Theory and Practice of Investment Management

FRANK J. FABOZZI, PhD, CFA, CPA, is Professor in the Practice of Finance and Becton Fellow at the Yale School of Management, Editor of the Journal of Portfolio Management, and an Associate Editor of the Journal of Fixed Income. He is on the Advisory Council for the Department of Operations Research and Financial Engineering at Princeton University. HARRY M. MARKOWITZ, PHD, is a consultant in the area of finance. In 1990, he was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for his groundbreaking work in portfolio theory. In 1989, he received the John von Neumann Theory Prize from the Operations Research Society of America for his work in portfolio theory and other applications of mathematics and computers to business practice.

• About the Editors xiiiContributing Authors xvForeword xviiPART ONE Instruments, Asset Allocation, Portfolio Selection, and Asset Pricing 1CHAPTER 1 Overview of Investment Management 3Frank J. Fabozzi and Harry M. MarkowitzSetting Investment Objectives 4Establishing an Investment Policy 4Selecting a Portfolio Strategy 6Constructing the Portfolio 6Measuring and Evaluating Performance 7Key Points 14CHAPTER 2 Asset Classes, Alternative Investments, Investment Companies, and Exchange-Traded Funds 15Mark J. P. Anson, Frank J. Fabozzi, and Frank J. JonesAsset Classes 15Overview of Alternative Asset Products 21Investment Companies 31Exchange-Traded Funds 36Mutual Funds vs. ETFs: Relative Advantages 39Key Points 41Questions 44CHAPTER 3 Portfolio Selection 45Frank J. Fabozzi, Harry M. Markowitz, Petter N. Kolm, and Francis GuptaSome Basic Concepts 47Measuring a Portfolio’s Expected Return 49Measuring Portfolio Risk 52Portfolio Diversification 56Choosing a Portfolio of Risky Assets 60Issues in Portfolio Selection 68Key Points 76Questions 78CHAPTER 4 Capital Asset Pricing Models 79Frank J. Fabozzi and Harry M. MarkowitzSharpe-Lintner CAPM 79Roy CAPM 81Confusions Regarding the CAPM 82Two Meanings of Market Efficiency 83CAPM Investors Do Not Get Paid for Bearing Risk 94The “Two Beta” Trap 95Key Points 100Questions 101CHAPTER 5 Factor Models 103Guofu Zhou and Frank J. FabozziArbitrage Pricing Theory 104Types of Factor Models 105Factor Model Estimation 112Key Points 118Appendix: Principal Component Analysis in Finance 119Questions 124CHAPTER 6 Modeling Asset Price Dynamics 125Dessislava A. Pachamanova and Frank J. FabozziFinancial Time Series 125Binomial Trees 127Arithmetic Random Walks 128Geometric Random Walks 134Mean Reversion 142Advanced Random Walk Models 148Stochastic Processes 152Key Points 157Questions 158CHAPTER 7 Asset Allocation and Portfolio Construction 159Noël Amenc, Felix Goltz, Lionel Martellini, and Vincent MilhauAsset Allocation and Portfolio Construction Decisions in the Optimal Design of the Performance-Seeking Portfolio 161Asset Allocation and Portfolio Construction Decisions in the Optimal Design of the Liability-Hedging Portfolio 173Dynamic Allocation Decisions to the Performance-Seeking and Liability-Hedging Portfolios 179Key Points 195Appendix 196Questions 202PART TWO Equity Analysis and Portfolio Management 205CHAPTER 8 Fundamentals of Common Stock 207Frank J. Fabozzi, Frank J. Jones, Robert R. Johnson, and Pamela P. DrakeEarnings 208Dividends 210The U.S. Equity Markets 213Trading Mechanics 215Trading Costs 220Stock Market Indicators 222Key Points 224Questions 226CHAPTER 9 Common Stock Portfolio Management Strategies 229Frank J. Fabozzi, James L. Grant, and Raman VardharajIntegrating the Equity Portfolio Management Process 229Capital Market Price Efficiency 230Tracking Error and Related Measures 233Active vs. Passive Portfolio Management 239Equity Style Management 240Passive Strategies 245Active Investing 247Performance Evaluation 264Key Points 267Questions 268CHAPTER 10 Approaches to Common Stock Valuation 271Pamela P. Drake, Frank J. Fabozzi, and Glen A. Larsen Jr.Discounted Cash Flow Models 271Relative Valuation Methods 278Key Points 284Questions 285CHAPTER 11 Quantitative Equity Portfolio Management 287Andrew Alford, Robert Jones, and Terence LimTraditional and Quantitative Approaches to Equity Portfolio Management 289Forecasting Stock Returns, Risks, and Transaction Costs 292Constructing Portfolios 298Trading 300Evaluating Results and Updating the Process 302Key Points 304Questions 305CHAPTER 12 Long-Short Equity Portfolios 307Bruce I. Jacobs and Kenneth N. LevyConstructing a Market-Neutral Portfolio 308The Importance of Integrated Optimization 312Adding Back a Market Return 316Some Concerns Addressed 321Evaluating Long-Short 323Key Points 324Questions 325CHAPTER 13 Multifactor Equity Risk Models 327Frank J. Fabozzi, Raman Vardharaj, and Frank J. JonesModel Description and Estimation 328Risk Decomposition 330Applications in Portfolio Construction and Risk Control 336Key Points 341Questions 343CHAPTER 14 Fundamentals of Equity Derivatives 345Bruce M. Collins and Frank J. FabozziThe Role of Derivatives 345Listed Equity Options 348Futures Contracts 366Pricing Stock Index Futures 370OTC Equity Derivatives 375Structured Products 380Key Points 381Questions 382CHAPTER 15 Using Equity Derivatives in Portfolio Management 383Bruce M. Collins and Frank J. FabozziEquity Investment Management 384Portfolio Applications of Listed Options 386Portfolio Applications of Stock Index Futures 390Applications of OTC Equity Derivatives 399Risk and Expected Return of Option Strategies 410Key Points 413Questions 414PART THREE Bond Analysis and Portfolio Management 415CHAPTER 16 Bonds, Asset-Backed Securities, and Mortgage- Backed Securities 417Frank J. FabozziGeneral Features of Bonds 417U.S. Treasury Securities 421Federal Agency Securities 423Corporate Bonds 424Municipal Securities 428Asset-Backed Securities 430Residential Mortgage-Backed Securities 434Commercial Mortgage-Backed Securities 450Key Points 453Questions 456CHAPTER 17 Bond Analytics 457Frank J. FabozziBasic Valuation of Option-Free Bonds 457Conventional Yield Measures 463Total Return 468Measuring Interest Rate Risk 471Key Points 484Questions 486CHAPTER 18 Bond Analytics 489Frank J. Fabozzi and Steven V. MannArbitrage-Free Bond Valuation 489Yield Spread Measures 496Forward Rates 498Overview of the Valuation of Bonds with Embedded Options 505Lattice Model 507Valuation of MBS and ABS 522Key Points 531Questions 533CHAPTER 19 Bond Portfolio Strategies for Outperforming a Benchmark 535Bülent Baygün and Robert TzuckerSelecting the Benchmark Index 536Creating a Custom Index 539Beating the Benchmark Index 544Key Points 553Questions 554CHAPTER 20 The Art of Fixed Income Portfolio Investing 557Chris P. Dialynas and Ellen J. Rachlin The Global Fixed Income Portfolio Manager 558The Global Challenge 565Portfolio Parameters 565Regulatory Changes, Demographic Trends, and Institutional Bias 568Information in the Markets 569Duration and Yield Curve 573Volatility 574International Corporate Bonds 577International Investing and Political Externalities 579Foreign Investment Selection 579Currency Selection 582Key Points 583Questions 584CHAPTER 21 Multifactor Fixed Income Risk Models and Their Applications 585Anthony Lazanas, António Baldaque da Silva, Radu Găbudean, and Arne D. StaalApproaches Used to Analyze Risk 587Applications of Risk Modeling 615Key Points 621Questions 622CHAPTER 22 Interest Rate Derivatives and Risk Control 623Frank J. FabozziInterest Rate Futures and Forward Contracts 623Interest Rate Swaps 634Interest Rate Options 640Interest Rate Agreements (Caps and Floors) 642Key Points 643Questions 644CHAPTER 23 Credit Default Swaps and the Indexes 647Stephen J. Antczak, Douglas J. Lucas, and Frank J. FabozziWhat Are Credit Default Swaps? 648Credit Default Swaps Indexes 654Key Points 658Questions 658About the Web Site 661Index 663