The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, 2nd Edition

About the Editors xiii

Contributing Authors xv

Foreword xvii

PART ONE Instruments, Asset Allocation, Portfolio Selection, and Asset Pricing 1

CHAPTER 1 Overview of Investment Management 3
Frank J. Fabozzi and Harry M. Markowitz

Setting Investment Objectives 4

Establishing an Investment Policy 4

Selecting a Portfolio Strategy 6

Constructing the Portfolio 6

Measuring and Evaluating Performance 7

Key Points 14

CHAPTER 2 Asset Classes, Alternative Investments, Investment Companies, and Exchange-Traded Funds 15
Mark J. P. Anson, Frank J. Fabozzi, and Frank J. Jones

Asset Classes 15

Overview of Alternative Asset Products 21

Investment Companies 31

Exchange-Traded Funds 36

Mutual Funds vs. ETFs: Relative Advantages 39

Key Points 41

Questions 44

CHAPTER 3 Portfolio Selection 45
Frank J. Fabozzi, Harry M. Markowitz, Petter N. Kolm, and Francis Gupta

Some Basic Concepts 47

Measuring a Portfolio’s Expected Return 49

Measuring Portfolio Risk 52

Portfolio Diversification 56

Choosing a Portfolio of Risky Assets 60

Issues in Portfolio Selection 68

Key Points 76

Questions 78

CHAPTER 4 Capital Asset Pricing Models 79
Frank J. Fabozzi and Harry M. Markowitz

Sharpe-Lintner CAPM 79

Roy CAPM 81

Confusions Regarding the CAPM 82

Two Meanings of Market Efficiency 83

CAPM Investors Do Not Get Paid for Bearing Risk 94

The “Two Beta” Trap 95

Key Points 100

Questions 101

CHAPTER 5 Factor Models 103
Guofu Zhou and Frank J. Fabozzi

Arbitrage Pricing Theory 104

Types of Factor Models 105

Factor Model Estimation 112

Key Points 118

Appendix: Principal Component Analysis in Finance 119

Questions 124

CHAPTER 6 Modeling Asset Price Dynamics 125
Dessislava A. Pachamanova and Frank J. Fabozzi

Financial Time Series 125

Binomial Trees 127

Arithmetic Random Walks 128

Geometric Random Walks 134

Mean Reversion 142

Advanced Random Walk Models 148

Stochastic Processes 152

Key Points 157

Questions 158

CHAPTER 7 Asset Allocation and Portfolio Construction 159
Noël Amenc, Felix Goltz, Lionel Martellini, and Vincent Milhau

Asset Allocation and Portfolio Construction Decisions in the Optimal Design of the Performance-Seeking Portfolio 161

Asset Allocation and Portfolio Construction Decisions in the Optimal Design of the Liability-Hedging Portfolio 173

Dynamic Allocation Decisions to the Performance-Seeking and Liability-Hedging Portfolios 179

Key Points 195

Appendix 196

Questions 202

PART TWO Equity Analysis and Portfolio Management 205

CHAPTER 8 Fundamentals of Common Stock 207
Frank J. Fabozzi, Frank J. Jones, Robert R. Johnson, and Pamela P. Drake

Earnings 208

Dividends 210

The U.S. Equity Markets 213

Trading Mechanics 215

Trading Costs 220

Stock Market Indicators 222

Key Points 224

Questions 226

CHAPTER 9 Common Stock Portfolio Management Strategies 229
Frank J. Fabozzi, James L. Grant, and Raman Vardharaj

Integrating the Equity Portfolio Management Process 229

Capital Market Price Efficiency 230

Tracking Error and Related Measures 233

Active vs. Passive Portfolio Management 239

Equity Style Management 240

Passive Strategies 245

Active Investing 247

Performance Evaluation 264

Key Points 267

Questions 268

CHAPTER 10 Approaches to Common Stock Valuation 271
Pamela P. Drake, Frank J. Fabozzi, and Glen A. Larsen Jr.

Discounted Cash Flow Models 271

Relative Valuation Methods 278

Key Points 284

Questions 285

CHAPTER 11 Quantitative Equity Portfolio Management 287
Andrew Alford, Robert Jones, and Terence Lim

Traditional and Quantitative Approaches to Equity Portfolio Management 289

Forecasting Stock Returns, Risks, and Transaction Costs 292

Constructing Portfolios 298

Trading 300

Evaluating Results and Updating the Process 302

Key Points 304

Questions 305

CHAPTER 12 Long-Short Equity Portfolios 307
Bruce I. Jacobs and Kenneth N. Levy

Constructing a Market-Neutral Portfolio 308

The Importance of Integrated Optimization 312

Adding Back a Market Return 316

Some Concerns Addressed 321

Evaluating Long-Short 323

Key Points 324

Questions 325

CHAPTER 13 Multifactor Equity Risk Models 327
Frank J. Fabozzi, Raman Vardharaj, and Frank J. Jones

Model Description and Estimation 328

Risk Decomposition 330

Applications in Portfolio Construction and Risk Control 336

Key Points 341

Questions 343

CHAPTER 14 Fundamentals of Equity Derivatives 345
Bruce M. Collins and Frank J. Fabozzi

The Role of Derivatives 345

Listed Equity Options 348

Futures Contracts 366

Pricing Stock Index Futures 370

OTC Equity Derivatives 375

Structured Products 380

Key Points 381

Questions 382

CHAPTER 15 Using Equity Derivatives in Portfolio Management 383
Bruce M. Collins and Frank J. Fabozzi

Equity Investment Management 384

Portfolio Applications of Listed Options 386

Portfolio Applications of Stock Index Futures 390

Applications of OTC Equity Derivatives 399

Risk and Expected Return of Option Strategies 410

Key Points 413

Questions 414

PART THREE Bond Analysis and Portfolio Management 415

CHAPTER 16 Bonds, Asset-Backed Securities, and Mortgage- Backed Securities 417
Frank J. Fabozzi

General Features of Bonds 417

U.S. Treasury Securities 421

Federal Agency Securities 423

Corporate Bonds 424

Municipal Securities 428

Asset-Backed Securities 430

Residential Mortgage-Backed Securities 434

Commercial Mortgage-Backed Securities 450

Key Points 453

Questions 456

CHAPTER 17 Bond Analytics 457
Frank J. Fabozzi

Basic Valuation of Option-Free Bonds 457

Conventional Yield Measures 463

Total Return 468

Measuring Interest Rate Risk 471

Key Points 484

Questions 486

CHAPTER 18 Bond Analytics 489
Frank J. Fabozzi and Steven V. Mann

Arbitrage-Free Bond Valuation 489

Yield Spread Measures 496

Forward Rates 498

Overview of the Valuation of Bonds with Embedded Options 505

Lattice Model 507

Valuation of MBS and ABS 522

Key Points 531

Questions 533

CHAPTER 19 Bond Portfolio Strategies for Outperforming a Benchmark 535
Bülent Baygün and Robert Tzucker

Selecting the Benchmark Index 536

Creating a Custom Index 539

Beating the Benchmark Index 544

Key Points 553

Questions 554

CHAPTER 20 The Art of Fixed Income Portfolio Investing 557
Chris P. Dialynas and Ellen J. Rachlin The Global Fixed Income Portfolio Manager 558

The Global Challenge 565

Portfolio Parameters 565

Regulatory Changes, Demographic Trends, and Institutional Bias 568

Information in the Markets 569

Duration and Yield Curve 573

Volatility 574

International Corporate Bonds 577

International Investing and Political Externalities 579

Foreign Investment Selection 579

Currency Selection 582

Key Points 583

Questions 584

CHAPTER 21 Multifactor Fixed Income Risk Models and Their Applications 585
Anthony Lazanas, António Baldaque da Silva, Radu Găbudean, and Arne D. Staal

Approaches Used to Analyze Risk 587

Applications of Risk Modeling 615

Key Points 621

Questions 622

CHAPTER 22 Interest Rate Derivatives and Risk Control 623
Frank J. Fabozzi

Interest Rate Futures and Forward Contracts 623

Interest Rate Swaps 634

Interest Rate Options 640

Interest Rate Agreements (Caps and Floors) 642

Key Points 643

Questions 644

CHAPTER 23 Credit Default Swaps and the Indexes 647
Stephen J. Antczak, Douglas J. Lucas, and Frank J. Fabozzi

What Are Credit Default Swaps? 648

Credit Default Swaps Indexes 654

Key Points 658

Questions 658

About the Web Site 661

Index 663