Security Analysis and Portfolio Management
By
Cheng-Few Lee
Joseph E. Finnerty
Donald H. Wort
Published by Glenview, IL:Scott, Foresman/Little Brown, 1990
Contents
Chapter 1
Introduction to Security analysis and Portfolio Management
OBJECTIVE OF SECURITY ANALYSIS
OBJECTIVE OF PORTFOLIO MANAGEMENT
BASIC APPROACHES TO SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
GENERAL AREAS OF COVERAGE
Theory
Methods
Statistical Distributions Regression Technique
Maximization Procedures
Applications
SUMMARY
QUESTIONS AND PROBLEMS
REFERENCES
Chapter 2
Information and Security Valuations
SOURCE OF INFORMATION
The Economy
Financial Markets
Industry Information
Corporate Information
THE DETERMINATION OF THE INVESTMENT WORTH OF ABBOTT LABORATORIES
Accounting Information and Abbott’s financial Position
Financial-Ratio Analysis Liquidity Ratios Leverage Ratios
Activity Ratios Profitability Ratios Summary of Ratio Use
Dynamic Adjustment of Financial Ratios
Forecasts of Sales, Earnings, and Dividends
Sales Forecast Earnings Forecast Dividend Forecast
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 2A: REGRESSION ANALYSIS
Forecasting and Regression Analysis
REFERENCES
Chapter 3
Common Stock: Return, Growth, and Risk
HOLDING-PERIOD RETURN
HOLDING-PERIOD YIELD
Arithmetic Mean
Geometric Mean
Weighted Unbiased Mean
COMMON-STOCK VALUATION APPROACHES
GROWTH-RATE ESTIMATION AND ITS APPLICATION
Compound-Sum Method
Regression Method
One-Period Growth Model
Two-Period Growth Model
Three-Period Growth Model
RISK
Definitions of Risk
Sources of Risk
Firm-specific Factors Market and Economic Factors
COVARIANCE AND CORRELATION
SYSTEMATIC AND UNSYSTEMATIC RISK AND THE MARKET MODEL
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 3A: LOGARITHMS AND THEIR PROPERTIES
APPENDIX 3B: ln X2, ln X3, AND ln X4 AND THEIR ESTIMATES
REFERENCES
Chapter 4
Introduction to Valuation Theories
DISCOUNTED CASH-FLOW VALUATION THEORY
BOND VALUATION
Perpetuity
Term Bonds
CONNON-STOCK VALUATION
M AND M VALUATION THEORY
Review and Extension of M and M Proposition I
Miller’s Proposition on Debt and Taxes
THE TAX REFORM ACT OF 1986 AND ITS IMPACT ON FIRM VALUE
CORPORATE RESPONSE TO THE TA X REFORM ACT OF 1986
CAPITAL ASSET PRICING MODEL (CAPM)
OPTION VALUATION
SUMMARY
QUESTION AND PROBLEMS
REFERENCES
Chapter 5
Bond Valuation and Analysis
BOND FUNDAMENTALS
Type of Issuer
U.S Treasury Federal Agencies Municipalities
Corporations
Bond Provisions
Maturity Classes Mortgage Bond Debentures
Coupons Maturity Callability Sinking Funds
HOLDING-PERIOD RETURN
Bond Valuation
Bond Indexes
Bond Beta
BOND-RATING PROCEDURES
TERM STRUCTURE OF INTEREST
Theory
Estimation
CONVERTIBLE BONDS AND THEIR VALUATION
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 5A: WORKSHEETS FOR YIELD CURVES
REFERENCES
Chapter 6
The Uses and Calculation of Market Indexes
ALTERNATIVE METHODS FOR COMPILATION OF STOCK AND PRICE INDEXES
Price-Weighted and Quantity-Weighted Indexes
Value-Weighted Indexes
ALTERNATIVE MARKET INDEXES
Dow Jones Industrial Average
Standard & Poor’s Composite 500 Index
New York Stock Exchange Composite Index
Value Line Composite Index
Wilshire 5000 Equity Index
The Major Market Index
Standard & Poor’s Composite 100 Index
THE USER AND USES OF MARKET INDEXES
HISTORICAL BEHAVIOR OF MARKET INDEXES AND THE IMPLICATIONS OF THEIR USE FOR FORECASTING
Historical Behavior
Implications
MARKET-INDEX PROXY ERRORS AND THEIR IMPACT ON BETA ESTIMATES AND EFFICIENT-MARKET-HYPOTHESIS TESTS
INDEX-PROXY ERROR, PERFORMANCE MEASURE, AND THE EMH TEST
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 6A: MONTHLY RETURNS FOR THE WILSHIRE 5000 EQUITY INDEXES
REFERENCES
Chapter 7
Source of Risk and Their Determination
RISK CLASSIFICATION AND MEASUREMENT
Call Risk
Convertible Risk
Default Risk
Interest-Rate Risk
Management Risk
Marketability (Liquidity) Risk
Political Risk
Purchasing-Power Risk
Systematic and Unsystematic Risk
PORTFOLIO ANALYSIS AND APPLICATION
Expected Return on a Portfolio
Variance and Standard Deviation of a Portfolio
The Two-Asset Case
THE EFFICIENT PORTFOLIO AND RISK DIVERSIFICATION
The efficient Portfolio
Corporate Application of Diversification
The Dominance Principle
Three Performance Measures
Interrelationship among Three Performance Measure
DETERMINATION OF COMMERCIAL LENDING RATE
THE MARKET RATE OF RETURN AND MARKET RISK PREMIUM
SUMMARY
QUESTIONS AND PROBLEMS
REFERENCES
Chapter 8
Markowitz Portfolio-Selection Model
MEASUREMENT OF RETURN AND RISK
Return
Risk
UTILITY THEORY, UTILITY FUNCTIONS, AND INDIFFERENCE CURVES
Utility Functions
Linear Utility Function and Risk Concave Utility Function and Risk
Indifference Curves
Efficient Portfolios
Portfolio Combinations
Short Selling
The Dyl Model Techniques for Calculating the Efficient Frontier with Short Selling The Normal Distribution The Log Normal Distribution
Three-Security Empirical Solution
Graphical Analysis Minimum-Risk Portfolio The Iso-Expected Return Line Iso-Variance Ellipses The Critical Line and Efficient Frontier Mathematical Analysis
Portfolio Determination with Specific Adjustment for Short Selling
Portfolio Determination without Short Selling
SUMMARY
QUESTIONS AND PROBLEMS
REFERENCES
Chapter 9
Capital Asset Pricing Model and Beta Forecasting
A GRAPHICAL APPROACH TO THE DERIVATION OF THE CAPITAL ASSET PRICING MODEL
The Lending, Borrowing, and Market Portfolios
The Capital Market Line
The Security Market Line-The Capital Asset Pricing Model
MATHEMATICAL APPROACH TO THE DERIVATION OF THE CAPITAL ASSET PRICING MODEL
THE MARKET MODEL AND RISK DECOMPOSITION
The Market Model
Risk Decomposition
Why Beta Is Important for Security Analysis
Determination of Systematic Risk
GROWTH RATES, ACCOUNTING BETAS, AND VARIANCE IN EBIT
Growth Rates
Accounting Beta
Variance in EBIT
Capital-Labor Ratio
Fixed Costs and Variable Costs
Beta Forecasting
Market-Based versus Accounting-Based Beta Forecasting
SOME APPLICATIONS AND IMPLICATIONS OF THE CAPITAL ASSET PRICING MODEL
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 9A: EMPIRICAL EVIDENCE FOR THE RISK-RETURN RELATIONSHIP
Anomalies in the Semi-Strong Efficient-Market Hypothesis
REFERENCES
Chapter 10
Index Models for Portfolio Selection
THE SINGLE-INDEX MODEL
Deriving the Single-Index Model
Expected Return of a Portfolio Variance of a Portfolio
Portfolio Analysis and the Single-Index Model
The Market Model and Beta
MULTIPLE INDEXES AND THE MULTIPLE-INDEX MODEL
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 10A: A LINEAR-PROGRAMMING APPROACH TO PORTFOLIO-ANALYSIS MODELS
APPENDIX 10B: EXPECTED RETURN, VARIANCE, AND COVARIANCE FOR A MULTI-INDEX MODEL
REFERENCES
Chapter 11
Arbitrage Pricing Theory: Theory, Evidence, and Applications
MULTI-INDEX MODELS
MODEL SPECIFICATION OF ARBITRAGE PRICING THEORY
Ross’s Arbitrage Model Specification
Empirical Test Methodology
ARBITRAGE PRICING THEORY: EMPIRICAL RESULTS AND IMPLICATIONS
IDENTIFYING THE MODEL FACTORS
ARBITRAGE PRICING THEORY VERSUS MODERN PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
APPLICATIONS OF ARBITRAGE PRICING THEORY
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 11A: ALTERNATIVE SPECIFICATIONS OF ARBITRAGE PRICING THEORY
APPENDIX 11B: LEE AND WET’S EMPIRICAL RESULTS
REFERENCES
Chapter 12
Futures Valuation and Hedging
FUTURES VERSUS FORWARD MARKETS
FUTURES MARKETS: OVERVIEW
COMPONENTS AND MECHANICS OF FUTURES MARKETS
The Exchanges
The Clearinghouse
Margin
Order Execution
A Sample T-bill Futures Transaction
THE VALUATION OF FUTURES CONTRACTS
The Arbitrage Argument
Interest Costs
Carrying Costs
Supply and Demand Effects
The Effect of Hedging Demand
HEDGING CONCEPTS AND STRATEGIES
Hedging Risks and Costs
The classic Hedge Strategy
The Working Hedge Strategy
The Johnson Minimum-Variance Hedge Strategy
The Howard-D’Antonio Optimal Risk-Return Hedge Strategy
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 12A: BASIC FUTURES TERMINOLOGY
REFERENCES
Chapter 13
Commodity Futures, Financial Futures, and Stock-Index Futures
COMMODITY FUTURES
FUTURES QUOTATIONS
FINANCIAL FUTURES
Foreign-Currency Futures
Evolution Advantages Pricing Foreign-Currency Futures
The Traditional Theory of International Parity
Interest-Rate Parity Purchasing-Power Parity Fisherian Relation
Forward Parity
Interest-Rate Futures
The GNMA Futures Contract
Hedging with GNMA Futures
U.S. Treasury Debt Futures
Characteristics of T-Bill Futures
Pricing T-Bill Futures Contracts
Characteristics of T-Note and T-Bond Futures
Bank Certificate of Deposit Futures
The Eurodollar Futures Market
Evolution
Eurodollar Futures
STOCK-INDEX FUTURES
Pricing Stock-Index Futures Contracts
Stock-Index Futures: Does the Tail Wag the Dog?
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 13A: FUTURES-CONTRACT SPECIFICATIONS
REFERENCES
Chapter 14
Options and Option Strategies
THE OPTION MARKET AND RELATED DEFINITIONS
What Is an Option?
Types of Options and Their Characteristics
Relationships Between the Option Price and the Underlying Asset Price
Additional Definitions and Distinguishing Features
Types of Underlying Asset
Institutional Characteristics
INDEX AND FUTURES OPTIONS
PUT-CALL PARITY
European Options
American Options
Futures Options
Market Application
RISK-RETURN CHARACTERISTICS OF OPTIONS
Long call
Short Call
Long Put
Short Put
Long Straddle
Short Straddle
Long Vertical (Bull) Spread
Short Vertical (Bear) Spread
Calendar (Time) Spreads
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 14A: OPTIONS AND EXCHANGES
REFERENCES
Chapter 15
Option Valuation and Hedging
THE BINOMIAL OPTION-PRICING APPROACH
Summary of Binomial Option Pricing
The Generalized Binomial Model
The Black-Scholes Option-Pricing Model (OPM)
The Hedge Ratio
Option Elasticity and Beta .
The Sensitivity of the Black-Scholes OPM to the Inputs
Calculating and Interpreting the Option Sensitivity, Elasticity, and Beta
ESTIMATING THE INPUTS
Stock Price
Exercise Price
Time to Maturity
Interest Rate
Volatility
Historical Variance Time-Series Analysis Implicit Volatility
Dividend Payments and Ex-Dividend Dates
EXTENSIONS OF THE BLACK-SCHOLES OPM
The OPM Adjusted for Dividends
Stochastic Dividends Known Dividends Black’s OPM for Futures Options
Put-Option Valuation
Put-Call Parity Revisited The Black-Scholes European-Put Pricing Model The Binomial Option-Pricing Model Applied to Puts
PRICING OTHER FINANCIAL SECURITIES USING OPTION-PRICING THEORY
The Analogy Between Equity and a Call Option
Pricing Common Stock with the OPM
Pricing Discount Bonds with the OPM
Pricing Convertible Bonds with the OPM
Pricing Convertible Bonds with Call Provisions
EVALUATING THE BLACK-SCHOLES OPTION-PRICING MODEL
Tests of the Black-Scholes Model’s Accuracy and Reliability
The Validity of the Black-Scholes Assumptions
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 15A: DERIVATION OF THE BINOMIAL FORMULA AND ITS RELATION TO THE BLACK-SCHOLES OPM
APPENDIX 15B: ESTIMATING THE IMPLIED STANDARD DEVIATION WITH OLS
REFERENCES
Chapter 16
The Efficient-Market Hypothesis and Security Valuation
MARKET VALUE VERSUS BOOK VALUE
Assets
Liabilities and Owner’s Equity
Ratios and Market Information
Market-to-Book Ratio
MARKET EFFICIENCY IN A MARKET-MODEL AND CAPM CONTEXT
Market Model
Sharpe-Lintner CAPM Model
TESTS FOR MARKET EFFICIENCY
Weak-Form Efficiency
Semi-Strong-Form Efficiency
Strong-Form Efficiency
OTHER METHODS OF TESTING THE EMG
Random walk with Reflecting Barriers
Variance-Bound Approach Test
Hillmer and Yu’s Relative EMH Test
MARKET ANOMALIES
The P/E Effect
The Size Effect
The January Effect
SUMMARY
QUESTIONS AND PROBLEMS
REFERENCES
Chapter 17
Timing and Selectivity of Stocks and Mutual Funds
FUNDAMENTAL VERSUS TECHNICAL ANALYSIS
Fundamental Analysis
Technical Analysis
Dow Theory
The Odd-Lot Theory
The Confidence Index
Trading Volume
Moving Average
ANOMALIES AND THEIR IMPLICATIONS
Basu’s Findings
Reinganum’s Findings
Banz’s Findings
Keim’s Findings
Additional Findings
SECURITY RATE-OF-RETURN FORECASTING
Regression Approach
Fixed-Coefficient Market Model Time-Varying-Coefficient Market Model
Time-Series Approach
Component Analysis ARIMA Models
Composite Forecasting
VALUE LINE RANKING
Criteria of Ranking
Performance Evaluation
MUTUAL FUNDS
Mutual-Fund Classification
Mutual-Fund Manager’s Timing and Selectivity
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 17A: COMPOSITE FORECASTING METHOD
REFERENCES
Chapter 18
Performance-Measure Approaches for Selecting Optimum Portfolios
SHARPE PERFORMANCE-MEASURE APPROACH WITH SHORT SALES ALLOWED
TREYNOR-MEASURE APPROACH WITH SHORT SALES ALLOWED
TREYNOR-MEASURE APPROACH WITH SHORT SALES NOT ALLOWED
IMPACT OF SHORT SALES ON OPTIMAL-WEIGHT DETERMINATION
ECONOMIC RATIONALE OF THE TREYNOR PERFORMANCE-MEASURE METHOD
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 18A: DERIVATION OF EQUATION (18.6)
APPENDIX 18B: DERIVATION OF EQUATION (18.10)
APPENDIX 18C: DERIVATION OF EQUATION (18.16)
REFERENCES
Chapter 19
International Diversification
EXCHANGE RISK
THEORETICAL EFFECTS OF INTERNATIONAL DIVERSIFICATION
Segmented versus Integrated World Markets
The CAPM and the APT Applied Internationally
Inflation and Exchange-Rate Risks
Are World Markets Efficient?
Empirical Evidence Supporting International Diversification
APPLIED INTERNATIONAL DIVERSIFICATION
Direct Foreign Investment
Canada West Germany Japan Other Pacific-Basin Countries
United Kingdom
Indirect Foreign Investment
American Depository Receipts (ADRs) Eurobonds
International Mutual Funds
SUMMARY
QUESTIONS AND PROBLEMS
APPENDIX 19A: OBJECTIVES AND POLICIES OF AN INTERNATIONAL MUTUAL FUND
REFERENCES
Chapter 20
Bond Portfolios: Management and Strategy
BOND STRATEGIES
Riding the Yield Curve
Maturity-Structure strategies
Swapping
Substitution Swap Intermarket-Spread Swap Interest-Rate
Application Swap Pure-Yield Pickup Swap
Duration
Weighted-Average Term to Maturity (WATM)
Weighted-Average Term to Maturity versus Duration Measure
Yield to Maturity
The Macaulay Model
Contingent immunization
Bond portfolios: a case study
Summary
Questions and problems
References
Chapter 21
Portfolio Insurance and Synthetic Options
BASIC CONCEPTS OF PORTFOLIO INSURANCE
STRATEGIES AND IMPLEMENTATION OF PORTFOLIO INSURANCE
Stop-Loss Orders
Portfolio Insurance with Listed Put Options
Portfolio Insurance with Synthetic Options
Portfolio Insurance with Dynamic Hedging
COMPARISON OF ALTERNATIVE PORTFOLIO-INSURANCE STRATEGIES
Synthetic Options
Listed Put Options
Dynamic Hedging and Listed Put Options
IMPACT OF PORTFOLIO INSURANCE ON THE STOCK (MARKET AND PRICING OF EQUITIES
Regulation and the Brady Report
EMPIRICAL STUDIES OF PORTFOLIO INSURANCE
Lelalld (1985)
Asay and Edelsburg (1986)
Eizman (1986)
Rendleman and McEnally (1987)
Garcia and Gould (1987)
SUMMARY
QUESTIONS AND PROBLEMS
REFERENCES
Chapter 22
Itô’s Calculus: Derivation of the Black-Scholes
THE ITô PROCESS AND FINANCIAL MODELING
Itô LEMMA
STOCHASTIC DIFFERENTIAL-EQUATION APPROACH TO STOCK-PRICE BEHAVIOR
THE PRICING OF AN OPTION
A REEXAMINATION OF OPTION PRICING REMARKS ON OPTION PRICING
SUMMARY
APPENDIX 22A: AN ALTERNATIVE METHOD TO DERIVE THE BLACK-SCHOLES OPTION-PRICING MODEL
Assumptions and the Present Value of the Expected Terminal Option Price
Present Value of the Partial Expectation of the Terminal Stock Price
Present Value of the Exercise Price under Uncertainty
REFERENCES
Appendix Tables
TABLES I COMPOUND SUM OF $1 FOR n YEARS
TABLE II PRESENT VALUE OF $1
TABLE III SUM OF AN ANNUAL FOR $1 FOR n YEAR
TABLE IV PRESENT VALUE OF $1 RECEIVED ANNUALLY
TABLE V AREAS UNDER THE STANDARD NORMAL DISTRIBUTION
Acknowledgements
Authors Index
Subject Index