE PRICING OF DERIVATIVE SECURITIES454

16 European Option Pricing454

PARY FIVE454

PART FIVE454

THE PRICING OF DERIVATIVE SECURITIES454

PRICING OPTIONS UNDER RISK NEUTRALITY AND UNIFORM PROBABILITY DISTRIBUTIONS455

Valuing a Call Option455

Valuing a Put Option457

The Relationship Between Option Values and Stock Values459

The Effect of a Change in Stock Variance on Option Values463

BINOMIAL OPTION PRICING465

Binomial Call Option Pricing over a Single Period466

Binomial Put Option Pricing over a Single Period469

Binomial Option Pricing over Multiple Periods470

VALUING OPTIONS USING THE BLACK-SCHOLES FRAMEWORK474

The Black-Scholes Value for a Call Option478

Estimating the Variance of the Stock sReturn481

The Relationship Between Black-Scholes Put and Call Values and Underlying Stock Pritces482

The Black-Scholes Value for a Put Option482

PUT-CALL PARITY484

Using the Black-Scholes Framework to Value Options on Stocks That Pay Dividends484

APPENDIX 8：PROOF THAT αVc/αVs IS THE PROBABILITY OF EXERCISE FOR A CALL OPTION ON A STOCK WITH A487

SUMMARY487

17 AMERICAN OPTION PRICING497

17 American Option Pricing497

THE LOWER LIMITS TO THE VALUE OF AMERICAN OPTIONS498

Market forces Supporting the Hard Floor498

Floors Supporting American Call Options498

Market Forces Supporting the Soft Floor499

Floors Supporting American Put Options501

When the Right to Exercise Early Has No Value502

THE VALUE OF EARLY EXERCISE502

How Dividend Payments May Induce Early Exercise of American Call Options503

Early Exercise of American Put Options504

THE BINOMIAL MODEL AS AN AMERICAN OPTION-PRICING MODEL504

SUMMARY506

APPENDIX 9：THE GESKEROLL-WHALEY AMERICAN OPTION-PRICING MODEL507

18 Additional Issues in Option Pricing512

18 ADDITIONAL ISSUES IN OPTION PRICING512

USING THE OPTION-PRICING FORMULAS TO FIND THE MARKET S ESTIMATE OF THE STOCK S VARIANCE513

BIAS PROBLEMS IN OPTION-PRICING MODELS514

Changing Volatility as a Source of Bias in Option-Pricing Models516

Bias from Using European Models to Value American Options518

Pricing Bias Resulting from Error in the Model s Inputs519

OPTION STRATEGIES520

The Straddle520

The Butterfly Spread522

Computing the Expected Return on an Option Strategy523

Delta, Gamma, and Theta524

Getting Delta Neutral526

Portfolio Insurance530

COMPLEX SECURITIES AS PORTFOLIOS OF OPTIONS533

Common Stock as an Option533

Bonds as Portfolios of Options and Option Complements535

SUMMRY536

19 Financial Forward and Futures Contracts541

19 FINANCIAL FORWARD AND FUTURES CONTRACTS541

CHARACTERISTICS OF FORWARD AND FUTURES CONTRACTS542

THE DETERMINATION OF FORWARD PRICES543

The Relationship Between the Forward Price and the Current Commodity Price544

The Relationship Between the Forward Price and the Expected Commodity Price548

The Consistency of the Two Expressions for the Forward Price551

Market Value of Previously Issued Forward Contracts552

DETERMINATION OF FUTURES PRICES553

The Sign of the Premiums for Various Financial Futures556

The Significance of the Premiums to Investors and Financial Managers556

THE SECURITY UNDERLYING A FUTURES CONTRACT TO BUY TREASURY BONDS557

HEDGING WITH BOND FUTURES CONTRACTS562

USES OF STOCK INDEX FUTURES563

FULL COVARIANCE APPROACH TO CONSTRUCTING A FUTURES OVERLAY564

SUMMARY566

ISSUES IN INVESTMENT MANAGEMENT573

PART FIVE573

20 The Effect of Taxes on Investment Strategy and Securities Prices573

ISSUES IN INVESTMENT MANGEMENT573

20 THE EFFECT OF TAXES ON INVESTMENT STRATEGY AND SECURITIES PRICES573

PART SIX573

THE TAX STRUCTURE574

What Investment Income Is Taxed?574

Capital Gains and Losses575

TAXES AND INVESTMENT STRATEGY575

Computing After-Tax Rates of Return575

The Locked-In Effect577

Dividend Clienteles579

THE EFFECT OF TAXES ON SECURITIES PRICES581

The Effiect of Dividends on Expected Stock Returns581

Relative Expected Returns on Taxable and Tax-Exempt Securities584

SUMMARY587

21 STOCK VALUATION594

21 Stock Valuation594

A FRAMEWORK FOR VALUING COMMON STOCKS595

Dividends versus Earnings596

The Constant Growth Model596

The Multistage Growth Model597

COMPUTERIZED THREE-STAGE STOCK VALUATION601

PRICE-EARNINGS RATIO607

What Determines the Level of the Price-Earnings Ratio?608

Changes That Can Be Expected in the Price-Earnings Ration over Time608

SUMMARY609

22 Issues in Estimating Future Earnings and Dividends612

22 ISSUES IN ESTIMATING FUTURE EARNINGS AND DIVIDENDS612

PAYING IN ADVANCE FOR GROWTH613

THE LINK BETWEEN GROWTH AND STOCK VALUATION AND RISK AND EXPECTED RETURN619

THE ACCURACY OF PREDICTIONS OF GROWTH IN EARNINGS AND DIVIDENDS623

Is Past Growth a Reliable Guide to Future Growth?623

The Accuracy of Short-Term Professional Forecasts625

The Accuracy of Growth Forecasts Made by Protessional Analysts625

The Accuracy of Long-Term Professional Forecasts628

The Accuracy of Market Forecasts of the Growth in Earnings Per Share629

IMPLICATIONS FOR INVESTMENT STRATEGY634

SUMMARY637

23 Market Efficiency：The Concept641

23 MARKET EFFICIENCY：THE CONCEPT641

FORMS OF THE EFFICIENT MARKET HYPOTHESIS642

THE SIGNIFICANCE OF THE EFFICIENT MARKET HYPOTHESIS645

RISK AND EXPECTED RETURN IN AN EFFICIENT MARKET647

QUICK AND ACCURATE RESPONSE TO NEW INFORMATION650

SYSTEMATIC PATTERNS IN STOCK PRICES RELATED ONLY TO TIME-VARYING INTEREST RATES AND RISK PREMIA651

FAILURE OF SIMULATED TRADING STRATEGIES653

MEDIOCRITY IN THE PERFORMANCE OF INFORMED INVESTORS655

SUMMARY656

24 MARKT EFFICIENCY：THE EVIDENCE661

24 Market Efficiency：The Evidence661

Measuring Stock Price Response662

DO SECURITY PRICES RESPOND RAPIDLY AND ACCURATIELY TO THE RECEIPT OF NEW INFORMATION?662

The Response of Stock Prices to the Announcement of a Stock Split665

The Pesponse of Stock Prices to Quarterly Earnings Reports667

Further Evidence on the Reaction of Stock Prices to Positive and Negative Events669

THE BEHAVIOR OF CHANGES IN STOCK PRICES673

Studies of Serial Correlation673

Studies of Seasonality677

The Day-of-the -Week Effect677

DO TRADING RULES FAIL UNDER SIMULATION?693

SUMMARY710

APPENDIX10：ADDITIONAL PROPERTIES OF THE MINIMUM VARIANCE SET718

Appendix10：Additional Properties of the Minimum Variance Set718

Appendix11：Invest Software727

APPENDIX11：INVEST SOFTWARE727

Glossary729

GLOSSARY729

Index737

INDEX737