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Official© Solutions Manual to Accompany Essentials of Investments,Bodie,11e
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TEST BANK FOR ESSENTIALS OF INVESTMENTS 11TH EDITION
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TEST BANK FOR ESSENTIALS OF INVESTMENTS 11TH EDITION
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Investment Analysis and Portfolio ManagementCHAPTER 1: Investments: Background and Issues
An investment1 is the current commitment of money or other resources in the expectation of reaping future
benefits. There is one key attribute that is central to all investments: someone sacrifices something of value
now, expecting to benefit from that sacrifice later.
1.1 Real Assets versus Financial Assets
The material wealth of a society is determined by the productive capacity of its economy àthe goods and
services its members can create. This capacity is a function of the real assets2 of the economy: the land,
buildings, equipment, and knowledge that can be used to produce goods and services.
In contrast to such real assets are financial assets3 such as stocks and bonds. Such securities do not directly
contribute to the productive capacity of the economy. Instead, these assets are claims to the income
generated by real assets (or claims on income from the government).
While real assets generate net income to the economy, financial assets simply define the allocation of
income or wealth among investors. Individuals can choose between consuming their wealth today or
investing for the future. If they choose to invest, they may place their wealth in financial assets by purchasing
securities. When investors buy these securities from companies, the firms use the money so raised to pay
for real assets. So investors’ returns on securities come from the income produced by the real assets that
were financed by the issuance of those securities.
1.2 Financial Assets
It is common to distinguish among 3 broad types of financial assets: debt, equity, and derivatives. Fixed-
income4 or debt securities promise either a fixed stream of income or a stream of income that is determined
according to a specified formula. Unless the borrower is declared bankrupt, the payments on these securities
are either fixed or determined by formula. For this reason, the investment performance of debt securities
typically is least closely tied to the financial condition of the issuer.
Debt securities come in a great variety of maturities and payment provisions. At one extreme, the money
market refers to fixed-income securities that are short term, highly marketable, and generally of very low
risk. In contrast, the fixed-income capital market includes long-term securities. These bonds range from very
safe in terms of default risk to relatively risky. They also are designed with diverse provisions regarding
payments provided to the investor and protection against the bankruptcy of the issuer.
Unlike debt securities, common stock, or equity5, in a firm represents an ownership share in the corporation.
Equity holders are not promised any particular payment. They receive any dividends the firm may pay and
have prorated ownership in the real assets of the firm. If the firm is successful, the value of equity will
increase; if not, it will decreaseàThe performance of equity investments is tied directly to the success of
the firm and its real assetsà equity investments tend to be riskier than investments in debt securities.
Finally, derivative securities6 such as options and futures contracts provide payoffs that are determined by
the prices of other assets such as bond or stock prices. Derivative securities are so named because their
values derive from the prices of other assets. Other important derivative securities are futures and swap
contracts. Derivatives have become an integral part of the investment environment. One use of derivatives
is to hedge risks or transfer them to other parties. Derivatives also can be used to take highly speculative
positions, however.
Investors and corporations regularly encounter other financial markets as well. Firms engaged in
international trade regularly transfer money back and forth between dollars and other currencies. Investors
also might invest directly in some real assets.
Commodity and derivative markets allow firms to adjust their exposure to various business risks. Wherever
there is uncertainty, investors may be interested in trading, either to speculate or to lay off their risks, and
a market may arise to meet that demand.
1 Investment: Commitment of current resources in the expectation of deriving greater resources in the future.
2 Real assets: Assets used to produce goods and services.
3 Financial assets: Claims on real assets or the income generated by them.
4 Fixed-income (debt) securities: Pay a specified cash flow over a specific period
5 Equity: an ownership share in a corporation.
6 Derivative securities: Securities providing payoffs that depend on the values of other assets.
, Investment Analysis and Portfolio Management
1.3 Financial Markets and the Economy
Real assets determine the wealth of an economy, while financial assets merely represent claims on real
assets. Nevertheless, financial assets and the markets in which they trade play several crucial roles in
developed economies.
The Informational Role of Financial Markets
Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects.
When the market is more optimistic about the firm, its share price will riseà easier for the firm to raise
capital; encourages investment à Stock prices play a major role in the allocation of capital in market
economies, directing capital to the firms and applications with the greatest perceived potential.
Are capital markets always efficient? Companies or whole industries can be “hot” for a period of time attract
a large flow of investor capital, and then fail after only a few years. The process seems highly wasteful. But
no one knows with certainty which ventures will succeed and which will fail. It is therefore unreasonable to
expect that markets will never make mistakes. The stock market encourages allocation of capital to those
firms that appear at the time to have the best prospects.
Consumption Timing
How can you shift your purchasing power from high-earnings to low-earnings periods of life? One way is to
“store” your wealth in financial assets. In high-earnings periods, you can invest your savings in financial
assets. In low-earnings periods, you can sell these assets to provide funds for your consumption needs. By
so doing, you can “shift” your consumption over the course of your lifetime, thereby allocating your
consumption to periods that provide the greatest satisfaction. Thus, financial markets allow individuals to
separate decisions concerning current consumption from constraints that otherwise would be imposed by
current earnings.
Allocation of Risk
Virtually all real assets involve some risk. Financial markets and the diverse financial instruments traded in
those markets allow investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant
individuals can, to a greater extent, stay on the sidelines. Thus, capital markets allow the risk that is inherent
to all investments to be borne by the investors most willing to bear it. This allocation of risk also benefits the
firms that need to raise capital to finance their investments. When investors are able to select security types
with the risk-return characteristics that best suit their preferences, each security can be sold for the best
possible price. This facilitates the process of building the economy’s stock of real assets.
Separation of Ownership and Management
Many businesses are owned and managed by the same individual. This simple organization is well suited to
small businesses. Today, however, with global markets and large-scale production, the size and capital
requirements of firms have skyrocketed. Corporations of big size cannot exist as owner-operated firms.
There are usually many stockholders with an ownership stake in the firm proportional to their holdings of
shares. Such a large group of individuals cannot actively participate in the day to day management of the
firm à they elect a Board of directors that in turn hires and supervises the management of the firm. This
structure means that the owners and managers of the firm are different partiesà stability. Financial assets
and the ability to buy and sell those assets in the financial markets allow for easy separation of ownership
and management.
How can all of the owners of the firm agree on the objectives of the firm? All may agree that the firm’s
management should pursue strategies that enhance the value of their shares. But managers might be
tempted to engage in activities not in the best interest of shareholdersà agency problems7 : managers, who
are hired as agents of the shareholders, may pursue their own interests instead.
Several mechanisms have evolved to mitigate potential agency problems. First, compensation plans tie the
income of managers to the success of the firm. A major part of the total compensation of top executives is
typically in the form of shares or stock options, which means that the managers will not do well unless the
7 Agency problems: Conflicts of interest between managers and stockholders.
, Investment Analysis and Portfolio Management
stock price increases, benefiting shareholders. However, options can create an incentive for managers to
manipulate information to prop up a stock price temporarily, giving them a chance to cash out before the
price returns to a level reflective of the firm’s true prospects.
Second, boards of directors can force out management teams that are underperforming. Third, outsiders
monitor the firm closely and make the life of poor performers uncomfortable. Finally, bad performers are
subject to the threat of takeover. If the board of directors is lax in monitoring management, unhappy
shareholders in principle can elect a different board. They can do this by launching a proxy contest in which
they seek to obtain enough proxies to take control of the firm and vote in another board. In recent years,
the odds of a successful proxy contest have increased along with the rise of so-called activist investors. These
are large and deep-pocketed investors that identify firms they believe to be mismanaged in some respect.
They can buy large positions in shares of those firms, and then campaign for slots on the board of directors
and/or for specific reforms. Aside from proxy contests, the real takeover threat is from other firms. If one
firm observes another underperforming, it can acquire the underperforming business and replace
management with its own team. The stock price should rise to reflect the prospects of improved
performance, which provides an incentive for firms to engage in such takeover activity.
Corporate Governance and Corporate Ethics
Securities markets can play an important role in facilitating the deployment of capital resources to their
most productive uses. But market signals will help to allocate capital efficiently only if investors are acting
on accurate information. à Markets need to be transparent for investors to make informed decisions.
Despite the many mechanisms to align incentives of shareholders and managers, the 3 years from 2000
through 2002 were filled with a seemingly unending series of scandals that signalled a crisis in corporate
governance and ethics.
Other scandals of that period included systematically misleading and overly optimistic research reports put
out by stock market analysts (their favorable analysis was traded for the promise of future investment
banking business, and analysts were compensated not for their accuracy or insight but for their role in
garnering investment banking business for their firms) and allocations of IPOs to corporate executives as a
quid pro quo for personal favors or the promise to direct future business back to the manager of the IPO.
What about the auditors? Here too, incentives were skewed. Recent changes in business practice made the
consulting businesses of these firms more lucrative than the auditing function. In 2002, in response to the
spate of ethics scandals, Congress passed the Sarbanes-Oxley Act to tighten the rules of corporate
governance à the act requires corporations to have more independent directors (more directors who are
not themselves managers or affiliated with managers). The act also requires each CFO to personally vouch
for the corporation’s accounting statements, provides for an oversight board to oversee the auditing of
public companies, and prohibits auditors from providing various other services to clients.
1.4 The Investment Process
An investor’s portfolio is his collection of investment assets. Once the portfolio is established, it is updated or
“rebalanced” by selling existing securities and using the proceeds to buy new securities, by investing
additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of the
portfolio.
Investment assets can be categorized into broad asset classes. Investors make two types of decisions in
constructing their portfolios. The asset allocation8 decision is the choice among these broad asset classes,
while the security selection9 decision is the choice of which particular securities to hold within each asset
class.
• “Top-down” portfolio construction starts with asset allocation. The broad features of the portfolio are
established. The decision to allocate your investments to the stock market or to the money market where
Treasury bills are traded will have great ramifications for both the risk and the return of your portfolio. A
top-down investor first makes this and other crucial asset allocation decisions before turning to the
decision of the particular securities to be held in each asset class.
8 Asset allocation: allocation of an investment portfolio across broad asset classes.
9 Security selection: choice of specific securities within each asset class.
, Investment Analysis and Portfolio Management
Security analysis10 involves the valuation of particular securities that might be included in the portfolio. Both
bonds and stocks must be evaluated for investment attractiveness, but valuation is far more difficult for
stocks because a stock’s performance usually is far more sensitive to the condition of the issuing firm.
• “Bottom-up” strategy: the portfolio is constructed from securities that seem attractively priced without as
much concern for the resultant asset allocation. Such a technique can result in unintended bets on one or
another sector of the economy. However, a bottom-up strategy does focus the portfolio on the assets that
seem to offer the most attractive investment opportunities.
1.5 Markets Are Competitive
Financial markets are highly competitive. This competition means that we should expect to find few “free
lunches,” securities that are so underpriced that they represent obvious bargains. There are several
implications of this no-free-lunch proposition.
The Risk-Return Trade-Off
Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. Actual or
realized returns will almost always deviate from the expected return anticipated at the start of the
investment period. Naturally, if all else could be held equal, investors would prefer investments with the
highest expected return. However, the no-free-lunch rule tells us that all else cannot be held equal. If any
particular asset offered a higher expected return without imposing extra risk, investors would rush to buy it,
with the result that its price would be driven up. Individuals considering investing in the asset at the now-
higher price would find the investment less attractive. The price will rise until its expected return is no more
than commensurate with riskà investors can anticipate a “fair” return relative to the asset’s risk, but no
more.
Similarly, if returns were independent of risk, there would be a rush to sell high-risk assets. Their prices
would fall (improving their expected future rates of return) until they eventually were attractive enough to
be included again in investor portfolios. è There should be a risk-return trade-off11 in the securities markets,
with higher-risk assets priced to offer higher expected returns than lower-risk assets.
One would think that risk would have something to do with the volatility of an asset’s returns, but this turns
out to be only partly correct. When we mix assets into diversified portfolios, we need to consider the
interplay among assets and the effect of diversification on the risk of the entire portfolio. Diversification
means that many assets are held in the portfolio so that the exposure to any particular asset is limited.
Efficient Markets
We should rarely expect to find bargains in the security markets. Financial markets process all available
information about securities quickly and efficiently àthe security price usually reflects all the information
available to investors concerning the value of the security. According to this hypothesis, as new information
about a security becomes available, the price of the security quickly adjusts so that the security price equals
the market consensus estimate of the value of the securityà there would be neither underpriced nor
overpriced securities. One implication of this “efficient market hypothesis” concerns the choice between
active and passive investment-management strategies.
Passive management 12 calls for holding highly diversified portfolios without spending effort or other
resources attempting to improve investment performance through security analysis. Active management13
is the attempt to improve performance either by identifying mispriced securities or by timing the
performance of broad asset classes.
If markets are efficient and prices reflect all relevant information, it is better to follow passive strategies.
If the efficient market hypothesis were taken to the extreme, there would be no point in active security
analysis. Without ongoing security analysis, however, prices eventually would depart from “correct” values,
creating new incentives for experts to move in. Even in environments as competitive as the financial markets,
we may observe only near-efficiency.
10 Security analysis: Analysis of the value of securities.
11 Risk-return trade-off: Assets with higher expected returns entail greater risk.
12 Passive management: Buying and holding a diversified portfolio without attempting to identify mispriced securities.
13 Active management: Attempting to identify mispriced securities or to forecast broad market trends.
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