book

Handbook of Finance: Investment Management and Financial Management

by Frank J. Fabozzi

August 2008

Beginner

996 pages

97h 31m

English

Wiley

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TOPIC CATEGORIES
ORGANIZATIONTABLE OF CONTENTSINDEXCHAPTERSOutlineAbstractKeywordsIntroductionBodySummaryReferences
1.1. SOME BASIC CONCEPTS1.1.1. Utility Function and Indifference Curves1.1.2. The Set of Efficient Portfolios and the Optimal Portfolio1.1.3. Risky Assets versus Risk-Free Assets1.2. MEASURING A PORTFOLIO'S EXPECTED RETURN1.2.1. Measuring Single-Period Portfolio Return1.2.2. The Expected Return of a Portfolio of Risky Assets1.3. MEASURING PORTFOLIO RISK1.3.1. Variance and Standard Deviation as a Measure of Risk1.3.1.1. Standard Deviation1.3.1.2. Measuring the Portfolio Risk of a Two-Asset Portfolio1.3.1.3. Covariance1.3.1.4. Relationship between Covariance and Correlation1.3.2. Measuring the Risk of a Portfolio Comprised of More than Two Assets1.4. PORTFOLIO DIVERSIFICATION1.4.1. Portfolio Risk and Correlation1.4.2. The Effect of the Correlation of Asset Returns on Portfolio Risk1.5. CHOOSING A PORTFOLIO OF RISKY ASSETS1.5.1. Constructing Efficient Portfolios1.5.2. Feasible and Efficient Portfolios1.5.3. Choosing the Optimal Portfolio in the Efficient Set1.6. INDEX MODEL'S APPROXIMATIONS TO THE COVARIANCE STRUCTURE1.6.1. Single-Index Market Model1.6.2. Multi-Index Market Models1.7. SUMMARY
2.1. CHARACTERISTICS OF AN ASSET PRICING MODEL2.2. CAPITAL ASSET PRICING MODEL2.2.1. Derivation of the CAPM2.2.1.1. Assumptions2.2.1.2. Capital Market Line2.2.1.3. Systematic and Unsystematic Risk2.2.1.4. Security Market Line2.2.2. Tests of the CAPM2.2.3. Modifications of the CAPM2.3. ARBITRAGE PRICING THEORY MODEL2.3.1. Arbitrage Principle2.3.2. APT Model Formulation2.4. MULTIFACTOR RISK MODELS IN PRACTICE2.4.1. Statistical Factor Models2.4.2. Macroeconomic Factor Models2.4.3. Fundamental Factor Models2.5. SUMMARY
3.1. STOCHASTIC GROWTH3.1.1. The Centrality of Logarithmic Returns3.1.2. The Importance of Symmetry3.1.2.1. The Distribution of Logarithmic Wealth Tends to Be Symmetrical3.1.2.2. Mapping Mean Logarithmic Wealth into Median Wealth3.1.3. Dealing with Exceptions3.1.3.1. The Shortfall Case3.1.3.2. Limited Lifetimes3.1.3.3. The Dynamic Hedging Case3.1.4. An Operational Stochastic Growth Objective3.2. EXPECTED GROWTH WITH NO SHORTFALL CONCERNS3.2.1. Finding the Optimum Risk3.2.2. Maximum Expected Growth for Aggressive Investors3.2.2.1. Taylor Series Representation3.2.2.2. Back to Markowitz3.2.2.3. Questions of Existence and Convergence3.2.2.4. Adjustments for Limited Lifetimes3.3. MANAGING AGAINST A SHORTFALL CONSTRAINT3.3.1. Managing Discretionary Wealth3.3.1.1. The Implicit Balance Sheet3.3.1.2. Shortfalls Summarized as Zero Discretionary Wealth3.3.1.3. Dynamic Reaction3.3.1.4. Response to Old Objections3.3.2. Objective for Investors Avoiding Positive Wealth Shortfalls3.3.3. Implication for Markowitz Mean-Variance Optimization3.3.4. Higher-Moment Optimization3.3.4.1. When Higher Moments Are Important3.3.4.2. Operational Use of Higher Moments3.3.5. Bayesian Modification3.3.6. Other Applications3.3.6.1. Performance Reporting3.3.6.2. Getting Stuck with CPPI3.3.6.3. Understanding Markets3.4. RELATED RESEARCH3.5. SUMMARY
4.1. WHY BE A QUANTITATIVE INVESTOR?4.1.1. Human Nature Was Not Designed for Investing in Liquid Competitive Markets4.1.2. The Advantage of the Scientific Method4.1.3. Efficient Diversification4.1.4. Identifying Market Inefficiencies4.2. THE ARGUMENT FOR JUDGMENTAL INVESTING4.3. SYNTHESIS OF QUALITATIVE AND QUANTITATIVE APPROACHES4.4. SUMMARY
5.1. USING DERIVATIVES IN PORTFOLIO MANAGEMENT5.2. CURRENCY MANAGEMENT5.3. BENCHMARKS5.4. QUANTITATIVE RETURN-FORECASTING TECHNIQUES AND MODEL-BASED TRADING STRATEGIES5.4.1. Momentum and Reversal Strategies5.4.2. Models Based on Exogenous Predictors5.4.3. More Sophisticated Econometric Models5.4.4. Model Selection and Testing5.5. TRADE EXECUTION AND ALGORITHMIC TRADING5.6. SUMMARY
6.1. ACTUARIES: FINANCIAL ECONOMISTS IN THRALL TO THE MARKET6.2. THREE DIVISIONS OF FINANCIAL ECONOMICS6.3. MATHEMATICAL FINANCE6.4. THE CAPITAL ASSET PRICING MODEL6.5. THE EFFICIENT MARKET HYPOTHESIS6.6. INVESTMENT STRATEGIES FOR PENSION FUNDS6.7. SUMMARY
7.1. WHYDOWENEED INVESTMENT BELIEFS?7.2. HOW DO WE KNOW WHAT WE KNOW?7.3. WHAT DO WE KNOW?7.4. WHAT DON'T WE KNOW?7.5. WHAT DO WE BELIEVE?7.6. INVESTMENT BELIEFS AND STRATEGY7.7. SUMMARY7.8. ACKNOWLEDGMENTS
8.1. THE MARKET AS A COLLECTION OF INDIVIDUAL BEHAVIORS8.1.1. Realistic Individual Decision Making8.1.1.1. Satisficing and Heuristics8.1.1.2. Representativeness8.1.1.3. Availability8.1.1.4. Anchoring and Adjustment8.1.1.5. Cognitive Dissonance8.1.2. The Market Is More than the Sum of Nearly Identical Parts8.1.2.1. Heterogeneity of Decision Rules8.1.2.2. Social Psychology and Group Influence8.1.2.3. Laboratory Markets8.1.2.4. Artificial Markets8.2. APPLYING THE PRINCIPLES OF BEHAVIORAL FINANCE8.2.1. Hypotheses and Studies of Market Anomalies8.2.2. Commentary on Grand Theory8.3. SUMMARY
9.1. "NORMAL" INVESTORS AND RATIONAL ONES9.2. BEHAVIORAL PORTFOLIO THEORY9.3. BEHAVIORAL ASSET PRICING MODEL9.4. MARKET EFFICIENCY9.5. ELEGANT THEORIES AND TESTABLE HYPOTHESES9.6. SUMMARY
10.1. WHAT IS RISK PERCEPTION?10.2. WHAT IS PERCEPTION?10.2.1. A Visual Presentation of the Perceptual Process: The Litterer Perception Formation Model10.3. JUDGMENT AND DECISION MAKING: HOW DO INVESTORS PROCESS INFORMATION WITHIN ACADEMIC FINANCE?10.3.1. The Standard Finance Viewpoint: The Efficient Market Hypothesis10.3.2. The Behavioral Finance Perspective: The Significance of Information Overload and the Role of Cognitive Factors10.4. FINANCIAL AND INVESTMENT DECISION MAKING: ISSUES OF RATIONALITY10.4.1. The Standard Finance Viewpoint: Classical Decision Theory10.5. The Behavioral Finance Perspective: Behavioral Decision Theory10.6. WHAT ARE THE MAIN THEORIES AND CONCEPTS FROM BEHAVIORAL FINANCE THAT INFLUENCE AN INDIVIDUAL'S PERCEPTION OF RISK?10.6.1. Heuristics10.6.1.1. Availability Heuristic10.6.2. Overconfidence10.6.3. Prospect Theory10.6.4. Loss Aversion10.6.5. Representativeness10.6.6. Framing10.6.7. Anchoring10.6.8. Familiarity Bias10.6.9. The Issue of Perceived Control10.6.10. The Significance of Expert Knowledge10.6.11. The Role of Affect (Feelings)10.6.12. The Influence of Worry10.7. SUMMARY10.8. ACKNOWLEDGMENTS
11.1. MAKING SAVING AND SPENDING DECISIONS11.2. UNDERSTANDING THE REPRESENTATIVE INVESTOR11.3. PREDICTABLE INEFFICIENCIES11.4. USING ESTIMATES OF BETA11.5. SUMMARY
12.1. WHY TRADING IS NOT LIKE PORTFOLIO MANAGEMENT12.1.1. Trade Motivation12.1.2. Assessing Market Conditions12.1.3. Establish Initial Trading Strategy12.1.4. Probing for Liquidity and Information12.1.5. Adapting to Market Conditions12.1.6. Assess Effectiveness12.2. A FRAMEWORK FOR MEASURING IMPLEMENTATION12.3. THE COST COMPONENTS OF TRADING12.3.1. Commission12.3.2. Price Impact Cost12.3.3. Trader Timing Cost12.3.4. Opportunity Cost12.4. TRENDS IN TRADING COSTS12.5. BEST EXECUTION12.6. INTEGRATING TRANSACTION COSTS AND BEST EXECUTION INTO THE INVESTING PROCESS12.6.1. Case Study 1: Momentum Manager Mismatched with Cautious Trader12.6.2. Case 2: Capturing an Insufficient Concession When Providing Liquidity12.6.3. Case 3: Overreliance on Low-Cost Brokers12.7. FOUR PRACTICAL TRADING RECOMMENDATIONS12.7.1. Recommendation 1: One Trading Strategy Does Not Fit All Situations12.7.2. Recommendation 2: Prioritize and Make Contingency Plans12.7.3. Recommendation 3: Build Expected Costs into Portfolio Decision Making12.7.4. Recommendation 4: Rationalize Broker Use12.8. SUMMARY
13.1. INVESTMENT DECISIONS IN THE PRESENCE OF TAXES13.1.1. Types of Taxes13.1.1.1. Taxes on Capital Gains13.1.1.2. Taxes on Dividends13.1.1.3. Taxes on Estates13.1.1.4. After-Tax Performance Measurement13.1.2. After-Tax Performance Evaluation13.1.3. Performance Benchmarking13.1.4. After-Tax Risk13.1.5. After-Tax Asset Allocation13.1.6. Investment Vehicle13.2. PORTFOLIO MANAGEMENT SOLUTIONS13.2.1. The Power of Passive Investing13.2.2. Active Tax Management13.2.3. Active Stock Selection13.3. SUMMARY
14.1. BASIC CONCEPTS14.1.1. Definitions of Socially Responsible Investment14.1.2. SRI Is Equity Based14.1.3. Community Development or Ethical Banking14.1.4. Relationship between SRI and "Green" Investing14.1.5. Importance of Financial Returns14.1.6. Identifying SRI Demand Factors14.1.7. Historic Origins of SRI14.2. SRI STRATEGIES14.2.1. Exclusion or Negative Screening14.2.2. Exclusion Levels and Investors' Portfolio Approach14.2.3. Shareholder Activism14.2.4. SRI Activism14.2.5. Nongovernmental Organization Advocacy Contrasted with SRI Activism14.2.6. Engagement or Dialogue14.2.7. Collaborative Engagement14.3. LEGAL FRAMEWORK14.3.1. Legal Inhibitions14.3.2. New Pension Regulations14.3.3. Legal Background to Activism14.4. IMPACT ON FINANCIAL PERFORMANCE14.4.1. A Brief Review of the Literature14.4.2. The Performance of Retail SRI Funds14.4.3. The Question of Materiality14.5. OUTSTANDING QUESTIONS14.5.1. Sinstocks: An Exogenous Variable?14.5.2. Scope for Deeper Analysis14.5.3. Distinction between Institutional and Retail SRI14.5.4. Public Policy Issues14.6. SUMMARY
15.1. A REVIEW OF EXISTING MODELS15.1.1. Mean-Variance Optimization15.1.2. Black-Litterman Approach15.1.3. Minimizing Expected Shortfall15.2. EMPIRICAL ISSUES15.2.1. Volatility of Returns15.2.2. Correlation of Returns15.2.3. Excess Returns15.2.4. Joint Distribution Specification15.3. INCLUDING LIABILITY CONSTRAINTS15.3.1. Modeling Pension Liabilities15.3.2. Practical Difficulties15.4. A REAL-WORLD EXAMPLE15.4.1. Service Cost15.4.2. Strategic Asset Allocation15.5. SUMMARY
16.1. ASSET ALLOCATION16.1.1. Strategic versus Tactical Allocation16.1.2. Tactical Asset Allocation and Tactical Style Allocation Decisions16.2. IMPLEMENTING ASSET ALLOCATION DECISION AND PORTFOLIO CONSTRUCTION16.2.1. Using Forecasts16.2.2. Applying the Markowitz Model16.2.3. Alternative Models to Markowitz16.2.4. Stock Selection16.3. SUMMARY
17.1. INDEX, CORE, AND HEDGE FUNDS17.1.1. Benchmark17.1.2. Active Bets17.1.3. Active Return17.1.4. Active Risk17.1.5. Tracking Risk17.1.6. Tracking Error17.1.7. Information Ratio17.2. TURNING A HEDGE FUND INTO A CORE PRODUCT17.2.1. Would the Transaction Really Be So Easy?17.3. TURNING A CORE MANAGER INTO A HEDGE FUND MANAGER17.3.1. Management Fees17.4. SUMMARY
18.1. WHAT IS PORTABLE ALPHA?18.2. THE INVARIANCE OF PORTABLE AND FIXED ALPHA18.2.1. The Inefficiency of 130–30 Strategies18.3. SUMMARY
19.1. THE MATHEMATICS OF CURRENCY OVERLAY MANAGEMENT19.1.1. Some Conventions19.1.2. Currency Hedging Taxonomy19.1.2.1. Full or Unitary Hedging19.1.2.2. Partial Hedging19.1.2.3. Overhedging19.1.2.4. Cross-Hedging19.1.3. Basic Overlay Model19.1.4. Fully Interdependent Solution19.1.5. Active Overlay and Risk Overlay19.1.6. Practical Considerations19.1.7. Who Should Invest in a Currency Overlay?19.2. ACTIVE CURRENCY OVERLAY19.2.1. Common Strategies19.2.1.1. Currency Alpha19.2.1.2. Carry Strategies19.2.1.3. Momentum Strategies19.2.1.4. Flow Strategies19.2.1.5. Valuation Strategies19.2.1.6. Quantitative Currency Overlay19.2.2. Active Portfolio Construction and Currency Perspective19.2.3. Strategy Weighting19.2.3.1. Portfolio Optimization19.2.3.2. Regime-Based Weightings19.2.3.3. Performance-Based Weightings19.2.3.4. Strategy Termination19.3. SUMMARY
20.1. PORTFOLIO RISK FORECASTING20.1.1. Estimating Variances20.1.1.1. Enough Observations20.1.1.2. Downward Bias20.1.1.3. Dispersion in the Estimate of the Mean20.1.1.4. Unstable Parameters20.1.1.5. Indicators20.1.1.6. Wasted Information20.1.2. Estimating Correlations20.1.2.1. Higher Frequency Observations20.1.2.2. Problem Size Dependency20.1.2.3. Types of Solutions to the Size Problem20.1.2.4. Winsorization20.1.2.5. Structuring Correlation Estimates by Factor Analysis20.1.2.6. Is Diversification There When You Need It?20.1.2.7. Bayesian Shrinkage20.1.3. Value at Risk20.1.4. Higher Moment Risk20.2. PORTFOLIO CONSTRUCTION20.2.1. Coping with Key Assumptions20.2.1.1. Application to the Relevant Mean and Variance20.2.2. Risk Aversion Is Known20.2.2.1. Single-Period Model20.2.2.2. Adequacy of Variance as a Risk Measure20.2.2.3. Single-Point Estimates of Mean and Variance20.2.2.4. Adequate Computational Facility20.2.3. Additional Practical Considerations20.2.3.1. Sensitivity to Input Changes20.2.3.2. Constraints20.2.3.3. Trade Management20.2.3.4. Multiple Levels20.2.3.5. Simulation Capability20.3. SUMMARY
21.1. WHY DO WE CARE ABOUT RISK?21.1.1. Introducing Risk21.1.2. Introduction to Mean-Variance Analysis21.1.3. Justification for Risk and Return Trade-off21.2. MEASUREMENT OF RISK21.2.1. Discrete and Continuous Distributions21.2.2. Traditional Measures21.2.2.1. Variance and Standard Deviation21.2.2.2. Covariance and Correlation21.2.3. Other Risk Measures21.2.3.1. Skewness21.2.3.2. Kurtosis21.2.3.3. Semivariance21.2.4. Value at Risk21.2.4.1. Definition21.2.4.2. Normal Distribution and VaR21.2.5. Calculus of Risk21.2.5.1. Time Aggregation of Risk and Return21.2.5.2. Excess Return and Tracking Error21.2.6. Risk Calculation Example21.3. RISK BUDGETING21.3.1. Example: Two Risky Assets21.3.1.1. The Starting Portfolio21.3.1.2. Marginal Contribution to Risk21.3.2. Implied View Analysis21.3.3. The Role of Correlation21.4. APPLICATIONS21.4.1. Pension Fund Example21.5. ADVANCED CONCEPTS21.5.1. Estimating Volatility21.5.2. Time Aggregation of Risks21.5.3. Critique of VaR21.6. SUMMARY
22.1. INTERNATIONAL PERFORMANCE MEASUREMENT STANDARDIZATION PROCESS22.1.1. Risk-Adjusted Measure22.1.2. Indices and Benchmarking22.1.3. Debate on Size and Book-to-Market Factors22.2. USE OF BENCHMARKS22.2.1. Generic Indices22.2.2. Customized Benchmarks and Normal Portfolios22.3. ANALYSIS OF ALPHAS22.3.1. Different Models for Normal Returns: Academic Approach22.3.1.1. Market Models22.3.1.2. Multifactor Models22.3.1.3. Style Analysis22.3.2. Evaluating Alphas: Practitioners' Approach22.3.2.1. Performance Relative to a Peer Group22.3.2.2. Performance Relative to a Benchmark22.4. PERFORMANCE ATTRIBUTION22.5. "PERFORMANCE IS THE PRODUCT"22.5.1. Fund Performance Rating22.6. SUMMARY
23.1. PORTFOLIO SELECTION UNDER UNCERTAINTY23.1.1. Mean-Variance Model23.1.2. Stochastic Dominance Framework as an Alternative to M-V Model23.1.3. Mean–Lower Partial Moment Framework23.2. LPM-CAPM23.3. EVALUATION OF PORTFOLIO PERFORMANCE IN LPM-CAPM FRAMEWORK23.4. MEAN-EQUIVALENCE APPROACH23.5. NUMERICAL EXAMPLE23.6. SUMMARY
24.1. TOP-DOWN VERSUS BOTTOM-UP APPROACHES24.2. FUNDAMENTAL VERSUS TECHNICAL ANALYSIS24.3. STRATEGIES BASED ON TECHNICAL ANALYSIS24.3.1. Dow Theory24.3.2. Simple Filter Rules24.3.3. Moving Averages24.3.4. Advance/Decline Line24.3.5. Relative Strength24.3.6. Price and Trading Relationship24.3.7. Short Interest Ratio24.3.8. Linear and Nonlinear Dynamic Models24.3.9. Market Overreaction24.4. STRATEGIES BASED ON FUNDAMENTAL ANALYSIS24.4.1. Earnings Surprises24.4.2. Low Price-Earnings Ratio24.4.3. Market-Neutral Long-Short Strategy24.4.4. Market Anomaly Strategies24.4.4.1. Small-Firm Effect24.4.4.2. Low P/E Effect24.4.4.3. Neglected-Firm Effect24.4.4.4. Calendar Effects24.4.4.5. Following Insider Activity24.4.5. Equity Style Management24.4.5.1. Types of Equity Styles24.4.5.2. Style Classification Systems24.4.5.3. Strategies Based on Mathematical Models24.5. SUMMARY
25.1. AN INTEGRATED APPROACH TO A SEGMENTED MARKET25.1.1. A Coherent Framework25.2. DISENTANGLING25.2.1. Noise Reduction25.2.2. Return Revelation25.2.3. Predictive Power25.2.4. Additional Complexities25.3. CONSTRUCTING, TRADING, AND EVALUATING PORTFOLIOS25.4. PROFITING FROM COMPLEXITY25.5. SUMMARY
26.1. ARCHITECTURE26.2. TRADITIONAL ACTIVE MANAGEMENT26.2.1. Cognitive Errors26.2.1.1. Loss Aversion: The "Better Not Take the Chance/What the Heck" Paradox26.2.1.2. Endowment Effect: The "Pride in Ownership" Syndrome26.2.1.3. The Gambler's Fallacy: "Hot Streaks, Empty Wallets"26.2.1.4. Confirmation Bias: "Don't Confuse Me with the Facts"26.2.2. Constructing Portfolios26.3. PASSIVE MANAGEMENT26.4. ENGINEERED MANAGEMENT26.4.1. Engineering Portfolios26.5. MEETING CLIENT NEEDS26.5.1. Expanding Opportunities26.5.2. Long-Short Portfolios26.6. THE RISK-RETURN CONTINUUM26.7. THE ULTIMATE OBJECTIVE26.8. SUMMARY
27.1. ALPHA: THE FOUNDATION OF ACTIVE INVESTING27.1.1. Comparing Beta and Alpha27.1.2. Benefits of Alpha27.2. CHALLENGES IN CONSTRUCTING PORTFOLIOS WITH ACTIVE MANAGERS27.3. CURRENT APPROACHES TO ACTIVE INVESTMENT MANAGEMENT27.3.1. Selecting Active Managers on the Basis of Beta Characteristics27.3.2. Core Satellite27.3.3. Portable Alpha27.4. A NEW APPROACH TO ACTIVE INVESTING27.4.1. Measuring Performance27.4.1.1. Accounting for Measurement Biases27.4.1.2. Separating Historical Returns into Alpha and Beta27.4.2. Projecting Manager Performance27.4.3. Quantifying Unique Manager Risks27.4.4. Constructing Portfolios27.5. PERFORMANCE IN PRACTICE27.6. SUMMARY27.7. ACKNOWLEDGMENTS
28.1. IMPLICIT TRANSACTION COSTS28.1.1. Investment Delay28.1.2. Market Impact Cost28.1.3. Price Movement Risk28.1.4. Market Timing Cost28.1.5. Opportunity Cost28.2. MARKET IMPACT MEASUREMENTS28.3. FORECASTING AND MODELING MARKET IMPACT28.3.1. A Factor-Based Market Impact Model28.4. INCORPORATING TRANSACTION COSTS IN ASSET ALLOCATION MODELS28.5. OPTIMAL TRADING28.6. SUMMARY
29.1. TRADITIONAL AND QUANTITATIVE APPROACHES TO EQUITY PORTFOLIO MANAGEMENT29.2. FORECASTING STOCK RETURNS, RISKS, AND TRANSACTION COSTS29.2.1. Forecasting Returns29.2.2. Forecasting Risks29.2.3. Forecasting Transaction Costs29.3. CONSTRUCTING PORTFOLIOS29.4. TRADING29.5. EVALUATING RESULTS AND UPDATING THE PROCESS29.6. SUMMARY
30.1. EVOLUTION OF SPECIFIC EQUITY STYLES30.2. CONSULTANTS, BENCHMARKS, AND BOXES30.3. VALUE MANAGER TECHNIQUES AND FACTORS30.4. GROWTHMANAGER TECHNIQUES AND FACTORS30.5. PASSIVE APPROACHES TO STYLE—WE NEED INDICES30.6. LONG-RUN BEHAVIOR OF GROWTH VERSUS VALUE30.7. GROWTH VERSUS VALUE REGIMES: THE LONG AND SHORT OF IT30.8. SUMMARY
31.1. MODEL DESCRIPTION AND ESTIMATION31.2. RISK DECOMPOSITION31.2.1. Total Risk Decomposition31.2.2. Systematic-Residual Risk Decomposition31.2.3. Active Risk Decomposition31.2.4. Active Systematic-Active Residual Risk Decomposition31.2.5. Summary of Risk Decomposition31.3. APPLICATIONS IN PORTFOLIO CONSTRUCTION AND RISK CONTROL31.3.1. Assessing the Exposure of a Portfolio31.3.2. Risk Control Against a Stock Market Index31.3.3. Tilting a Portfolio31.4. SUMMARY
32.1. DEFINITION OF TRACKING ERROR32.1.1. Tracking Error for an Active/Passive Portfolio32.2. COMPONENTS OF TRACKING ERROR32.3. FORWARD-LOOKING VERSUS BACKWARD-LOOKING TRACKING ERROR32.4. INFORMATION RATIO32.5. DETERMINANTS OF TRACKING ERROR32.5.1. Number of Stocks in the Portfolio32.5.2. Portfolio Market Cap and Style Difference Relative to the Benchmark32.5.3. Sector Deviation from the Benchmark32.5.4. Market Volatility32.5.5. Portfolio Beta32.6. MARGINAL CONTRIBUTION TO TRACKING ERROR32.7. SUMMARY
33.1. CONSTRUCTING A MARKET-NEUTRAL PORTFOLIO33.1.1. Market Neutrality Illustrated33.2. THE IMPORTANCE OF INTEGRATED OPTIMIZATION33.2.1. The Real Benefits of Long-Short33.3. ADDING BACK A MARKET RETURN33.3.1. Return Transportability33.3.2. Enhanced Active 120-20 Portfolio33.4. SOME CONCERNS ADDRESSED33.5. EVALUATING LONG-SHORT33.6. SUMMARY
34.1. DYNAMIC PRICE DISCOVERY34.1.1. Investor Behavior34.1.2. Analytic Context34.1.3. How the Participants Communicate34.1.4. A Static Framework34.1.5. A Dynamic Framework34.2. QUANTITY DISCOVERY34.3. TWO-SIDED MARKETS34.4. TECHNICAL ANALYSIS34.5. TOWARD TECHNICAL ANALYSIS TERRITORY34.5.1. Efficient Market Hypothesis (EMH)34.5.2. Trading the Order Flow34.6. TECHNICAL ANALYSIS AND ALGORITHMIC TRADING34.6.1. Algorithmic Trading versus Technical Analysis34.6.2. Algorithmic Trading and Quantity Discovery34.6.3. Where the Rubber Meets the Road34.6.4. Trading Tools and More34.6.5. Human Algo Traders34.7. SUMMARY34.8. APPENDIX: ORDER HANDLING AND MARKET TIMING ON A TRADING FLOOR
35.1. PRICE CHART PRIMER35.2. CLASSICAL CHART PATTERN EVOLUTION35.3. CLASSICAL CHART PATTERN BASICS35.4. ROLE OF CLASSICAL CHART PATTERNS35.5. STRENGTHS AND WEAKNESSES OF CHART PATTERNS35.6. THE MODEL35.7. THE VOLATILITY COMPONENT35.8. THE STRUCTURE COMPONENT35.9. SCREENING EXAMPLES35.9.1. Adobe (ADBE)35.9.2. Sysco (SYY)35.10. SUMMARY
36.1. PROBLEMS ENCOUNTERED IN MEAN-VARIANCE OPTIMIZATION IN PRACTICE36.2. THE BLACK-LITTERMAN MODEL36.2.1. Step 1: Basic Assumptions and Starting Point36.2.2. Step 2: Expressing an Investor's Views36.2.3. Step 3: Combining an Investor's Views with Market Equilibrium36.2.4. Some Properties of the Black-Litterman Model36.2.4.1. Absence of Views36.2.4.2. A Confidence Weighted Expected Return36.2.4.3. The Black-Litterman Expected Returns as the Solution of an Optimization Problem36.2.4.4. The Covariance Matrix of the Black-Litterman Returns36.2.4.5. How the Influence of Estimation Errors Is Mitigated36.2.5. Incorporating Trading Strategies in the Black-Litterman Model36.2.5.1. Factor Models36.2.5.2. Cross-Sectional Rankings36.2.5.3. Determining the Confidence Level36.3. AN EXAMPLE36.3.1. A Cross-Sectional Momentum Strategy36.3.2. Incorporating the Momentum Strategy in the Black-Litterman Model36.4. SUMMARY
37.1. SURPRISE! SURPRISE!37.2. THE BLINDNESS OF HINDSIGHT37.3. THE UNEXPECTED ROLE OF THEORY37.4. THE TREACHERY OF NUMBERS37.5. THE COMPUTER: FRIEND OR FOE?37.6. SUMMARY
38.1. THE THEORY OF SPECULATION38.2. CHARLES DOW AND THE DOW THEORY38.3. COWLES'S DAMNING EVIDENCE38.4. SUMMARY
39.1. METHODS OF ACTIVE MANAGEMENT39.1.1. Security Selection39.1.2. Examples of Factor Exposure39.1.2.1. Style/Size39.1.2.2. Regions, Countries, Industries, and Sectors39.1.2.3. Macroeconomic Factors39.1.2.4. Microeconomic Factors39.2. MODELING39.2.1. Fundamental Valuation Based Methods39.2.2. Momentum-Based and Trend-Sensitive Methods39.2.3. Combined Methods39.2.4. Other Techniques39.3. IMPLEMENTATION39.3.1. Physical Securities39.3.2. Trading in Aggregates39.4. SUMMARY
40.1. PAIRS TRADING40.1.1. Correlation Trading40.1.2. Examples of Pairs Trading40.1.2.1. Constant Relative Price Process Model40.1.2.2. Linear Regression–Based Model40.1.2.3. Correlated Residuals Model40.1.3. Cointegration and Error Correction Modeling40.2. GENERAL MODELS40.3. SUMMARY
41.1. LINEAR PAYOFFS: SWAPS41.2. LINEAR PAYOFFS: FUTURES41.2.1. Applications of Buying Futures41.2.2. Applications of Selling Futures41.2.3. Hedge Ratios Using Futures41.3. NONLINEAR PAYOFFS: OPTIONS41.3.1. Payoff Profiles for Options41.3.2. Selling Call Options: Exchanging Appreciation for Income41.3.3. Asymmetric Hedges: Protecting the Downside41.3.3.1. Protective Put41.3.3.2. Protective Put Spread41.3.3.3. Collar (Range Forward or Fence)41.3.4. Buying Call Options: Creating Market Exposure41.3.5. Probability Distribution of Returns41.3.6. Automatic Changes in Market Exposure41.4. SUMMARY
42.1. The Problem With Black-Scholes42.2. WHY OBSERVED PRICES MAY DIFFER FROM BLACK-SCHOLES42.2.1. Perfectly Liquid Markets42.2.2. Constant Interest Rates42.2.3. Continuous Markets42.2.4. Geometric Brownian Motion42.2.5. Short-Selling Assumption42.3. A Generalized Actuarial Model42.3.1. Examples of Actuarial Valuation42.4. Summary
43.1. SELECTING THE BENCHMARK INDEX43.1.1. Principle 1: Relevance to the Investor43.1.2. Principle 2: Representative of the Market43.1.3. Principle 3: Transparent Rules and Consistent Constituents43.1.4. Principle 4: Investible and Replicable43.1.5. Principle 5: High-Quality Data43.1.6. Principle 6: Independence43.2. CREATING A CUSTOM INDEX43.2.1. Rules-Based Indices43.2.1.1. Market Type43.2.1.2. Inflation Index43.2.1.3. Rating43.2.1.4. Aggregate Face Value43.2.1.5. Percentage of Index43.2.2. Using Mean/Variance Analysis to Customize an Index43.2.2.1. Setting Up the Problem43.3. BEATING THE BENCHMARK INDEX43.3.1. Choosing Scenarios for the Optimization43.3.2. Choosing the Optimization Criterion43.3.3. Defining the Constraints43.3.3.1. Duration Bands43.3.3.2. Partial Duration43.3.3.3. Asset Allocation Weights43.3.3.4. Loss Constraints43.3.3.5. Issue Weights43.3.4. Putting It All Together: The Optimal Portfolio43.3.4.1. The Duration Decision43.3.4.2. The Optimal Portfolio in a Multiasset Setting43.4. SUMMARY
44.1. THE BOND PORTFOLIO MANAGER44.2. THE GLOBAL CHALLENGE44.3. PORTFOLIO PARAMETERS44.4. FORECAST CONFIDENCE AND RELATIVE RISK44.5. REGULATORY CHANGES, DEMOGRAPHIC TRENDS, AND INSTITUTIONAL BIAS44.6. INFORMATION IN THE MARKETS44.7. DURATION AND YIELD CURVE44.8. VOLATILITY44.9. LIMITATIONS OF SOVEREIGN ONLY BOND PORTFOLIOS44.10. INFLATION-LINKED BONDS44.11. INTERNATIONAL CORPORATE BONDS44.12. INTERNATIONAL INVESTING AND POLITICAL EXTERNALITIES44.13. FOREIGN INVESTMENT SELECTION44.14. CURRENCY SELECTION44.15. THE EVOLUTION OF GLOBAL BOND INDICES44.16. SUMMARY
45.1. QUANTITATIVERATING MODELS45.1.1. Scoring Models45.1.2. Discriminant Analysis45.1.3. The Selection of Financial Ratios for the Rating Model45.1.4. Model Formation45.1.5. Forming the Discriminant Function45.1.6. Testing the Discriminant Function45.1.7. Analysis of a Discriminant Function on the Basis of a Case Study45.2. RELATIVE VALUE ANALYSIS45.3. SUMMARY
46.1. SHAPES OBSERVED FOR THE YIELD CURVE46.2. THE EXPECTATIONS HYPOTHESIS46.3. LIQUIDITY PREFERENCE THEORY46.4. MONEY SUBSTITUTE HYPOTHESIS46.5. SEGMENTATION HYPOTHESIS46.6. THE COMBINED THEORY46.7. THE FLAT YIELD CURVE46.8. FURTHER VIEWS ON THE YIELD CURVE46.9. SUMMARY
47.1. CURRENT PENSION FUND STRUCTURE47.1.1. Liabilities: The Same as a Short Exposure to Long-Duration Bonds47.1.2. Assets: Dominated by Equity Risk47.1.3. Funding Status: Lots of Volatility and Zero Positive Return47.1.4. Why the Typical Plan's Assets Do Not Outperform Liabilities47.1.5. Funding Ratio Drawdowns Happen at the Wrong Time47.2. A BETTER APPROACH TO STRUCTURING A DEFINED BENEFIT PENSION PORTFOLIO47.2.1. The Liability-Immunizing Portfolio (Matching the Return on Liabilities)47.2.2. Adding a Liability-Immunizing Exposure47.2.3. A More Optimally Structured Portfolio Means Smaller, Less Frequent Contributions47.2.3.1. Note on Leverage and Timing47.2.4. The Excess Return Portfolio (Exceeding the Return on Liabilities)47.2.5. Diversifying Exposures in the Excess Return Portfolio47.2.6. Case Study: An Underfunded Pension Plan47.3. SUMMARY
A.1.A.1.1. Cash Requirements for Liability-Immunizing PortfolioA.1.2. Funding Status DrawdownsA.1.3. Funding Status and Contributions with Liability GrowthA.1.4. Expected Returns, Volatility, Tracking Error, and Correlations AssumptionsA.1.5. Return HistoryA.1.5.1. Typical Pension Fund Asset Allocation Return Histories Used
48.1. CASH-FLOW ARBITRAGE48.2. VOLATILITY TRADING48.3. GAMMA TRADING48.3.1. High-Convexity Convertibles48.4. CREDIT ARBITRAGE48.5. SKEWED ARBITRAGE48.6. CARRY TRADE48.7. REFINANCING PLAYS48.8. LATE-STAGE RESTRUCTURING PLAYS48.9. MULTISTRATEGY48.10. RISK CONTROL IN CONVERTIBLE ARBITRAGE STRATEGIES48.11. SUMMARY
49.1. FIRM VALUATION AND BOND PRICING49.2. UPGRADING THE CAPITAL STRUCTURE: EFFECT OF SUBORDINATION ON BOND PRICING49.3. BOND MATURITY, CREDIT RISK, AND HEDGE RATIOS49.4. EXPANDING THE RANGE OF POSSIBLE OUTCOMES49.5. RESPONSES TO SHOCKS49.6. SUMMARY
50.1. CASH BONDS, NO CREDIT RISK50.2. PURE INTEREST RATE DERIVATIVES50.3. CASH BOND WITH CREDIT RISK50.4. FLOATING-RATE NOTES50.5. SIMPLE CREDIT DERIVATIVE50.6. DEFAULT50.7. CASH INSTRUMENTS50.8. ASSET SWAPS50.9. CREDIT DEFAULT SWAPS50.10. BOND/DEFAULT SWAP COMBINATION50.11. SUMMARY
51.1. TRADITIONAL INVESTMENT ALTERNATIVES51.2. ENTER SWAPS51.3. NEW COMBINATIONS51.4. REAL VERSUS INFLATION RISK51.5. INFLATION SWAPS51.6. SUMMARY
52.1. INVESTOR TYPES AND STRATEGIES52.2. CONSTRAINTS AND GUIDELINES52.3. IDENTIFYING ABS RISKS52.3.1. Fundamentals52.3.2. Technicals52.4. MONITORING ABS PORTFOLIOS AND MEASURING PERFORMANCE52.4.1. Measuring ABS Performance52.5. SUMMARY
53.1. MODERN PORTFOLIO THEORY AND ITS LEGACY53.2. ASSUMPTIONS THAT UNDERLIE STANDARD ASSET ALLOCATION MODELS53.3. THE CHALLENGE OF ALTERNATIVE INVESTMENTS53.4. THE INVESTOR'S DILEMMA53.5. TOWARD A NEW ASSET ALLOCATION PARADIGM: THE FOUR CLASSES OF RETURN53.6. TOWARD A NEW ASSET ALLOCATION PARADIGM: COSTS ASSOCIATED WITH EACH RETURN CLASS53.7. INVESTMENT CLASSIFICATION IN A MULTIDIMENSIONAL FRAMEWORK53.8. MULTIDIMENSIONAL ASSET ALLOCATION53.9. EXAMPLE OF MULTIDIMENSIONAL ASSET ALLOCATION53.10. IMPLEMENTING THE NEW ASSET ALLOCATION PARADIGM53.11. SUMMARY53.12. ACKNOWLEDGMENTS
54.1. BACKGROUND54.2. THE MARKET FOR FOREIGN EXCHANGE54.3. SPOT MARKET54.4. THE PURCHASE AND SALE OF FOREIGN EXCHANGE54.5. TRADITIONAL APPLICATIONS54.5.1. Short/Long Currencies Part of Money Market Hedge54.5.2. Short-Term Currency Speculation with Leverage and Interest Rate Calculations54.5.2.1. A Practical Algorithm for Computing Net Currency and Interest Changes54.5.2.2. The Case for Currency Programs: Currencies as an Asset Class54.6. SUMMARY
55.1. FINANCIAL ANALYSIS55.2. FORMS OF BUSINESS ENTERPRISE55.2.1. Sole Proprietorships55.2.2. Partnerships55.2.3. Corporations55.2.4. Other Forms of Business55.2.5. Prevalence55.3. THE OBJECTIVE OF FINANCIAL MANAGEMENT55.3.1. The Measure of Owner's Economic Well-Being55.3.2. Economic Profit versus Accounting Profit: Share Price versus Earnings per Share55.3.3. Share Prices and Efficient Markets55.3.4. Financial Management and the Maximization of Owners' Wealth55.4. THE AGENCY RELATIONSHIP55.4.1. Problems with the Agency Relationship55.4.2. Costs of the Agency Relationship55.4.3. Motivating Managers: Executive Compensation55.4.4. Shareholder Wealth Maximization and Accounting "Irregularities"55.4.5. Shareholder Wealth Maximization and Social Responsibility55.5. SUMMARY
56.1. MULTINATIONAL FIRMS56.2. FOREIGN CURRENCY56.2.1. Exchange Rates56.2.2. Currency Risk56.2.3. Purchasing Power Parity56.3. TAX CONSIDERATIONS56.3.1. Establishing a Business Entity56.3.2. Corporate Income Tax Rates56.3.3. Determining Taxable Income56.3.3.1. Interest Expense56.3.3.2. Intercompany Transactions and Transfer Prices56.4. FINANCING OUTSIDE THE DOMESTIC MARKET56.4.1. Motivation for Raising Funds Outside of the Domestic Market56.4.2. Implications of Global Market Integration for Funding Costs56.4.3. Cross-Listing Stock56.4.3.1. International Depositary Receipts56.4.3.2. Euroequity Issues56.4.4. Eurobond Market56.5. FINANCIAL ANALYSIS ISSUES56.6. CAPITAL BUDGETING56.7. CAPITAL STRUCTURE56.8. WORKING CAPITAL MANAGEMENT56.9. HEDGING CURRENCY RISK56.9.1. Currency Forward Contracts56.9.2. Currency Futures Contracts56.9.3. Currency Swaps56.9.4. Currency Option Contracts56.10. SUMMARY
57.1. STRATEGY AND VALUE57.1.1. Comparative and Competitive Advantages57.1.2. Strategy and Adding Value57.2. FINANCIAL PLANNING AND BUDGETING57.3. IMPORTANCE OF FINANCIAL PLANNING57.4. BUDGETING PROCESS57.5. SALES FORECASTING57.5.1. Forecasting with Regression Analysis57.5.2. Market Surveys57.5.3. Management Forecasts57.6. SEASONAL CONSIDERATIONS57.7. BUDGETING57.7.1. Cash Budget57.8. PRO FORMA FINANCIAL STATEMENTS57.8.1. Analysis of Accounts57.8.2. Percent-of-Sales Method57.9. LONG-TERM FINANCIAL PLANNING57.10. FINANCIAL MODELING57.11. PERFORMANCE EVALUATION57.11.1. Economic Value Added57.11.1.1. Economic Profit/Economic Value Added57.11.1.2. Market Value Added57.11.2. Balanced Scorecard57.11.2.1. The Process57.11.2.2. The Measures57.11.2.3. How Do Companies Use the Balanced Scorecard?57.11.2.4. Scorecard for the Balanced Scorecard57.12. STRATEGY AND VALUE CREATION57.12.1. Sources of Value Creation57.13. SUMMARY
58.1. AGENCY THEORY AND PROBLEMS58.1.1. Failure of Internal Corporate Control Systems58.1.1.1. Board Agenda58.1.1.2. Board Composition58.1.1.3. Equity Alignment58.1.1.4. Board Size58.1.1.5. Joint CEO/Chairman Role58.2. CORPORATE GOVERNANCE PROGRAMS58.2.1. Definition of Corporate Governance58.2.2. Standards and Codes of Best Practice for Corporate Governance58.2.3. Shareowner versus Shareholder58.2.4. SEC Rule 14a-858.3. CORPORATE GOVERNANCE RATINGS58.4. SUMMARY
59.1. PERFORMANCE MEASUREMENT AND MANAGERIAL COMPENSATION59.1.1. Performance Measurement59.1.2. Accounting Measures59.1.2.1. Return on Investment (ROI)59.1.3. The Economic Income Method59.1.4. Market Measures59.1.5. Nonaccounting Quantitative Measures59.1.6. Qualitative Measures59.2. MANAGERIAL COMPENSATION59.2.1. Agency Theory Applied to Corporate Management and Performance Measurement59.2.2. Noncontrollable Factors59.2.3. A Nonzero Net Present Value59.2.4. Incentive Consideration59.2.5. Deferred Benefits59.2.6. Cash Flow Return on Investment59.3. PLANNING IMPLICATIONS59.4. SUMMARY
60.1. DEBT VERSUS EQUITY60.2. THE CONCEPT OF LEVERAGE60.2.1. Leverage and Operating Risk60.2.2. Leverage and Financial Risk60.3. CAPITAL STRUCTURE AND FINANCIAL LEVERAGE60.4. FINANCIAL LEVERAGE AND RISK60.4.1. The Leverage Effect60.4.2. Leverage and Financial Flexibility60.4.3. Governance Value of Debt Financing60.5. CAPITAL STRUCTURE AND TAXES60.5.1. Interest Deductibility and Capital Structure60.5.2. Interest Tax Shield60.5.3. Unused Tax Shields60.6. CAPITAL STRUCTURE AND FINANCIAL DISTRESS60.6.1. Costs of Financial Distress60.6.2. The Role of Limited Liability60.6.3. Bankruptcy and Bankruptcy Costs60.6.4. Financial Distress and Capital Structure60.7. THE COST OF CAPITAL60.8. THE AGENCY RELATIONSHIP60.8.1. Problems with the Agency Relationship60.8.1.1. Costs of the Agency Relationship60.8.2. The Agency Relationship and Capital Structure60.9. OPTIMAL CAPITAL STRUCTURE: THEORY AND PRACTICE60.9.1. Capital Structures among Different Industries60.9.2. Capital Structures within Industries60.9.3. Trade-off Theory and Observed Capital Structures60.9.4. Other Possible Explanations60.10. A CAPITAL STRUCTURE PRESCRIPTION60.11. SUMMARY
61.1. M&M IRRELEVANCE PROPOSITION61.2. M&M WITH TAX DEDUCTIBILITY OF INTEREST PAID ON DEBT61.3. CAPITAL STRUCTURE THEORY AND COSTS TO FINANCIAL DISTRESS61.4. THE TRADITIONAL TRADE-OFF MODEL AND CURRENT CAPITAL STRUCTURE THEORY AND PRACTICE61.5. SUMMARY
62.1. SHAREHOLDER AND BONDHOLDER—DEFINITION AND INTERESTS62.1.1. Shareholder Value62.1.2. Bondholder Value62.2. CONFLICTS OF INTEREST BETWEEN SHAREHOLDERS AND BONDHOLDERS62.2.1. Capital Structure62.2.2. Stock Buybacks62.2.3. Corporate Strategy and Business Policy62.3. INSTRUMENTS OF SHAREHOLDER VALUE TO ENHANCE BONDHOLDER VALUE62.3.1. Investor Relations Not Only for Shareholders62.3.2. Risk Management62.3.3. Balanced Scorecard62.4. SUMMARY
63.1. FRAMEWORK FOR RECAPITALIZATIONS63.2. OUT-OF-COURT WORKOUTS AND BANKRUPTCY63.2.1. Out-of-Court Workouts63.2.2. In-Court Reorganization63.2.3. Prepackaged Bankruptcy63.2.4. Liquidation63.3. ACCOUNTING TREATMENT63.3.1. Troubled Debt Restructuring63.3.2. Asset Impairment63.3.3. Fresh-Start Accounting63.3.4. TAX CONSIDERATIONS63.4. VALUING RECAPITALIZATION SECURITIES63.4.1. The Southland Leveraged Buyout63.4.2. The Recapitalization Plans63.4.3. Valuing the New Debt Securities63.4.4. Valuing Equity63.4.5. Recovery63.5. VALUING RECAPITALIZATION RIGHTS AND OPTIONS63.6. SUMMARY
64.1. DIVIDENDS64.1.1. Dividend Reinvestment Plans64.1.1.1. Stock Distributions64.2. DIVIDEND POLICY64.2.1. The Dividend Irrelevance Theory64.2.2. The "Bird in the Hand" Theory64.2.3. The Tax-Preference Explanation64.2.4. The Signaling Explanation64.2.5. The Agency Explanation64.2.6. Summing Up: To Pay Dividends or Not64.3. STOCK REPURCHASES64.4. SUMMARY
65.1. INVESTMENT DECISIONS AND OWNERS' WEALTH MAXIMIZATION65.2. CAPITAL BUDGETING PROCESS65.2.1. Stages in the Capital Budgeting Process65.2.1.1. Stage 1: Investment Screening and Selection65.2.1.2. Stage 2: Capital Budget Proposal65.2.1.3. Stage 3: Budgeting Approval and Authorization65.2.1.4. Stage 4: Project Tracking65.2.1.5. Stage 5: Postcompletion Audit65.3. CLASSIFYING INVESTMENT PROJECTS65.3.1. Classification According to Their Economic Life65.3.2. Classification According to Their Risk65.3.3. Classification According to Their Dependence on Other Projects65.4. SUMMARY
66.1. INCREMENTAL CASH FLOWS66.2. INVESTMENT CASH FLOWS66.2.1. Asset Acquisition66.2.2. Asset Disposition66.3. EXPECTED CASH FLOWS FROM THE DISPOSITION OF AN ASSET66.3.1. Case 1: Sell the Asset for More than Its Tax Basis, but Less than Its Original Cost66.3.2. Case 2: Sell the Asset for More than the Original Cost66.3.3. Case 3: Sell the Asset for Less than Its Tax Basis66.3.3.1. Disposition of New Investment66.3.3.2. Disposition of Existing Asset(s)66.4. OPERATING CASH FLOWS66.4.1. Change in Revenues66.4.2. Change in Expenses66.4.3. Change in Taxes66.4.4. Change in Working Capital66.4.5. Putting it All Together66.5. NET CASH FLOWS66.6. SIMPLIFICATIONS66.7. SUMMARY
67.1. EVALUATION TECHNIQUES67.1.1. The Cost of Capital, the Required Rate of Return, and the Discount Rate67.2. NET PRESENT VALUE67.2.1. Calculating the Net Present Value67.2.2. The Investment Profile67.2.2.1. Solving for the Crossover Rate67.3. PROFITABILITY INDEX67.4. INTERNAL RATE OF RETURN67.4.1. The IRR and Mutually Exclusive Projects67.4.2. The IRR and Capital Rationing67.4.3. Multiple Internal Rates of Return67.5. MODIFIED INTERNAL RATE OF RETURN67.5.1. Calculating the Modified Internal Rate of Return67.6. PAYBACK PERIOD67.7. DISCOUNTED PAYBACK PERIOD67.7.1. Calculating the Discounted Payback Period67.8. ISSUES IN CAPITAL BUDGETING67.8.1. Scale Differences67.8.1.1. Mutually Exclusive Projects67.8.1.2. Capital Rationing67.8.2. Unequal Lives67.9. COMPARING TECHNIQUES67.10. CAPITAL BUDGETING TECHNIQUES IN PRACTICE67.11. CAPITAL BUDGETING AND THE JUSTIFICATION OF NEW TECHNOLOGY67.12. SUMMARY
68.1. PROJECT RISK68.1.1. Different Types of Project Risk68.2. MEASUREMENT OF PROJECT RISK68.2.1. Range68.2.1.1. Standard Deviation68.2.1.2. Coefficient of Variation68.2.2. Tools That Can Be Used to Evaluate Total Risk68.3. MEASURING A PROJECT'S MARKET RISK68.3.1. Market Risk and Financial Leverage68.3.1.1. Using a Pure Play68.3.2. Adjusted Present Value68.4. INCORPORATING RISK IN THE CAPITAL BUDGETING DECISION68.4.1. Risk-Adjusted Rate68.4.1.1. Project's Cost of Capital Based on the CAPM Method68.4.1.2. Adjusting the Company's Cost of Capital68.5. REAL OPTIONS68.6. CERTAINTY EQUIVALENTS68.7. ASSESSMENT OF PROJECT RISK IN PRACTICE68.8. SUMMARY
69.1. THE DIFFERENCE BETWEEN REAL OPTIONS AND FINANCIAL OPTIONS69.2. USING OPTION PRICING TO VALUE BUSINESS OPPORTUNITIES69.3. CHOICE AND SPECIFICATION OF AN OPTION-PRICING MODEL69.3.1. The Binomial Model69.3.2. A Simplified Example69.4. USEFULNESS OF THE REAL-OPTIONS APPROACH69.5. ILLUSTRATION: THE OIL FIELD PROJECT69.5.1. The Project's Real Options69.5.2. Project Call Options69.5.3. Sources of Uncertainty69.5.4. Evaluating the Project69.5.5. Modeling Future Oil Prices69.5.6. Reserve Profile and the Quantity of Reserves69.5.7. Present Value of the Field Ignoring Abandonment69.5.8. Taking into Account the Option to Abandon Early69.5.9. Value of the Option to Develop the Field69.5.10. The Deferral Option69.5.11. Value of the Option to Drill Appraisal Wells69.5.12. Value of the Option to Drill Exploration Wells69.5.13. Net Present Value of the Project69.5.13.1. Traditional DCF Analysis69.5.13.2. Sensitivity of Option Value to Oil Price Volatility and to Reserve Dispersion69.6. SUMMARY
70.1. AN ILLUSTRATION70.2. IS NPV WRONG?70.3. WHY REAL OPTIONS ANALYSIS IS IMPORTANT70.4. TIMING OPTIONS70.4.1. Optimal Timing Under Negligible Uncertainty70.4.2. Timing and the Profitability Index70.4.3. Uncertain Growth in Value70.4.4. Value of the Timing Option70.5. EXPANSION OPTIONS70.5.1. Research and Development70.5.2. More Optionality70.5.3. An Expansion Question70.5.4. Volatility and Other Sensitive Parameters70.6. ABANDONMENT OPTIONS70.7. A NOTE OF CAUTION70.8. SUMMARY
71.1. PROJECT-SPECIFIC OPERATING BETAS AND THE GLOBAL CAPITAL ASSET PRICING MODEL71.1.1. Operating Beta Approach71.1.2. The Global CAPM71.2. SIMPLE APPROXIMATIONS OF A FOREIGN PROJECT'S OPERATING BETA71.2.1. Accounting Beta Method71.2.2. Country Beta Method71.3. EMERGING MARKET PROJECTS71.3.1. Country Risk for Emerging Markets71.3.2. Hurdle Rates for Emerging Market Projects71.4. CONSISTENT HURDLE RATES ACROSS CURRENCIES71.4.1. Conversion of Hurdle Rates across Currencies71.4.2. Risk and Return in Non-U.S. Dollar Currencies71.5. FOREIGN PURE PLAY PROXY METHOD71.5.1. Unlevering Equity Betas71.5.2. Foreign Pure Play Proxy71.5.3. FX Exposure and Operating Beta71.6. SUMMARY71.7. APPENDIX71.7.1. Derivation of Equation (71.3)71.7.2. Derivation of Equation (71.5)71.7.3. Derivation of Equation (71.6)
72.1. OTHER DEFINITIONS OF STRUCTURED FINANCE72.2. BORDERLINE CASES AND BOUNDARIES72.3. BASIC CONCEPTUAL DEFINITIONS72.4. INSTRUMENTS AND TECHNIQUES72.5. WHEN OR WHERE STRUCTURED FINANCE IS USED72.6. BENEFITS OF STRUCTURED FINANCE72.7. SECURITIZATION72.8. ARGUMENTS FOR BROADER DEFINITIONS72.9. SUMMARY
73.1. WHAT IS A SECURITIZATION?73.1.1. Illustration of a Securitization73.2. APPEAL OF SECURITIZATION73.2.1. Diversification and Reduced Cost of Funding73.2.2. Generation of Servicing Fee Income73.2.3. Earnings Acceleration and Management73.2.4. Management of Interest Rate Volatility73.2.5. Management of Regulatory Capital73.2.6. Off-Balance-Sheet Financing73.2.7. Less Public Disclosure than Competing Methods of Financing73.3. INVESTMENT ATTRIBUTES OF ABSs73.4. DEVELOPMENT OF ASSET SECURITIZATION73.5. WHAT IT TAKES TO SECURITIZE73.6. CREDIT ENHANCEMENT MECHANISMS73.7. RATING AGENCY CRITERIA FOR ABSs73.8. MACROECONOMIC BENEFITS OF SECURITIZATION73.9. ARE SECURITIZATIONS EXEMPT FROM CORPORATE RISK?73.10. SUMMARY
74.1. COMPARISON BETWEEN A CORPORATION AND A SECURITIZATION STRUCTURE74.2. IDENTIFICATION OF THE ASSET POOL74.3. SELECTION OF THE ASSETS74.4. IDENTIFICATION OF RISKS74.5. DETERMINATION OF THE SOURCES AND SIZE OF CREDIT SUPPORT74.6. DETERMINATION OF THE BOND CLASSES74.7. TIME TRANCHING OF BOND CLASSES74.8. SELECTING THE PAY-DOWN STRUCTURE FOR THE BOND CLASSES74.9. DETERMINATION OF THE AMOUNT AND SOURCES FOR LIQUIDITY SUPPORT74.10. DETERMINING IF ANY PREPAYMENT PROTECTION IS NEEDED74.11. INCLUSION OF STRUCTURAL PROTECTION TRIGGERS74.12. SUMMARY
75.1. INVESTMENT BANKER'S GOAL AND ISSUER'S OBJECTIVES75.2. COMPARISON TO OTHER FINANCING VEHICLES75.2.1. Whole-Loan Sales versus Securitizations75.2.2. Secured Financing versus Securitizations75.2.3. Defeased Debt versus Securitization75.3. BANKRUPTCY FIREWALLS AND THE ISSUANCE VEHICLE75.4. UNDERLYING CONSIDERATIONS OF FINANCING VERSUS SALE FOR GAAP AND TAX75.4.1. Tax Debt and Equity75.5. EFFICIENT ALLOCATION OF RISK—CREDIT RISK75.5.1. External Enhancement75.5.2. Internal Enhancement75.5.3. Combining External and Internal Enhancement75.5.4. Credit Enhancement Decisions75.5.5. Determining Credit Enhancement Levels75.6. TARGETING SPECIFIC INVESTORS75.6.1. Time Tranching75.6.2. Coupon and Volatility Tranching75.7. EMBEDDED OPTIONS AND FLOATING-RATE MISMATCH75.7.1. Public versus Private Execution75.7.2. Tax Efficiency75.7.3. Deal Size75.7.4. Prefunding Accounts75.7.5. Conduits75.8. SUMMARY
76.1. REASONS TO SECURITIZE RECEIVABLES76.2. RECEIVABLES SECURITIZATION76.3. UNDERWRITING76.4. CREDIT INSURANCE76.5. SERVICING76.6. FUNDING AVAILABILITY76.7. COLLATERALIZATION TEST76.8. NET RECEIVABLES POOL BALANCE76.9. STANDARD RESERVES76.9.1. Loss Reserve76.9.2. Trade Credit Insurance76.9.3. Dilution Reserve76.9.4. Dynamic and Static Reserves76.9.5. Yield and Fee Reserves76.10. FUNDING MECHANICS76.11. MONTHLY SETTLEMENTS76.12. SUMMARY
77.1. THE SERVICING FUNCTION77.2. TYPES OF SERVICERS77.3. SERVICER STRENGTHS77.3.1. Staff Strengths77.3.2. Organizational Structure77.3.3. Training77.3.4. Staff Turnover77.3.5. Systems77.3.6. Internal Controls77.3.7. Loan/Asset Administration77.4. SERVICER QUALITIES77.4.1. Consumer Finance77.4.2. Commercial Finance Servicers77.4.3. Franchise Loan Servicers77.4.4. Commercial Mortgage-Backed Finance Servicers77.4.4.1. Primary Servicers77.4.4.2. Master Servicers77.4.4.3. Special Servicers77.4.5. Residential Mortgage Servicers77.4.5.1. Primary Servicers77.4.5.2. Subprime Services77.4.5.3. Special Servicers77.4.5.4. Master Servicers77.5. SERVICING TRANSITION77.6. BACKUP SERVICER77.7. REPORTING BY THE SERVICER77.8. ROLE OF TRUSTEES IN OPERATION OF THE TRANSACTION77.9. FRAUD RISK77.10. SUMMARY
78.1. WHAT IS PROJECT FINANCING?78.2. REASONS FOR JOINTLY OWNED OR SPONSORED PROJECTS78.3. CREDIT EXPOSURES IN A PROJECT FINANCING78.3.1. Risk Phases78.3.1.1. Engineering and Construction Phase78.3.1.2. Start-up Phase78.3.1.3. Operations According to Specification78.3.2. Different Lenders for Different Risk Periods78.4. KEY ELEMENTS OF A SUCCESSFUL PROJECT FINANCING78.5. CAUSES FOR PROJECT FAILURES78.5.1. Market Risk78.5.1.1. PYCSA, Panama78.5.1.2. SCL Terminal Aéreo Santiago78.5.2. Market Risk, High Leverage, High Purchase Price78.5.2.1. Drax, UK78.5.3. Market Risk, Political Risk78.5.3.1. Dabhol, India78.5.4. Market Risk, Counterparty Risk, Currency Risk, Political Risk78.5.4.1. Paiton Energy, Indonesia78.5.5. Counterparty Risk, Political Risk78.5.5.1. Meizou Wan, China78.5.6. Market Risk, Currency Risk, Political Risk, High Purchase Price78.5.6.1. BCP, Brazil78.5.7. Market Risk, High Leverage78.5.7.1. FLAG78.5.8. Market Risk, Operating Risk78.5.8.1. Andacollo Gold Mine, Chile78.5.9. Counterparty Risk, Political Risk78.5.9.1. TermoEmcali, Colombia78.5.10. Counterparty Risk, Construction Risk, Political Risk78.5.10.1. Casecnan Water and Energy, Philippines78.6. CREDIT IMPACT OBJECTIVE78.6.1. Sources of Capital78.6.2. Project Finance Credit Ratings78.6.3. Institutional Investors' Needs78.7. ACCOUNTING CONSIDERATIONS78.8. MEETING INTERNAL RETURN OBJECTIVES78.9. OTHER BENEFITS OF A PROJECT FINANCING78.10. TAX CONSIDERATIONS78.11. DISINCENTIVES TO PROJECT FINANCING78.12. EFFECT OF ENRON DEBACLE ON TRADITIONAL PROJECT FINANCE78.12.1. Background78.12.2. Effect on Traditional Project Finance78.12.3. Structured Project Finance78.12.4. Special Purpose Entities78.12.5. Sources of Free Cash Flow78.12.6. Security Interests78.12.7. How Companies Have Responded78.12.8. Increased Transparency and Disclosure78.12.9. Regulatory Issues78.12.10. Other Lessons Learned78.13. RECENT TRENDS78.14. SUMMARY
79.1. HOW LEASING WORKS79.2. TYPES OF EQUIPMENT LEASES79.2.1. Non-Tax-Oriented Leases79.2.2. Tax-Oriented True Leases79.2.2.1. Single-Investor Leases versus Leveraged Leases79.3. FULL PAYOUT LEASES VERSUS OPERATING LEASES79.4. REASONS FOR LEASING79.4.1. Cost79.4.2. Conservation of Working Capital79.4.3. Preservation of Credit Capacity by Avoiding Capitalization79.4.4. Risk of Obsolescence and Disposal of Equipment79.4.5. Restrictions on Management79.4.6. Impact on Cash Flow and Book Earnings79.5. TYPES OF LESSORS79.6. LEASE BROKERS AND FINANCIAL ADVISERS79.7. OVERVIEW OF LEASE DOCUMENTATION FOR NONLEVERAGED LEASES79.8. LEASE PROGRAMS79.9. FINANCIAL REPORTING OF LEASE TRANSACTIONS BY LESSEES79.9.1. Classification of Leases79.9.2. Accounting for Operating Leases79.9.3. Accounting for Capital Leases79.10. FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS79.11. SUMMARY
80.1. PARTIES TO A LEVERAGED LEASE80.1.1. Lessee80.1.2. Equity Participants80.1.3. Loan Participants or Lenders80.1.4. Owner Trustee80.1.5. Indenture Trustee80.1.6. Manufacturer or Contractor80.1.7. Packager or Broker80.1.8. Guarantor80.2. STRUCTURE OF A LEVERAGED LEASE80.3. CLOSING THE TRANSACTION80.3.1. Participation Agreement80.3.2. Other Key Documents80.3.3. Indemnities by the Lessee80.4. CASH FLOWS DURING THE LEASE80.5. DEBT FOR LEVERAGED LEASES80.6. FACILITY LEASES80.7. CONSTRUCTION FINANCING80.8. CREDIT EXPOSURE OF EQUITY PARTICIPANTS80.9. TAX INDEMNIFICATION FOR FUTURE CHANGES IN TAX LAW80.10. NEED FOR A FINANCIAL ADVISER80.11. THE STEPS IN STRUCTURING, NEGOTIATING, AND CLOSING A LEVERAGED LEASE80.12. SUMMARY
81.1. STEPS IN THE LEASE VERSUS BORROW-TO-BUY DECISION81.2. CAPITAL BUDGETING USING THE NET PRESENT VALUE TECHNIQUE81.2.1. How to Compute the Net Present Value81.2.2. Decision Rules Using the Net Present Value Technique81.2.3. Why the Net Present Value Technique?81.3. VALUING A LEASE81.3.1. Direct Cash Flow from Leasing81.3.2. Valuing the Direct Cash Flow from Leasing81.3.3. Concept of an Equivalent Loan81.3.4. Comparison of Alternative Leases81.4. ANOTHER APPROACH TO LEASE VALUATION81.5. UNCERTAINTY AND THE LEASE VALUATION MODEL81.5.1. Alternative Discount Rates and the Uncertainty of Cash Flows81.5.2. Residual Value and the Lease Term81.5.3. Debt Displacement and the Lease Valuation Model81.5.4. Sensitivity Analysis81.6. GENERALIZATION OF THE LEASE VALUATION MODEL81.6.1. Modification of the Model When Tax Shield Cannot Be Carried Forward81.7. SUMMARY
82.1. OVERVIEW OF TREASURY MANAGEMENT82.1.1. Treasury Management Functions82.1.2. The Operating Cycle and the Cash-Flow Timeline82.1.3. Cash Cycles82.1.4. Cash-Flow Variability82.1.5. The Role of the Treasury Manager82.1.6. Essential Treasury Concepts82.1.6.1. Float82.1.6.2. Availability82.1.6.3. Finality82.1.6.4. Idle Balances82.1.6.5. The Account Analysis82.2. PAYMENT SYSTEMS82.2.1. Fedwire System82.2.2. Automated Clearinghouse82.2.3. Purchasing Cards82.2.4. Paper-Based Transactions82.3. COLLECTION SYSTEMS82.3.1. Mail Float82.3.2. Processing Float82.3.3. Availability Float82.4. LOCKBOXING82.4.1. Lockbox Services82.4.2. Wholesale Lockboxing82.5. CASH MOBILIZATION82.5.1. Concentration Systems82.5.1.1. Concentration Decision Factors82.6. DISBURSEMENT SYSTEMS82.6.1. Regular Checking and Zero-Balance Accounts82.6.2. Controlled Disbursement and Positive Pay82.6.2.1. Controlled Disbursement82.6.2.2. Positive Pay82.6.3. Other Disbursement Services82.6.3.1. Reconciliation82.6.3.2. Comprehensive Payables82.7. SUMMARY
83.1. LIQUIDITY MANAGEMENT83.1.1. Cash Forecasting83.1.1.1. Cash Budgeting83.1.1.2. The Distribution Method83.1.1.3. Cash Modeling83.1.1.4. Choosing a Forecasting Method83.1.2. Issues in Short-Term Liquidity83.1.2.1. Short-Term Investment Objectives83.1.2.2. Investment Policies83.1.2.3. Short-Term Credit83.1.3. Other Credit Facilities83.2. INTERNATIONAL TREASURY MANAGEMENT83.2.1. Differences Between U.S. and International Treasury Management83.2.1.1. Complexities of International Treasury Management83.2.1.2. Banking Compensation83.2.2. International Risk83.2.3. Foreign Exchange Risk83.2.3.1. Cross-Border Commercial Risk83.2.3.2. Risk Management Tools83.2.4. Other Issues in International Treasury Management83.2.4.1. Cross-Border Clearing and Settlement83.2.4.2. International Treasury Systems83.2.4.3. Pooling83.2.4.4. Netting83.3. TREASURY INFORMATION SYSTEMS83.3.1. Standard Modules83.3.2. Advanced Functionality83.3.2.1. Modules for International Treasury Management83.3.2.2. Modules for Debt and Investment Management83.3.2.3. Modules for Intracompany Data Exchange83.3.3. Benefits of Current Treasury Systems83.3.3.1. Provider Support83.4. BANK RELATIONSHIP MANAGEMENT83.4.1. Considerations in Relationship Management83.4.1.1. Twenty-first-Century Relationship Management83.4.1.2. The Request for Proposal83.4.1.3. Bank Pricing83.4.2. Banking Relationships in the Twenty-first Century83.4.2.1. Service-Level Agreements83.4.2.2. Relationship Reviews83.4.2.3. Future Role of the Treasurer83.5. SUMMARY
84.1. REASONS FOR EXTENDING CREDIT84.2. COSTS OF CREDIT84.2.1. The Cost of Discounts84.2.2. Other Costs84.2.3. The Implicit Cost of Trade Credit to the Customer84.2.4. Credit and the Demand for a Company's Goods and Services84.3. CREDIT AND COLLECTION POLICIES84.3.1. Credit Policies84.3.2. Evaluation of Creditworthiness84.3.3. Collection Policies84.4. MONITORING ACCOUNTS RECEIVABLE84.4.1. Establishing and Changing Credit Policies84.5. CAPTIVE FINANCE SUBSIDIARIES84.6. SECURITIZATION OF ACCOUNTS RECEIVABLE84.7. SUMMARY
85.1. REASONS FOR HOLDING INVENTORY85.2. COSTS ASSOCIATED WITH INVENTORY85.3. MODELS OF INVENTORY MANAGEMENT85.3.1. The Economic Order Quantity Model85.3.2. Just-in-Time Inventory85.3.3. Other Considerations85.4. MONITORING INVENTORY MANAGEMENT85.5. SUMMARY
86.1. BACKGROUND ON ACQUISITIONS86.1.1. Classifying Acquisitions86.1.2. The Process of an Acquisition86.2. EMPIRICAL EVIDENCE ON THE VALUE EFFECTS OF TAKEOVERS86.3. STEPS IN AN ACQUISITION86.3.1. Developing an Acquisition Strategy86.3.1.1. Acquire Undervalued Firms86.3.1.2. Diversify to Reduce Risk86.3.1.3. Create Operating or Financial Synergy86.3.1.4. Take Over Poorly Managed Firms and Change Management86.3.1.5. Cater to Managerial Self-Interest86.3.2. Choosing a Target Firm and Valuing Control/Synergy86.3.2.1. Choosing a Target Firm86.3.2.2. Valuing the Target Firm86.3.2.3. Takeover Valuation: Biases and Common Errors86.3.3. Structuring the Acquisition86.3.3.1. Deciding on an Acquisition Price86.3.3.2. Payment for the Target Firm86.3.3.3. Accounting Considerations86.4. ANALYZING MANAGEMENT AND LEVERAGED BUYOUTS86.4.1. The Valuation of a Buyout86.4.2. Valuing a Leveraged Buyout86.5. SUMMARY
87.1. THE RISE OF MERGERS AND ACQUISITIONS87.1.1. Merger and Acquisition Waves87.1.2. Macroeconomic Factors87.1.3. Microeconomic Factors87.1.4. Human Factors87.1.5. The Larger Context87.2. CHOOSING A NEGOTIATING STRATEGY87.2.1. Private Negotiation87.2.1.1. Memorandum of Understanding or Letter of Intent87.2.1.2. Agreement in Principle87.2.1.3. Financial Sweeteners87.2.2. Auction87.2.3. The Outcome of Negotiations87.3. TAKING OVER A LISTED EUROPEAN COMPANY87.3.1. Stake Building87.3.2. Type of Offer87.3.2.1. Cash and Share Offers87.3.2.2. Voluntary and Mandatory Offers87.3.2.3. Hostile and Recommended Offers87.3.3. Certainty of the Offer87.3.4. Market Authority Role87.3.5. Summary of National Regulations87.3.6. Contingent Value Rights87.4. SUMMARY
88.1. ALL-SHARE DEALS88.1.1. The Different Techniques88.1.1.1. Legal Merger88.1.1.2. Contribution of Shares88.1.1.3. Asset Contribution88.1.2. Analysis of the Different Techniques88.1.2.1. Company Perspective88.1.2.2. Shareholder's Perspective88.1.2.3. Pros and Cons of Paying in Shares88.2. THE MECHANICS OF ALL-SHARE TRANSACTIONS88.2.1. Relative Value Ratio and Exchange Ratio88.2.2. Dilution or Accretion Criteria88.2.2.1. Synergies88.2.3. The "Bootstrap Game"88.3. DEMERGERS AND SPLIT-OFFS88.3.1. Principles88.3.2. Why Demerge?88.4. SUMMARY
89.1. LBO STRUCTURES89.2. TYPES OF LBO TRANSACTIONS89.3. EXIT STRATEGIES89.4. THE PLAYERS89.4.1. Potential Targets89.4.2. The Sellers89.5. LBO FUNDS ARE THE EQUITY INVESTORS89.6. THE LENDERS89.6.1. Senior Debt89.6.2. Junior or Subordinated Bonds89.6.3. Mezzanine Debt89.6.4. Securitization89.7. LBOs AND FINANCIAL THEORY89.8. SUMMARY

Overview

Volume II: Investment Management and Financial Management focuses on the theories, decisions, and implementations aspects associated with both financial management and investment management. It discusses issues that dominate the financial management arena—capital structure, dividend policies, capital budgeting, and working capital—and highlights the essential elements of today’s investment management environment, which include allocating funds across major asset classes and effectively dealing with equity and fixed income portfolios.

Incorporating timely research and in-depth analysis, the Handbook of Finance is a comprehensive 3-Volume Set that covers both established and cutting-edge theories and developments in finance and investing. Other volumes in the set: Handbook of Finance Volume I: Financial Markets and Instruments and Handbook of Finance Volume III: Valuation, Financial Modeling, and Quantitative Tools.

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Finance: Capital Markets, Financial Management, and Investment Management

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ISBN: 9780470078150Purchase book

Handbook of Finance: Investment Management and Financial Management

by Frank J. Fabozzi

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