Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications

860 Pages·2009·5.28 MB·English

by  Frank J. Fabozzi(auth.)

Institutional
Investment
Management
The Frank J. Fabozzi Series
Fixed Income Securities, Second Edition by Frank J. Fabozzi
Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate
Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi
Real Options and Option-Embedded Securities by William T. Moore
Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi
The Exchange-Traded Funds Manual by Gary L. Gastineau
Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu
Handbook of Alternative Assets by Mark J. P. Anson
The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry
The Handbook of Financial Instruments edited by Frank J. Fabozzi
Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi
Investment Performance Measurement by Bruce J. Feibel
The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi
The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz
Foundations of Economic Value Added, Second Edition by James L. Grant
Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson
Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi,
Steven V. Mann, and Moorad Choudhry
The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry
The Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad Choudhry
The Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. Fabozzi
Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi
The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer
Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy
Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. Mann
Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and Frank J. Fabozzi
Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M.
Focardi, and Petter N. Kolm
Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J. Fabozzi,
Lionel Martellini, and Philippe Priaulet
Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi
Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S.
Goodman, and Frank J. Fabozzi
Handbook of Alternative Assets, Second Edition by Mark J. P. Anson
Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry
Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and Teo Jasic
Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas,
Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning
Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm,
Dessislava A. Pachamanova, and Sergio M. Focardi
Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev,
Stogan V. Stoyanov, and Frank J. Fabozzi
How to Select Investment Managers and Evaluate Performance by G. Timothy Haight, Stephen O. Morrell,
and Glenn E. Ross
Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank J. Fabozzi
The Handbook of Municipal Bonds edited by Sylvan G. Feldstein and Frank J. Fabozzi
Subprime Mortgage Credit Derivatives by Laurie S. Goodman, Shumin Li, Douglas J. Lucas,
Thomas A Zimmerman, and Frank J. Fabozzi
Introduction to Securitization by Frank J. Fabozzi and Vinod Kothari
Structured Products and Related Credit Derivatives edited by Brian P. Lancaster, Glenn M. Schultz, and
Frank J. Fabozzi
Handbook of Finance: Volume I: Financial Markets and Instruments edited by Frank J. Fabozzi
Handbook of Finance: Volume II: Financial Management and Asset Management edited by Frank J. Fabozzi
Handbook of Finance: Volume III: Valuation, Financial Modeling, and Quantitative Tools edited by
Frank J. Fabozzi
Finance: Capital Markets, Financial Management, and Investment Management by Pamela Peterson Drake
and Frank J. Fabozzi
Leveraged Finance: Concepts, Methods, and Trading of High Yield Bonds, Loans, and Derivatives by
Stephen J. Antczak, Douglas J. Lucas, and Frank J. Fabozzi
Modern Financial Systems: Theory and Applications by Edwin H. Neave
Institutional
Investment
Management
Equity and Bond Portfolio
Strategies and Applications
FRANK J. FABOZZI
John Wiley & Sons, Inc.
Copyright © 2009 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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ISBN: 978-0-470-40094-4
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
FJF
To my wife Donna, and my children
Francesco, Patricia, and Karly
Contents
Preface xv
Acknowledgments xix
About the Author xxiii
CHAPTER 1
Overview of Investment Management 1
Setting Investment Objectives 2
Establishing an Investment Policy 4
Selecting a Portfolio Strategy 9
Constructing and Monitoring the Portfolio 10
Measuring and Evaluating Performance 11
References 11
PART ONE
Portfolio Theory and Asset Pricing 13
CHAPTER 2
Theory of Portfolio Selection 15
Some Basic Concepts 16
Measuring a Portfolio’s Expected Return 19
Measuring Portfolio Risk 21
Portfolio Diversifi cation 26
Choosing a Portfolio of Risky Assets 30
Index Model’s Approximations to the Covariance Structure 36
Summary 39
References 40
vii
viii CONTENTS
CHAPTER 3
Applying Mean-Variance Analysis 41
Using Historical Data to Estimate Inputs 42
Application of Portfolio Theory to Asset Allocation 46
Implementing the Optimal Portfolio 53
Summary 56
References 57
CHAPTER 4
Issues in the Theory of Portfolio Selection 59
Quick Review of Probability Theory 60
Limitations of the Variance as a Risk Measure 64
Desirable Features of Investment Risk Measures 68
Alternative Risk Measures for Portfolio Selection 74
Extensions of the Theory of Portfolio Selection 77
Behavioral Finance Attack on the Theory of Portfolio 80
Summary 82
References 84
CHAPTER 5
Asset Pricing Theories 89
Characteristics of an Asset Pricing Model 90
Capital Asset Pricing Model 91
Arbitrage Pricing Theory Model 102
Some Principles to Take Away 107
Summary 108
Appendix 109
References 117
PART TWO
Common Stock Analysis and Portfolio Management 119
CHAPTER 6
The U.S. Equity Markets 121
Exchange Market Structures 121
The U.S. Stock Markets: Exchanges and OTC Markets 125
Off-Exchange Markets and Alternative Electronic Markets 134
Evolving Stock Market Practices 138
Basic Functioning of Stock Markets 140
Contents ix
Summary 145
References 145
CHAPTER 7
Common Stock Strategies and Performance Evaluation 147
Market Effi ciency 147
Stock Market Indicators 149
Top-Down vs. Bottom-Up Approaches 152
Fundamental vs. Technical Analysis 153
Strategies Based on Technical Analysis 154
Strategies Based on Fundamental Analysis 161
Equity Style Investing 166
Passive Strategies 169
Measuring and Evaluating Performance 176
Summary 187
References 189
CHAPTER 8
Financial Analysis 193
Financial Ratio Analysis 194
Cash Flow Analysis 223
Usefulness of Cash Flows in Financial Analysis 235
Summary 241
References 242
CHAPTER 9
Applied Equity Valuation 245
Discounted Cash Flow Models 245
Relative Valuation Methods 266
DCF vs. RV Methods 272
Summary 275
References 276
CHAPTER 10
Forecasting Stock Returns 277
The Concept of Predictability 279
A Closer Look at Pricing Models 286
Predictive Return Models 287
Is Forecasting Markets Worth the Effort? 293
Summary 295
References 297
x CONTENTS
CHAPTER 11
Managing a Common Stock Portfolio with Fundamental Factor Models 299
Tracking Error 300
Fundamental Factor Model Description and Estimation 309
Risk Decomposition 312
Applications in Portfolio Construction and Risk Control 316
Summary 329
References 330
CHAPTER 12
Transaction Costs and Trade Execution in
Common Stock Portfolio Management 331
Trading Mechanics 332
Trading Arrangements for Institutional Investors 335
A Taxonomy of Transaction Costs 340
Liquidity and Transaction Costs 347
Market Impact Measurements and Empirical Findings 349
Forecasting and Modeling Market Impact 352
Incorporating Transaction Costs in Asset-Allocation Models 355
Optimal Trading 356
Integrated Portfolio Management:
Beyond Expected Return and Portfolio Risk 359
Summary 360
References 362
CHAPTER 13
Using Stock Index Futures and Equity Swaps in
Equity Portfolio Management 365
Derivatives Process 366
Basic Features of Futures Contracts 367
Basic Features of Stock Index Futures 373
Applications for Stock Index Futures 381
Equity Swaps 393
Summary 394
References 395
CHAPTER 14
Using Equity Options in Investment Management 397
Basic Features of Options 397
Basic Features of Listed Equity Options 400
Risk and Return Characteristics of Listed Options 402
Contents xi
The Option Price 410
Use of Listed Equity Options in Portfolio Management 415
OTC Equity Options: The Basics 421
Use of Exotic Equity Options 425
Summary 426
References 427
CHAPTER 15
Equity Option Pricing Models 429
Put-Call Parity Relationship 429
Option Pricing Models 431
Sensitivity of the Option Price to a Change in Factors 447
Estimating Expected Stock Return Volatility 452
Summary 453
References 454
PART THREE
Bond Analysis and Portfolio Management 455
CHAPTER 16
Bond Fundamentals and Risks 457
Features of Bonds 457
Risks Associated with Investing in Bonds 467
Summary 482
Appendix: Calculating Accrued Interest 484
References 486
CHAPTER 17
Treasury and Agency Securities, Corporate Bonds, and Municipal Bonds 487
Treasury Securities 487
Federal Agency Securities 490
Corporate Bonds 491
Municipal Bonds 495
Non-U.S. Bonds 501
Summary 504
References 505