The first edition of this textbook was written more than 15 years ago. The intervening years have been a period of rapid and profound changes in the investments industry. This is due in part to an abundance of newly designed securities, in part to the creation of new trading strategies that would have been impossible without concurrent advances in computer technology, and in part to rapid advances in the theory of investments that have come out of the academic community. In no other field, perhaps, is the transmission of theory to real-world practice as rapid as is now commonplace in the financial industry. These developments place new burdens on practitioners and teachers of investments far beyond what was required only a short while ago.

This Special Indian Edition (SIE) of Investments is intended primarily as a textbook forcourses in investment analysis and is written with students and practitioners in India in mind. Ourguiding principle has been to present the material in a framework that is organized by a central core of consistent fundamental principles. We have made every attempt to strip away unnecessary mathematical and technical detail, and we have concentrated on providing the intuition that may guide students and practitioners as they confront new ideas and challenges in their professional lives.

This text will introduce you to major issues currently of concern to all investors. It can give you the skills to conduct a sophisticated assessment of current issues and debates covered by both the popular media as well as more-specialized finance journals. Whether you plan to become an investment professional, or simply a sophisticated individual investor, you will find these skills essential.

Our primary goal is to present material of practical value, but all of us are active researchers in the science of financial economics and find virtually all of the material in this book to be of great intellectual interest. Fortunately, we think, there is no contradiction in the field of investments between the pursuit of truth and the pursuit of money. Quite the opposite. The capital asset pricing model, the arbitrage pricing model, the efficient markets hypothesis, the option-pricing model, and the other centerpieces of modern financial research are as much intellectually satisfying subjects of scientific inquiry as they are of immense practical importance for the sophisticated investor.

In this SIE, we have further extended our systematic collection of Excel spreadsheets that give tools to explore concepts more deeply than was previously possible. These spreadsheets are available on the website for this text (http://highered.mcgraw-hill.com/sites/0070600872), and provide a taste of the sophisticated analytic tools available to professional investors.

Of necessity, our text has evolved along with the financial markets. In this edition, we address many of the changes in the investment environment.

At the same time, many basic principles remain important. We believe that attention to these few important principles can simplify the study of otherwise difficult material and that fundamental principles should organize and motivate all study. These principles are crucial to understanding the securities already traded in financial markets and in understanding new securities that will be introduced in the future. For this reason, we have made this book thematic, meaning we never offer rules of thumb without reference to the central tenets of the modern approach to finance.

The common theme unifying this book is that security markets are nearly efficient, meaning most securities are usually priced appropriately given their risk and return attributes. There are few free lunches found in markets as competitive as the financial market. This simple observation is, nevertheless, remarkably powerful in its implications for the design of investment strategies; as a result, our discussions of strategy are always guided by the implications of the efficient markets hypothesis. While the degree of market effi- ciency is, and always will be, a matter of debate, we hope our discussions throughout the book convey a good dose of healthy criticism concerning much conventional wisdom.

1. The central theme is the near-informational-efficiency of well-developed security markets, such as those in the United States, and the general awareness that competitive markets do not offer “free lunches” to participants.

A second theme is the risk-return trade-off. This too is a no-free-lunch notion, holding that in competitive security markets, higher expected returns come only at a price: the need to bear greater investment risk. However, this notion leaves several questions unanswered. How should one measure the risk of an asset? What should be the quantitative trade-off between risk (properly measured) and expected return? The approach we present to these issues is known as modern portfolio theory, which is another organizing principle of this book. Modern portfolio theory focuses on the techniques and implications of efficient diversification, and we devote considerable attention to the effect of diversification on portfolio risk as well as the implications of efficient diversification for the proper measurement of risk and the risk–return relationship.

2. This text places greater emphasis on asset allocation than most of its competitors. We prefer this emphasis for two important reasons. First, it corresponds to the procedure that most individuals actually follow. Typically, you start with all of your money in a bank account, only then considering how much to invest in something riskier that might offer a higher expected return. The logical step at this point is to consider other risky asset classes, such as stock, bonds, or real estate. This is an asset allocation decision. Second, in most cases, the asset allocation choice is far more important in determining overall investment performance than is the set of security selection decisions. Asset allocation is the primary determinant of the risk-return profile of the investment portfolio, and so it deserves primary attention in a study of investment policy.

3. This text offers a much broader and deeper treatment of futures, options, and other derivative security markets than most investments texts. These markets have become both crucial and integral to the financial universe and are the major sources of innovation in that universe. Your only choice is to become conversant in these markets—whether you are to be a finance professional or simply a sophisticated individual investor.

4. This text combines investment theory with the Indian experience, Indian legal system, and Indian research judiciously. This text also compares the Indian experience with the US experience to make the students understand the similarities and differences between the Indian investment scenario and the US investment scenario. In a few cases, Indian research results have been compared with international research results in order to make the students understand the difference between investments in emerging markets and in the developed markets.

As we mentioned earlier, this SIE has been completely adapted to suit the requirements of students and practitioners in India. It therefore contains Indian examples and minicases, discussion of Indian research results, and Indian illustrations. Also included are a number of Indian websites and concept check questions. Apart from these, the text contains the following changes.

Chapter 1 contains extensive new material on failures in corporate governance in the boom years of the 1990s and the conflicts of interest that gave rise to the many scandals of those years. We have added new material on securities trading including initial public offerings, electronic trading, and regulatory reforms in the wake of recent corporate scandals to Chapter 3.

In Chapter 5, we have extended the historical evidence on security returns to include international comparisons as well as new approaches to estimating the mean market return. We also have added an introduction to value at risk using historic returns as a guideline.

We have largely rewritten Chapter 11. There is now greater focus on the use of factor models as a means to understand and measure various risk exposures. The intuition for the multifactor risk–return relation has been enhanced, and the comparison between the multifactor APT and CAPM has been further developed.

We have fully reworked our treatment of behavioral finance by adding more careful development of behavioral hypotheses, their implications for security pricing, and their relation to the empirical evidence on security pricing in Chapter 12.

We have updated our discussion of the value and size effects, with an emphasis on competing interpretations of these premiums in Chapter 13.

In Chapter 14, we have added new spreadsheet material helpful in analyzing bond prices and yields. This new material enables students to price bonds between coupon dates.

We have added new material on quality of earnings, earnings management, and the use of accounting data in valuation analysis to this chapter in Chapter 18.

We have added new material related to the accounting scandals of the last few years to this chapter in Chapter 19. It discusses ways in which accounting rules were skirted in the 1990s and ongoing reforms in accounting standards.

We have extended the binomial option pricing model to a multiperiod example to illustrate how the model may be used to obtain realistic prices in Chapter 21.

We have fully rewritten Chapter 25, which now contains considerably more evidence on global financial markets and security returns. In addition to these changes, we have updated and edited our treatment of topics wherever it was possible to improve exposition or coverage.

We have added to Chapter 26 an appendix containing an extensive spreadsheet model for sophisticated financial planning. The spreadsheets (available as well at the course website) allow students to study the interaction of taxes and inflation on long-term financial strategies.

The text is composed of seven sections that are fairly independent and may be studied in a variety of sequences. Since there is enough material in the book for a two-semester course, clearly a onesemester course will require the instructor to decide which parts to include.

Part I is introductory and contains important institutional material focusing on the financial environment. We discuss the major players in the financial markets, provide an overview of the types of securities traded in those markets, and explain how and where securities are traded. We also discuss, in depth, mutual funds and other investment companies, which have become an increasingly important means of investing for individual investors.

The material presented in Part I should make it possible for instructors to assign term projects early in the course. These projects might require the student to analyze in detail a particular group of securities. Many instructors like to involve their students in some sort of investment game and the material in these chapters will facilitate this process.

Parts II and III contain the core of modern portfolio theory. Chapter 5 is a general discussion of risk and return, making the general point that historical returns on broad asset classes are consistent with a risk–return trade-off. We focus more closely in Chapter 6 on how to describe investors’ risk preferences. In Chapter 7 we progress to asset allocation and then in Chapter 8 to portfolio optimization.

After our treatment of modern portfolio theory in Part II, we investigate in Part III the implications of that theory for the equilibrium structure of expected rates of return on risky assets. Chapters 9 and 10 treat the capital asset pricing model and its implementation using index models, and Chapter 11 covers multifactor descriptions of risk and the arbitrage pricing theory. We complete Part II with a chapter on the efficient markets hypothesis, including its rationale as well as the behavioral critique of the hypothesis, the evidence for and against it, and a chapter on empirical evidence concerning security returns. The empirical evidence chapter in this edition follows the efficient markets chapter so that the student can use the perspective of efficient market theory to put other studies on returns in context.

Part IV is the first of three parts on security valuation. This part treats fixed-income securities— bond pricing (Chapter 14), term structure relationships (Chapter 15), and interest-rate risk management (Chapter 16). The next two parts deal with equity securities and derivative securities. For a course emphasizing security analysis and excluding portfolio theory, one may proceed directly from Part I to Part III with no loss in continuity.

Part V is devoted to equity securities. We proceed in a “top down” manner, starting with the broad macroeconomic environment (Chapter 17), next moving on to equity valuation (Chapter 18), and then, using this analytical framework, we treat fundamental analysis including financial statement analysis (Chapter 19).

Part VI covers derivative assets such as options, futures, swaps, and callable and convertible securities. It contains two chapters on options and two on futures. This material covers both pricing and risk management applications of derivatives.

Finally, Part VII presents extensions of previous material. Topics covered in this part include evaluation of portfolio performance (Chapter 24), portfolio management in an international setting (Chapter 25), a general framework for the implementation of investment strategy in a nontechnical manner modeled after the approach presented in CFA study materials (Chapter 26), and an overview of active portfolio management (Chapter 27).

ZVI BODIE
ALEX KANE
ALAN J. MARCUS
PITABAS MOHANTY