We wrote the first edition of this textbook more than 15 years ago. The intervening years have been a period of rapid and profound change 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.

Investments, Sixth Edition, is intended primarily as a textbook for courses in investment analysis. Our guiding principle has been to present the material in a framework that is organized by a central core of consistent fundamental principles. We make 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 three 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 our effort to link theory to practice, we also have attempted to make our approach consistent with that of the Institute of Chartered Financial Analysts (ICFA), a subsidiary of the Association of Investment Management and Research (AIMR). In addition to fostering research in finance, the AIMR and ICFA administer an education and certification program to candidates seeking the title of Chartered Financial Analyst (CFA). The CFA curriculum represents the consensus of a committee of distinguished scholars and practitioners regarding the core of knowledge required by the investment professional. This text also is used by the CAIA Association, a nonprofit association that provides education concerning nontraditional investment vehicles and sponsors the Chartered Alternative Investment Analyst designation.

There are many features of this text that make it consistent with and relevant to the CFA curriculum. The end-of-chapter problem sets contain questions from past CFA exams, and, for students who will be taking the exam, Appendix B is a useful tool that lists each CFA question in the text and the exam from which it has been taken. Chapter 3 includes excerpts from the "Code of Ethics and Standards of Professional Conduct" of the ICFA. Chapter 26, which discusses investors and the investment process, is modeled after the ICFA outline.

In the Sixth Edition, 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://www.mhhe.com/bkm), and provide a taste of the sophisticated analytic tools available to professional investors.

Underlying Philosophy

Of necessity, our text has evolved along with the financial markets. In the Sixth 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 efficiency 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.

Investments is organized around several important themes:

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.

New in the Sixth Edition

Following is a summary of the content changes in the Sixth Edition:

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.

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 this chapter. 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.

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

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.

We have added new material related to the accounting scandals of the last few years to this chapter. 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.

We have fully rewritten this chapter, 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 this chapter 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.

Organization and Content

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 one-semester 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).

Supplements

Instructor's Resource CD 0072861819 This comprehensive CD contains all the following instructor supplements. We have compiled them in electronic format for easier access and convenience. Print copies are available through your publisher's representative.

• Instructor's Manual The Instructor's Manual, prepared by Richard D. Johnson, Colorado State University, has been revised and improved in this edition. Each chapter includes a chapter overview, a review of learning objectives, an annotated chapter outline (organized to include the Transparency Masters/PowerPoint package), and teaching tips and insights. Transparency Masters are located at the end of each chapter.
• PowerPoint Presentation Software These presentation slides, also developed by Richard D. Johnson, provide the instructor with an electronic format of the Transparency Masters. These slides, revised for this edition, follow the order of the chapters, but if you have PowerPoint software, you may choose to customize the presentations to fit your own lectures.
• Test Bank The Test Bank, prepared by Larry Prather, East Tennessee State University, has been revised to increase the quantity and variety of questions. Short-answer essay questions are also provided for each chapter to further test student comprehension and critical thinking abilities. The Test Bank is also available in computerized format for Windows.

The Wall Street Journal Edition Your students can subscribe to The Wall Street Journal for 15 weeks (which includes access to the Dow Jones Interactive Online Asset) at a specially priced rate of $20.00 in addition to the price of the text. Students will receive a "How to Use the WSJ" handbook plus a pass code card shrink-wrapped with the text.

Videos 0072861835 There are seven video segments covering careers, financial markets, bonds, going public, derivatives, portfolio management, and foreign exchange.

Solutions Manual 007286186X The Solutions Manual, prepared by Bruce Swensen, Adelphi University, provides detailed solutions to the end-of-chapter problems. This manual is available for packing with the text. Please contact your local McGraw-Hill/Irwin representative for further details on how to order the Solutions Manual/Textbook package.

Student Problem Manual 0072861843 New to this edition! To give students a better resource for working through problems, we have created a comprehensive problem manual. This useful supplement, also developed by Larry Prather, contains problems created to specifically relate to the concepts discussed in each chapter. Solutions are provided at the end of each chapter.

Online Learning Center Find a wealth of information online! At http://www.mhhe.com/bkm, instructors will have access to teaching support such as electronic files for the ancillary material and students will have access to study materials created specifically for this text. The Excel Applications spreadsheets, also prepared by Bruce Swensen, are located at this site. Additional information on the text and authors and links to our powerful support materials are also available.

Standard & Poor's Educational Version of Market Insight McGraw-Hill/Irwin and the Institutional Market Services division of Standard & Poor's are pleased to announce an exclusive partnership that offers instructors and students access to the educational version of Standard & Poor's Market Insight. The Educational Version of Market Insight is a rich online resource that provides 6 years of fundamental financial data for over 500 companies in the renowned COMPUSTAT database. Standard and Poor's and McGraw-Hill/Irwin have selected the best, most-often researched companies in the database. S&P-specific problems can be found at the end of relevant chapters in this text.

PowerWeb With PowerWeb, getting information online has never been easier. This McGraw-Hill/Irwin website is a reservoir of course-specific articles and current events. Simply type in a discipline-specific topic for instant access to articles, essays, and news for your class.
             All of the articles have been recommended to PowerWeb by professors, which means you will not get all the clutter that seems to pop up with typical search engines. However, PowerWeb is much more than a search engine. Students can visit PowerWeb to take a self-grading quiz, work through interactive exercises, click through an interactive glossary, and even check the daily news. In fact, an expert for each discipline analyzes the day's news to show students how it is relevant to their field of study.

Investments Online Introducing Investments Online! For each of the 18 different topics, the student completes challenging exercises and discussion questions that draw on recent articles, company reports, government data, and other Web-based resources. The "Finance Tutor Series" provides questions and problems that not only assess and improve students' understanding of the subject but also help students to apply it in real-world contexts.

Acknowledgments

Throughout the development of this text, experienced instructors have provided critical feedback and suggestions for improvement. These individuals deserve a special thanks for their valuable insights and contributions. The following instructors played a vital role in the development of this and previous editions of Investments:

Scott Besley
University of Florida

John Binder
University of Illinois at Chicago

Paul Bolster
Northeastern University

Phillip Braun
Northwestern University

L. Michael Couvillion
Plymouth State University

Anna Craig
Emory University

David C. Distad
University of California at Berkeley

Craig Dunbar
University of Western Ontario

Michael C. Ehrhardt
University of Tennessee at Knoxville

David Ellis
Babson College

Greg Filbeck
University of Toledo

Jeremy Goh
Washington University

Richard Grayson
Loyola College

John M. Griffin
Arizona State University

Mahmoud Haddad
Wayne State University

Robert G. Hansen
Dartmouth College

Joel Hasbrouck
New York University

Andrea Heuson
University of Miami

Eric Higgins
Drexel University

Shalom J. Hochman
University of Houston

Eric Hughson
University of Colorado

A. James Ifflander
A. James Ifflander and Associates

Robert Jennings
Indiana University

Richard D. Johnson
Colorado State University

Susan D. Jordan
University of Kentucky

G. Andrew Karolyi
Ohio State University

Josef Lakonishok
University of Illinois at Champaign/Urbana

Malek Lashgari
University of Hartford

Dennis Lasser
Binghamton University

Larry Lockwood
Texas Christian University

Christopher K. Ma
Texas Tech University

Anil K. Makhija
University of Pittsburgh

Steven Mann
University of South Carolina

Deryl W. Martin
Tennessee Technical University

Jean Masson
University of Ottawa

Ronald May
St. John's University

Rick Meyer
University of South Florida

Mbodja Mougoue
Wayne State University

Gurupdesh Pandner
DePaul University

Don B. Panton
University of Texas at Arlington

Dilip Patro
Rutgers University

Robert Pavlik
Southwest Texas State

Herbert Quigley
University of D.C.

Speima Rao
University of Southwestern Louisiana

Leonard Rosenthal
Bentley College

Eileen St. Pierre
University of Northern Colorado

Anthony Sanders
Ohio State University

Don Seeley
University of Arizona

John Settle
Portland State University

Edward C. Sims
Western Illinois University

Robert Skena
Carnegie Mellon University

Steve L. Slezak
University of North Carolina at Chapel Hill

Keith V. Smith
Purdue University

Patricia B. Smith
University of New Hampshire

Laura T. Starks
University of Texas

Manuel Tarrazo
University of San Francisco

Steve Thorley
Brigham Young University

Jack Treynor
Treynor Capital Management

Charles A. Trzincka
SUNY Buffalo

Yiuman Tse
Suny Binghampton

Gopala Vasuderan
Suffolk University

Joseph Vu
De Paul University

Simon Wheatley
University of Chicago

Marilyn K. Wiley
Florida Atlantic University

James Williams
California State University at Northridge

Tony R. Wingler
University of North Carolina at Greensboro

Guojun Wu
University of Michigan

Hsiu-Kwang Wu
University of Alabama

Thomas J. Zwirlein
University of Colorado at Colorado Springs

For granting us permission to include many of their examination questions in the text, we are grateful to the Institute of Chartered Financial Analysts.

Much credit is due also to the development and production team: our special thanks go to Steve Patterson, Executive Editor/Publisher; Rhonda Seelinger, Senior Marketing Manager; Meg Beamer, Marketing Specialist; Christina Kouvelis and Denise McGuinness, Developmental Editors; Jean Lou Hess, Senior Project Manager; Keith McPherson, Director of Design; Michael McCormick, Production Supervisor; Cathy Tepper, Supplements Coordinator; and Kai Chiang, Media Technology Lead Producer.

Finally, we thank Judy, Hava, and Sheryl, who contributed to the book with their support and understanding.

Zvi Bodie

Alex Kane

Alan J. Marcus

Walkthrough

New and Enhanced Pedagogy

This book contains several features designed to make it easy for the student to understand, absorb, and apply the concepts and techniques presented.

Concept Check
A unique feature of this book is the inclusion of Concept Checks in the body of the text. These self-test questions and problems enable the student to determine whether he or she has understood the preceding material. Detailed solutions are provided at the end of each chapter.

Current Event Boxes
Short articles from business periodicals are included in boxes throughout the text. The articles are chosen for relevance, clarity of presentation, and consistency with good sense.

Excel Applications
The Sixth Edition has expanded the boxes featuring Excel Spreadsheet Applications. A sample spreadsheet is presented in the text with an interactive version and related questions available on the book website at http://www.mhhe.com/bkm.

Summary and End-of-Chapter Problems
At the end of each chapter, a detailed Summary outlines the most important concepts presented. The problems that follow the Summary progress from simple to challenging and many are taken from CFA examinations. These represent the kinds of questions that professionals in the field believe are relevant to the "real world" and are indicated by an icon in the text margin.

Websites
Another feature in this edition is the inclusion of website addresses. The sites have been chosen for relevance to the chapter and for accuracy so students can easily research and retrieve financial data and information.

Internet Exercises: E-Investments
These exercises provide students with a structured set of steps to finding financial data on the Internet. Easy-to-follow instructions and questions are presented so students can utilize what they've learned in class in today's Web-driven world.

Internet Exercises: Standard & Poor's Problems
New to this edition! Relevant chapters contain problems directly incorporating the Educational Version of Market Insight, a service based on Standard & Poor's renowned COMPUSTAT database. Problems are based on real market data to gain a better understanding of practical business situations.