Modern Portfolio Theory and Investment Analysis, 7th Edition

by Edwin J. Elton (Leonard N. Stern School of Business, New York Univ.); Martin J. Gruber (Leonard N. Stern School of Business, New York Univ.); Stephen J. Brown (Leonard N. Stern School of Business, New York Univ. ); William N. Goetzmann (Yale Univ.)

• ISBN13: 9780470050828
• ISBN10: 0470050829
• Edition: 7th
• Format: Hardcover
• Copyright: 2006-12-01
• Publisher: Wiley

Summary

This book covers the characteristics and analysis of individual securities as well as the theory and practice of optimally combining securities into portfolios. Stressing the economic intuition behind the subject matter, this classic text pres-ents advanced concepts of investment analysis and portfolio management. It can be used for courses in both portfolio theory and in investment analysis that have an emphasis on portfolio the-ory. It can also be used in a course in investments where both portfolio analysis and security analysis are discussed. The authors' goal has been to make all the material in this text accessible to students of portfolio analysis and invest-ment management, both at the undergraduate and graduate levels while maintaining the rigor through the use of ap-pendices which can be used in conjunction with the text.

Author Biography

EDWIN J. ELTON is Nomura Professor of Finance at the Stern School of Business of New York University. He has authored or coauthored eight books and more than 100 articles. These articles have appeared in journals such as The Journal of Finance, The Review of Financial Studies, Review of Economics and Statistics, Management Science, Journal of Financial Economics, Journal of Business, Oxford Economic Papers, and Journal of Financial and Quantitative Analysis. He has been coeditor of the Journal of Finance. Professor Elton has been a member of the Board of Directors of the American Finance Association and an Associate Editor of Management Science. He is Associate Editor of Journal of Banking and Finance and Journal of Accounting Auditing and Finance. Professor Elton has served as a consultant for many major financial institutions. A compendium of articles by Professor Elton and Professor Gruber has recently been published in two volumes by MIT press. Professor Elton is a past president of the American Finance Association, a fellow of that association, and a recipient of distinguished research award by the Eastern Finance Association.

MARTIN J. GRUBER is Nomura Professor of Finance and past Chairman of the Finance Department at the Stern School of Business of New York University. He is a fellow of the American Finance Association. He has published nine books and more than 100 journal articles in journals such as The Journal of Finance, The Review of Financial Studies, Review of Economics and Statistics, Journal of Financial Economics, Journal of Business, Management Science, Journal of Financial and Quantitative Analysis, Operations Research, Oxford Economic Papers, and The Journal of Portfolio Management. He has been coeditor of the Journal of Finance. He has been President of the American Finance Association, a Director of the European Finance Association, a Director of the American Finance Association, and a Director of both the Computer Applications Committee and the Investment Technology Symposium of the New York Society of Security Analysts. He was formerly Finance Department Editor for Management Science. Professor Gruber has consulted in the areas of Investment Analysis and Portfolio Management with many major financial institutions. He is currently a director of DWS Mutual Funds, and a Director of the Diawa closed-end funds. He is formerly a director of TIAA, a director and chairman of CREF, and a director of the S. G. Cowen Mutual Funds.

STEPHEN J. BROWN is David S. Loeb Professor of Finance and Coordinator of Undergraduate Finance at the Leonard N. Stern School of Business, New York University. He has served on the Board of Directors of the American Finance Association, was   founding editor of The Review of Financial Studies and is currently a member of the Board of the Society of Quantitative Analysis. He is a Managing Editor of the Journal of Financial and Quantitative Analysis and has served on the editorial boards of The Journal of Finance, Pacific-Basin Finance Journal, and other journals. He has published numerous articles and four books on finance and economics related areas. In 1996 he served on the nominating committee for the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. He has served as an expert witness for the U.S. Department of Justice.

WILLIAM N. GOETZMANN is Edwin J. Beinecke Professor of Finance and Management Studies at the Yale School of Management and Director, International Center for Finance at the Yale School of Management and has served on the Board of Directors of the American Finance Association. His published research topics include global investing, forecasting stock markets, selecting mutual fund managers, housing as investment, and the risk and return of art. Professor Goetzmann has a background in arts and media management. As a documentary filmmaker, he has written and coproduced programs for Nova and the American Masters series, including a profile of the artist Thomas Eakins. A former director of Denver’s Museum of Western Art, Professor Goetzmann coauthored the award winning book, The West of the Imagination.

Table of Contents

Part 1 INTRODUCTION	1	(40)
Introduction	2	(9)
Outline of the Book	2	(2)
The Economic Theory of Choice: An Illustration Under Certainty	4	(4)
Conclusion	8	(1)
Multiple Assets and Risk	8	(1)
Questions and Problems	9	(1)
Bibliography	10	(1)
Financial Securities	11	(13)
Types of Marketable Financial Securities	11	(7)
The Return Characteristics of Alternative Security Types	18	(3)
Stock Market Indexes	21	(1)
Bond Market Indexes	22	(1)
Conclusion	23	(1)
Financial Markets	24	(17)
Trading Mechanics	24	(3)
Margin	27	(4)
Markets	31	(7)
Trade Types and Costs	38	(2)
Conclusion	40	(1)
Bibliography	40	(1)
Part 2 PORTFOLIO ANALYSIS	41	(2)
Section 1 Mean Variance Portfolio Theory	43	(86)
The Characteristics of the Opportunity Set Under Risk	44	(24)
Determining the Average Outcome	45	(1)
A Measure of Dispersion	46	(3)
Variance of Combinations of Assets	49	(2)
Characteristics of Portfolios in General	51	(10)
Two Concluding Examples	61	(3)
Conclusion	64	(1)
Questions and Problems	64	(2)
Bibliography	66	(2)
Delineating Efficient Portfolios	68	(31)
Combinations of Two Risky Assets Revisited: Short Sales Not Allowed	68	(9)
The Shape of the Portfolio Possibilities Curve	77	(7)
The Efficient Frontier with Riskless Lending and Borrowing	84	(4)
Examples and Applications	88	(4)
Three Examples	92	(4)
Conclusion	96	(1)
Questions and Problems	96	(1)
Bibliography	97	(2)
Techniques for Calculating the Efficient Frontier	99	(30)
Short Sales Allowed with Riskless Lending and Borrowing	100	(4)
Short Sales Allowed: No Riskless Lending and Borrowing	104	(1)
Riskless Lending and Borrowing with Short Sales Not Allowed	104	(1)
No Short Selling and No Riskless Lending and Borrowing	105	(1)
The Incorporation of Additional Constraints	106	(1)
An Example	107	(3)
Conclusion	110	(1)
Appendix A: An Alternative Definition of Short Sales	110	(1)
Appendix B: Determining the Derivative	111	(4)
Appendix C: Solving Systems of Simultaneous Equations	115	(3)
Appendix D: A General Solution	118	(4)
Appendix E: Quadratic Programming and Kuhn-Tucker Conditions	122	(3)
Questions and Problems	125	(1)
Bibliography	126	(3)
Section 2 Simplifying the Portfolio Selection Process	129	(80)
The Correlation Structure of Security Returns: The Single-Index Model	130	(29)
The Inputs to Portfolio Analysis	131	(1)
Single-Index Models: An Overview	132	(5)
Characteristics of the Single-Index Model	137	(2)
Estimating Beta	139	(13)
The Market Model	152	(1)
An Example	153	(1)
Questions and Problems	154	(2)
Bibliography	156	(3)
The Correlation Structure of Security Returns. Multi-Index Models and Grouping Techniques	159	(21)
Multi-Index Models	160	(6)
Average Correlation Models	166	(1)
Mixed Models	167	(1)
Fundamental Multi-Index Models	167	(6)
Conclusion	173	(1)
Appendix A: Procedure for Reducing Any Multi-Index Model to a Multi-Index Model with Orthogonal Indexes	173	(1)
Appendix B: Mean Return, Variance, and Covariance of a Multi-Index Model	174	(2)
Questions and Problems	176	(1)
Bibliography	177	(3)
Simple Techniques for Determining the Efficient Frontier	180	(29)
The Single-Index Model	181	(11)
Security Selection with a Purchasable Index	192	(1)
The Constant Correlation Model	193	(3)
Other Return Structures	196	(1)
An Example	196	(1)
Conclusion	197	(1)
Appendix A: Single-Index Model---Short Sales Allowed	198	(2)
Appendix B: Constant Correlation Coefficient---Short Sales Allowed	200	(1)
Appendix C: Single-Index Model with Short Sales Not Allowed	201	(2)
Appendix D: Constant Correlation Coefficient---Short Sales Not Allowed	203	(2)
Appendix E: Single-Index Model, Short Sales Allowed, and a Market Asset	205	(1)
Questions and Problems	205	(1)
Bibliography	206	(3)
Section 3 Selecting the Optimum Portfolio	209	(44)
Estimating Expected Returns	210	(9)
Aggregate Asset Allocatio	210	(4)
Forecasting Individual Security Returns	214	(2)
Portfolio Analysis with Discrete Data	216	(2)
Bibliography	218	(1)
How to Select Among the Portfolios in the Opportunity Set	219	(34)
Choosing Directly	219	(1)
An Introduction to Prefrerence Functions	220	(3)
Risk Tolerance Functions	223	(2)
Safety First	225	(6)
Maximizing the Geometric Mean Return	231	(2)
Value at Risk (VAR)	233	(1)
Utility and the Equity Risk Premium	234	(2)
Optimal Investment Strategies with Investor Liabilities	236	(4)
Liabilities and Safety-First Portfolio Selection	240	(1)
Simulations in Portfolio Choice	240	(6)
Conclusion	246	(1)
Appendix: The Economic Properties of Utility Functions	246	(2)
Questions and Problems	248	(1)
Bibliography	249	(4)
Section 4 Widening the Selection Universe	253	(30)
International Diversification	254	(29)
The World Portfolio	254	(2)
Calculating the Return on Foreign Investments	256	(2)
The Risk of Foreign Securities	258	(5)
Returns from International Diversification	263	(2)
The Effect of Exchange Risk	265	(2)
Return Expectations and Portfolio Performance	267	(3)
Other Evidence on Internationally Diversified Portfolios	270	(3)
Models for Managing International Portfolios	273	(3)
Conclusion	276	(1)
Questions and Problems	277	(1)
Bibliography	278	(5)
Part 3 MODELS OF EQUILIBRIUM IN THE CAPITAL MARKETS	283	(116)
The Standard Capital Asset Pricing Model	284	(21)
The Assumptions Underlying the Standard Capital Asset Pricing Model (CAPM)	284	(1)
The Capital Asset Pricing Model	285	(9)
Prices and the CAPM	294	(2)
Conclusion	296	(2)
Appendix: Appropriateness of the Single Period Asset Pricing Model	298	(4)
Questions and Problems	302	(1)
Bibliography	303	(2)
Nonstandard Forms of Capital Asset Pricing Models	305	(29)
Short Sales Disallowed	306	(1)
Modifications of Riskless Lending and Borrowing	306	(10)
Personal Taxes	316	(2)
Nonmarketable Assets	318	(2)
Heterogeneous Expectations	320	(1)
Non-Price-Taking Behavior	321	(1)
Multiperiod CAPM	321	(1)
The Consumption-Oriented CAPM	322	(1)
Inflation Risk and Equilibrium	323	(1)
The Multi-Beta CAPM	323	(1)
Conclusion	324	(1)
Appendix: Derivation of the General Equilibrium with Taxes	325	(2)
Questions and Problems	327	(1)
Bibliography	328	(6)
Empirical Tests of Equilibrium Models	334	(28)
The Models---Ex-Ante Expectations and Ex-Post Tests	334	(1)
Empirical Tests of the CAPM	335	(14)
Testing Some-Alternative Forms of the CAPM Model	349	(1)
Testing the Post-Tax Form of the CAPM Model	349	(4)
Some Reservations about Traditional Tests of General Equilibrium Relationships and Some New Research	353	(2)
Conclusion	355	(1)
Appendix: Random Errors in Beta and Bias in the Parameters of the CAPM	356	(1)
Questions and Problems	357	(1)
Bibliography	358	(4)
The Arbitrage Pricing Model Apt---A New Approach to Explaining Asset Prices	362	(37)
APT---What Is It?	362	(5)
Estimating and Testing APT	367	(12)
APT and CAPM	379	(1)
Recapitulation	380	(9)
Conclusion	389	(1)
Appendix A: A Simple Example of Factor Analysis	389	(1)
Appendix B: Specification of the APT with an Unobserved Market Factor	390	(1)
Questions and Problems	391	(1)
Bibliography	392	(7)
Part 4 SECURITY ANALYSIS AND PORTFOLIO THEORY	399	(232)
Efficient Markets	400	(42)
Some Background	402	(2)
Tests of Return Predictability	404	(16)
Announcement and Price Return	420	(1)
Methodology of Event Studies	420	(6)
Strong Form Efficiency	426	(3)
Market Rationality	429	(2)
Conclusion	431	(1)
Questions and Problems	431	(1)
Bibliography	431	(11)
The Valuation Process	442	(27)
Discounted Cash Flow Models	443	(12)
Cross-Sectional Regression Analysis	455	(4)
An Ongoing System	459	(5)
Conclusion	464	(1)
Questions and Problems	464	(1)
Bibliography	465	(4)
Earnings Estimation	469	(16)
The Elusive Number Called Earnings	469	(3)
The Importance of Earnings	472	(3)
Characteristics of Earnings and Earnings Forecasts	475	(7)
Conclusion	482	(1)
Questions and Problems	483	(1)
Bibliography	483	(2)
Behavioral Finance, Investor Decision Making, and Asset Pricing	485	(17)
Prospect Theory and Decision Making Under Uncertainty	485	(3)
Biases From Laboratory Experiments	488	(3)
Summary of Investor Behavior	491	(1)
Behavioral Finance and Asset Pricing	492	(7)
Bibliography	499	(3)
Interest Rate Theory and the Pricing of Bonds	502	(38)
An Introduction to Debt Securities	503	(2)
The Many Definitions of Rates	505	(7)
Bond Prices and Spot Rates	512	(2)
Determining Spot Rates	514	(2)
The Determinants of Bond Prices	516	(16)
Conclusion	532	(1)
Appendix A: Special Considerations in Bond Pricing	532	(1)
Appendix B: Estimating Spot Rates	532	(3)
Appendix C: Calculating Bond Equivalent Yield and Effective Annual Yield	535	(1)
Questions and Problems	535	(1)
Bibliography	536	(4)
The Management of Bond Portfolios	540	(35)
Duration	540	(8)
Protecting Against Term Structure Shifts	548	(4)
Bond Portfolio Management of Yearly Returns	552	(9)
Swaps	561	(2)
Appendix A: Duration Measures	563	(4)
Appendix B: Exact Matching Programs	567	(2)
Appendix C: Bond-Swapping Techniques	569	(1)
Appendix D: Convexity	570	(1)
Questions and Problems	571	(1)
Bibliography	572	(3)
Option Pricing Theory	575	(38)
Types of Options	575	(6)
Some Basic Characteristics of Option Values	581	(5)
Valuation Models	586	(11)
Artificial or Homemade Options	597	(1)
Uses of Options	598	(3)
Conclusion	601	(1)
Appendix A: Derivation of the Binomial Formula	601	(3)
Appendix B: Derivation of the Black-Scholes Formula	604	(2)
Questions and Problems	606	(1)
Bibliography	607	(6)
The Valuation and Uses of Financial Futures	613	(18)
Description of Financial Futures	613	(4)
Valuation of Financial Futures	617	(6)
The Uses of Financial Futures	623	(4)
Nonfinancial Futures and Commodity Funds	627	(1)
Questions and Problems	628	(1)
Bibliography	628	(3)
Part 5 EVALUATING THE INVESTMENT PROCESS	631	(82)
Evaluation of Portfolio Performance	632	(50)
Evaluation Techniques	633	(15)
Decomposition of Overall Evaluation	648	(10)
Multi-Index, APT, and Performance Evaluation	658	(6)
Mutual Fund Performance	664	(13)
Conclusion	677	(1)
Questions and Problems	677	(1)
Bibliography	677	(5)
Evaluation of Security Analysis	682	(15)
Why the Emphasis on Earnings?	683	(1)
The Evaluation of Earnings Forecasts	684	(7)
Evaluating the Valuation Process	691	(3)
Conclusion	694	(1)
Questions and Problems	695	(1)
Bibliography	695	(2)
Portfolio Management Revisited	697	(16)
Managing Stock Portfolios	698	(3)
Active Management	701	(1)
Passive Versus Active	702	(1)
International Diversification	703	(1)
Bond Management	703	(3)
Bond and Stock Investment with a Liability Stream	706	(5)
Bibliography	711	(2)
Index	713