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M O D E R N
PORTFOLIO THEORY
A N D I N V E S T M E N T
ANALYSIS
EIGHTH EDITION
INTERNATIONAL STUDENT VERSION
EDWIN J. ELTON
Leonard N. S tern School of Business
New York Univers i ty
MARTIN J. GRUBER
Leonard N. S tern School of Business
New York Univers i ty
STEPHEN J. BROW N
Leonard N. S tern School of Business
New York Univers i ty
WILLIAM N. GOETZMANN
Yale Universi ty
WILEY
Jo hn W iley Sons, Inc .
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Contents
P a r t 1
Cha pte r 1
Cha pte r 2
Cha pte r 3
Abou t the Au tho rs vii
Preface ix
I N T R O D U C T I O N 1
INTRODUCTION 2
Ou t l ine o f the Book 2
The Econom ic Theory o f Choice: An I l lustra tion Und er Cer ta in ty 4
Conclus ion 8
M ult iple Assets a n d Risk 8
Que stions an d Problems 9
Bib l iography 10
FINA NC IAL MARKETS 1 1
Trad ing Mechanics 11
Marg in 14
Markets 18
Trade Types an d Costs 2 5
Conclus ion 27
Bib l iography 27
FINANCIAL SECURITIES
Types of Ma rketable Financial Securit ies 2 8
The Return Characterist ics of Al ternative Securi ty Types
Stock Mark et Indexes 3 8
Bon d Market Indexes 3 9
Conclus ion 4 0
2 8
3 6
P a r t 2 P O R T F O L I O A N A L Y S I S
Section I MEA N VARIANCE PORTFOLIO THEORY
Cha pte r 4 THE CHARACTERISTICS OF THE OPPO RTUN ITY SET UN DER RISK
De te rm i n i n g th e A v e ra g e Ou tc o m e 4 5
A Measure of Dispersion 4 6
Variance of Co mb ination s of Assets 4 9
Characterist ics of Portfo l ios in Ge neral 5 1
Tw o Co nclu d ing Examples 61
Conc lus ion 64
4 1
4 3
4 4
XII I
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X I V
CONTENTS
Quest ions an d Prob lems 6 4
Bib l iography 6 6
Cha pte r 5 DELINEATING EFFICIENT PORTFOLIOS 6 8
Co mb ination s of Two Risky Assets Revisi ted: Short Sales No t A l lo w ed 6 8
The Shape of the Portfol io Possibil i ties Curve 7 7
The Eff ic ient Frontier w i t h Riskless Len ding an d Bo rro w ing 8 4
Examples an d Appl ica t ions 8 8
Three Examples 9 3
Conclus ion 96
Quest ions and Prob lems 9 6
Bib l iography 9 7
Cha pte r 6 TECH NIQUES FOR CALCULATING THE
EFFICIENT FRONTIER 9 9
Short Sales Al low ed w it h Riskless Le ndin g an d Bo rro w ing 1 0 0
Short Sales Al low ed : No Riskless Le ndin g an d Bo rro w ing 10 4
Riskless Len ding an d Borro win g wi t h Shor t Sales No t Al lo w ed 10 4
No Short Sel ling an d No Riskless Len ding an d Bo rro w ing 1 0 5
The Incorp orat ion o f Ad di t iona l Constra in ts 1 0 6
An Example 1 0 7
Conclus ion 1 1 0
App end ix A: A n Al ternat ive De f in i t ion o f Shor t Sales 11 0
Ap pen dix B: De term in ing the Der ivative 11 1
Appendix C: Solving Systems of Simultaneous Equations 1 1 5
Ap pen dix D: A Genera l So lu t ion 1 18
Appe nd ix E: Quadra t i c Prog ram ming and Kuhn-Tucker Cond i t ions 12 2
Quest ions and Prob lems 1 2 5
Bib l iography 1 2 6
Section 2 SIMPLIFYING THE POR TFOLIO SELECTION PROCESS 1 2 9
Cha pte r 7 THE CORR ELATION STRUCTURE OF SECURITY RETURNS:
THE SINGLE-INDEX MO DE L 1 3 0
The Inputs to Portfo l io Analysis 1 3 1
Sing le- Index Models : A n Ov erv iew 13 2
Characterist ics of the Single-Index M od el 1 3 7
Estimating Beta 1 3 9
The Market Mo del 15 2
An Example
5 3
Questions and Problems 5 4
Bib l iography 1 5 6
Chapter 8 THE CORR ELATION STRUCTURE OF SECURITY RETURNS:
MULTI- INDEX MODELS AN D GROUPING TECHNIQUES 5 9
Multi - Index Mode ls 1 6 0
Avera ge Corre la t ion Models 1 6 6
Mixed Models 1 6 7
Fundamenta l Mul t i - Index Models
1 6 7
Conclus ion 1 7 3
App endix A: Procedure for R educing An y Mul t i - Index M ode l to a
Mul t i - Index Model wi th Orthogonal Indexes 7 3
Appendix B: Mean Return , Var iance, and Covar iance o f a
Mul t i - Index Model 7 4
Quest ions and Prob lems 17 6
Bib l iography 1 7 7
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CONTENTS
X V
Ch ap ter 9 SIMPLE TECHNIQUE S FOR DETER MINING THE EFFICIENT FRONTIER 1 8 0
The Single- Index Model 181
Securi ty Select ion w it h a Purchasable Index 1 9 2
The Constant Corre lat ion Mo del 1 9 3
Oth er Return Structures 1
9 6
An Example
9 6
Conclusion 197
Ap pen dix A: Single- Index Mod elS hort Sales Al lo we d 1 98
Ap pen dix B: Constant Corre lat ion Coef f ic ientSho rt
Sales Al lowed 2 0 0
Appendix C: Single- Index Model wi th Short Sales Not Al lowed 2 0 1
Appendix D: Constant Correlat ion Coeff icientShort Sales
No t A l l owed 2 0 3
Ap pe ndix E: Single- Index M ode l , Short Sales Al low ed , an d a
Market Asset 2 0 5
Quest ions and Problems
2 0 5
Bib l iography 2 0 6
C h a p t e r 1 0 INTERN ATIONA L DIVERSIFICATION 2 0 8
The World Port fo l io 2 0 8
Calculat ing the Return on Foreign Investments 2 1 0
The Risk of Fo reig n Securit ies 2 1 2
Returns from Internat ional Diversi f icat ion 2 1 7
The Effect of Exchange Risk 2 1 8
Return Expectat ions and Port fol io Performance 2 1 9
Other Evidence on Internat ional ly Diversi f ied Port fol ios 2 2 2
Models for Managing Internat ional Port fo l ios 2 2 6
Conclus ion 2 2 9
Quest ions and Problems 2 2 9
Bib l iography 2 3 1
Section 3 SELECTING THE OP TIMU M PORTFOLIO 2 3 5
Ch ap te r 1 1 ESTIMATING EXPECTED RETURNS 2 3 6
Aggregate Asset Al locat ion 2 3 6
Forecast ing Individual Securi ty Returns 2 4 0
Portfol io Analysis with Discrete Data 2 4 2
Bib l iography 2 4 4
C h a p t e r
2 H O W TO SELECT A M O N G THE PORTFOLIOS
IN THE OPPORTUNITY SET 2 4 5
Choosing Di rect ly 2 4 5
An Int roduct ion to Pref rerence Funct ions 2 4 6
Risk Tolerance Functions 2 4 9
Safety First 2 5 1
Maximizing the Geometr ic Mean Return 2 5 7
Va lue at Risk VaR) 2 5 9
Uti l i ty and the Equity Risk Premium 2 6 0
Optimal Investment Strategies with Investor Liabi l i t ies 2 6 2
Liabil it ies and Safety-First Portfolio Selection 2 6 6
Simulat ions in Port fol io Choice 2 6 6
Conclusion 2 7 2
Appendix: The Economic Propert ies of Ut i l i ty Funct ions 2 7 2
Relative Risk Ave rsion an d W ealth 2 7 4
Quest ions and Problems 2 7 4
Bibl iography 2 7 5
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X V I
CONTENTS
Part 3
Cha pte r 1 3
Cha pte r 1 4
Cha pte r 1 5
Chapter 16
M O D E L S O F E Q U I L I B R I U M I N T H E C A P IT A L
M A R K E T S
THE STAND ARD CAPITAL ASSET PRICING MO DE L
The Assum pt ions Un der ly ing the Standard Capi tal Asset
Pricing M ode l CAPM) 2 8 0
The Capital Asset Pricing Model 2 8 1
Prices and the CAPM 2 9 0
Conc lus ion 2 9 2
Appendix : Appropr ia teness o f the Sing le-Per iod Asset
Pr ic ing Model 2 9 4
Quest ions and Prob lems 2 9 8
Bib l i og raphy 2 9 9
ALTERNATIVE FOR MS OF CAPITAL ASSET PRICING MO DE LS
Short Sales Disal lowed 3 0 2
Modi f ica t ions o f Risk less Lending and Borrowing 3 0 2
Personal Taxes 3 1 2
Nonm arke tab le Assets 3 1 4
Heterogeneous Expecta t ions 3 1 6
Non-Price-Taking Beha vior 3 1 7
Mu l t i pe r iod CAPM 3 1 7
The Con sum pt ion -Or ien ted CAPM 3 1 8
Inflat ion Risk and Equi l ibr ium 3 1 9
The Mult i -Beta CAPM 3 1 9
Conclus ion
3 2 0
Appendix : Der ivat ion o f the Genera l Equi l ib r ium wi th Taxes 3 2 1
Quest ions and Prob lems 3 2 3
Bib l i og raphy 3 2 4
EMPIRICAL TESTS OF FORMS OF THE CAPM
The M odels Ex-An te Expectations an d Ex-Post Tests 3 3 0
Empirical Tests of the CAPM 3 3 1
Test ing Some Al ternat ive Forms o f the CAPM Mo del 3 4 5
Testing the Post-Tax Form of the CAPM Model 3 4 5
Some Reservations about Tradi t ional Tests of General Equi l ibr ium
Relationships and Some New Research 3 4 9
Conclus ion 3 5 1
Appendix: Random Errors in Beta and Bias in the Parameters
of the CAPM 3 5 2
Quest ions and Prob lems 3 5 3
Bib l i og raphy 3 5 4
2 7 9
2 8 0
3 0 1
3 3 0
THE ARBITRAGE PRICING MO DEL A N D -
RELEVANCE
-ITS EMPIRICAL
3 5 8
APTWhat Is It? 3 5 8
Estimating and Testing APT 3 6 3
APT and CAPM 3 7 5
Recapitulat ion 3 7 6
Conclus ion 3 8 5
Appendix A: A Simple Example of Factor Analysis 3 8 5
App end ix B: Speci f ica t ion o f the APT w i th an Un observ ed
Market Factor 3 8 6
Quest ions and Prob lems 3 8 7
Bib l iography 3 8 8
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CONTENTS
X V I I
P a r t 4
Cha pte r 1 7
Cha pte r 1 8
Cha pte r 1 9
C h a p t e r 2 0
S E C U RI TY A N A L Y SI S A N D P O R T F O L I O T H E O R Y
EFFICIENT MARKETS
Some Background 3 9 8
Tests of Return Predictabil i ty 4 0 0
Announcement and Pr i ce Re tu rn 4 1 6
Me thod o logy o f Even t S tudies 4 1 6
Strong-Form Eff ic iency 4 2 2
Market Rational i ty 4 2 5
Conclus ion 4 2 7
Quest ions and Prob lems
4 2 7
Bib l i og raphy 4 2 7
BEHAVIORAL FINANCE, INVESTOR DECISION
MA KIN G, A N D ASSET PRICES
Prospect Theory and Decis ion Making Under Uncer ta in ty 4 3 8
Biases From Laboratory Experiments 4 4 1
Summary o f Investor Behavior 4 4 4
Behavioral Finance and Asset Pricing Theory 4 4 5
Bib l i og raphy 4 5 2
VALUATION MODELS
Discounted Cash Flow Models 4 5 6
Cross-Sectional Regression Analysis 4 6 8
An Ongo ing Sys tem 4 7 2
Conclus ion 4 7 7
Quest ions and Prob lems 4 7 7
Bib l iography 4 7 8
3 9 5
3 9 6
4 3 8
4 5 5
EARNINGS ESTIMATION
4 8 2
4 8 2
he Elusive Number Cal led Earnings
The Importance o f Earn ings 4 8 5
Characterist ics of Earnings and Earnings Forecasts 4 8 8
Conclus ion 4 9 5
Quest ions and Prob lems 4 9 6
Bib l i og raphy 4 9 6
C h a p t e r 2 1 INTEREST RATE THEORY A N D THE PRICING OF BOND S
An In troduct ion to Debt Secur i t ies 4 9 9
The Many Defin i t ions of Rates 5 0 1
Bond Prices and Spot Rates 5 0 8
De term in ing Spot Rates 5 1 0
The Determinants of Bond Prices 5 1 2
Conclus ion 5 2 8
Appendix A: Special Considerations in Bond Pricing 5 2 8
Appendix B: Estimating Spot Rates 5 2 8
Ap pe nd ix C: Calcu lating Bon d Equivalent Yield an d Effective
Annual Y ie ld 5 3 1
Quest ions and Prob lems 5 3 1
Bib l iography 5 3 2
C h a p t e r 2 2 THE MANAG EMENT OF BO ND PORTFOLIOS
Dura t ion 5 3 6
Protecting Against Term Structure Shifts 5 4 4
Bond Por t fo l io Management o f Year ly Returns 5 4 8
Swaps 5 5 7
4 9 8
5 3 6
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XVII I
CONTENTS
Appendix A: Durat ion Measures 5 5 9
Appendix B: Exact Match ing Programs 5 6 3
Appendix C: Bond-Swapping Techniques
5 6 5
Appendix D: Convexi ty
5 6 6
Questions and Problems
5 6 7
Bib l iography 5 6 8
Cha pte r 2 3 VALUATION A N D USES OF OPTIONS 5 7 1
Types of Options 5 7 1
Some Basic Characterist ics of Option Values 5 7 7
Valuat ion Models 5 8 2
Art i f i c ia l or Homemade Opt ions 5 9 3
Uses of Options 5 9 4
Conclus ion 5 9 7
Appendix A: Der ivat ion o f the Binomia l Formula 5 9 7
Appendix B: Derivation of the Black-Scholes Formula 6 0 0
Questions and Problems 6 0 2
Bib l iography 6 0 3
Cha pte r 2 4 THE VALU ATION A N D USES OF FINANC IAL FUTURES 6 0 9
Descript ion of Financial Futures 6 0 9
Valuation of Financial Futures
6 1 3
The Uses of Financial Futures
6 1 9
Nonf inancia l Futures and Commodi ty Funds 6 2 3
Questions and Problems 6 2 4
Bib l iography 6 2 4
P a rt 5 E V A L U A T I N G T H E I N V E S T M E N T P R O C ES S 6 2 7
Cha pte r 2 5 EVALUAT ION OF PORTFOLIO PERFORMANCE 6 2 8
Evaluation Techniques 6 2 9
A Manipu la t ion-Proof Per formance Measure 6 44
Decomposi t ion o f Overa l l Eva luat ion 6 4 5
Multi - Index, APT, and Performance Evaluation 6 5 5
Mutua l Fund Per fo rmance 6 6 1
Conclus ion 6 7 4
Questions and Problems 6 7 4
Bib l iography
6 7 5
Cha pte r 2 6 EVALU ATION OF SECURITY ANALYSIS 6 8 0
Why the Emphasis on Earn ings? 6 8 1
The Evaluation of Earnings Forecasts 6 8 2
Evaluating the Valuation Process 6 8 9
Conclus ion 6 9 2
Questions and Problems 6 9 3
Bib l iography 6 9 3
Cha pte r 2 7 PORTFOLIO MA NA GE ME NT REVISITED 6 9 5
Managing Stock Portfo l ios
6 9 6
Act i ve Management 6 9 9
Passive Versus Active 7 0 0
International Diversi f ication 7 0 1
B o n d M a n a g e m e n t 7 0 1
Bond and Stock Investment with a Liabi l i ty Stream 7 0 4
Bib l iography 7 0 9
I n d e x 7 1 1
