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Investments
 The McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate
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Investments
T E N T H E D I T I O N

ZVI BODIE
Boston University

ALEX KANE
University of California, San Diego

ALAN J. MARCUS
Boston College
INVESTMENTS, TENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2014 by McGraw-Hill
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Bodie, Zvi.
Investments / Zvi Bodie, Boston University, Alex Kane, University of California,
San Diego, Alan J. Marcus, Boston College.—10th Edition.
pages cm.—(The McGraw-Hill/Irwin series in finance, insurance and real estate)
Includes index.
ISBN-13: 978-0-07-786167-4 (alk. paper)
ISBN-10: 0-07-786167-1 (alk. paper)
1. Investments. 2. Portfolio management. I. Kane, Alex. II. Marcus, Alan J. III. Title.
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 About the Authors

ZVI BODIE ALEX KANE ALAN J. MARCUS

Boston University University of California, Boston College
San Diego
Zvi Bodie is the Norman Alan Marcus is the Mario J.
and Adele Barron Professor Alex Kane is professor of Gabelli Professor of Finance
of Management at Boston finance and economics at in the Carroll School of
University. He holds a PhD the Graduate School of Management at Boston
from the Massachusetts International Relations College. He received his PhD
Institute of Technology and and Pacific Studies at the in economics from MIT.
has served on the finance fac- University of California, Professor Marcus has been
ulty at the Harvard Business San Diego. He has been visit- a visiting professor at the
School and MIT’s Sloan ing professor at the Faculty Athens Laboratory of
School of Management. of Economics, University of Business Administration and
Professor Bodie has published Tokyo; Graduate School of at MIT’s Sloan School of
widely on pension finance Business, Harvard; Kennedy Management and has served
and investment strategy in School of Government, as a research associate at the
leading professional jour- Harvard; and research associ- National Bureau of Economic
nals. In cooperation with the ate, National Bureau of Research. Professor Marcus
Research Foundation of the Economic Research. An has published widely in the
CFA Institute, he has recently author of many articles in fields of capital markets and
produced a series of Webcasts finance and management portfolio management. His
and a monograph entitled The journals, Professor Kane’s consulting work has ranged
Future of Life Cycle Saving research is mainly in corporate from new-product develop-
and Investing. finance, portfolio management, ment to provision of expert
and capital markets, most testimony in utility rate
recently in the measurement proceedings. He also spent
of market volatility and 2 years at the Federal Home
pricing of options. Loan Mortgage Corporation
(Freddie Mac), where he
developed models of mortgage
pricing and credit risk. He cur-
rently serves on the Research
Foundation Advisory Board
of the CFA Institute.

v
 Brief Contents

Preface xvi PART III

PART I
Equilibrium in Capital
Introduction 1 Markets 291
1 9
The Investment Environment 1 The Capital Asset Pricing Model 291
2 10
Asset Classes and Financial Arbitrage Pricing Theory and Multifactor
Instruments 28 Models of Risk and Return 324
3 11
How Securities Are Traded 59 The Efficient Market Hypothesis 349
4 12
Mutual Funds and Other Investment Behavioral Finance and Technical
Companies 92 Analysis 388
13
PART II Empirical Evidence on Security Returns 414

Portfolio Theory
and Practice 117 PART IV

5 Fixed-Income
Risk, Return, and the Historical
Record 117 Securities 445
6 14
Capital Allocation to Risky Assets 168 Bond Prices and Yields 445
7 15
Optimal Risky Portfolios 205 The Term Structure of Interest Rates 487
8 16
Index Models 256 Managing Bond Portfolios 515

vi
 Brief Contents

PART V PART VII

Security Analysis 557 Applied Portfolio

17
Macroeconomic and Industry Analysis 557
Management 835
24
18 Portfolio Performance Evaluation 835
Equity Valuation Models 591
25
19 International Diversification 882
Financial Statement Analysis 635
26
PART VI Hedge Funds 926
27
Options, Futures, and The Theory of Active Portfolio
Management 951
Other Derivatives 678 28
20 Investment Policy and the Framework of the
Options Markets: Introduction 678 CFA Institute 977
21
Option Valuation 722
REFERENCES TO CFA PROBLEMS 1015
22 GLOSSARY G-1
Futures Markets 770
NAME INDEX I-1
23
Futures, Swaps, and Risk Management 799 SUBJECT INDEX I-4

vii
 Contents

Preface xvi Reverses / Federal Funds / Brokers’ Calls / The LIBOR

Market / Yields on Money Market Instruments
PART I 2.2 The Bond Market 34
Treasury Notes and Bonds / Inflation-Protected Treasury
Introduction 1 Bonds / Federal Agency Debt / International Bonds /
Municipal Bonds / Corporate Bonds / Mortgages and
CHAPTER 1 Mortgage-Backed Securities
The Investment Environment 1 2.3 Equity Securities 41
Common Stock as Ownership Shares / Characteristics of
1.1 Real Assets versus Financial Assets 2
Common Stock / Stock Market Listings / Preferred Stock /
1.2 Financial Assets 3 Depository Receipts
1.3 Financial Markets and the Economy 5 2.4 Stock and Bond Market Indexes 44
The Informational Role of Financial Markets / Stock Market Indexes / Dow Jones Averages / Standard
Consumption Timing / Allocation of Risk / Separation of & Poor’s Indexes / Other U.S. Market-Value Indexes /
Ownership and Management / Corporate Governance Equally Weighted Indexes / Foreign and International
and Corporate Ethics Stock Market Indexes / Bond Market Indicators
1.4 The Investment Process 8 2.5 Derivative Markets 51
1.5 Markets Are Competitive 9 Options / Futures Contracts
The Risk–Return Trade-Off / Efficient Markets End of Chapter Material 54–58
1.6 The Players 11
Financial Intermediaries / Investment Bankers / Venture
CHAPTER 3
Capital and Private Equity
1.7 The Financial Crisis of 2008 15 How Securities Are Traded 59
Antecedents of the Crisis / Changes in Housing Finance / 3.1 How Firms Issue Securities 59
Mortgage Derivatives / Credit Default Swaps / The Rise Privately Held Firms / Publicly Traded Companies / Shelf
of Systemic Risk / The Shoe Drops / The Dodd-Frank Registration / Initial Public Offerings
Reform Act 3.2 How Securities Are Traded 63
1.8 Outline of the Text 23 Types of Markets
End of Chapter Material 24–27 Direct Search Markets / Brokered Markets / Dealer
Markets / Auction Markets
CHAPTER 2 Types of Orders
Asset Classes and Financial Instruments 28 Market Orders / Price-Contingent Orders
2.1 The Money Market 29 Trading Mechanisms
Treasury Bills / Certificates of Deposit / Commercial Dealer Markets / Electronic Communication Networks
Paper / Bankers’ Acceptances / Eurodollars / Repos and (ECNs) / Specialist Markets

viii
 Contents

3.3 The Rise of Electronic Trading 68 5.1 Determinants of the Level of Interest Rates 118
3.4 U.S. Markets 69 Real and Nominal Rates of Interest / The Equilibrium
NASDAQ / The New York Stock Exchange / ECNs Real Rate of Interest / The Equilibrium Nominal Rate of
3.5 New Trading Strategies 71 Interest / Taxes and the Real Rate of Interest
Algorithmic Trading / High-Frequency Trading / Dark 5.2 Comparing Rates of Return for Different Holding
Pools / Bond Trading Periods 122
3.6 Globalization of Stock Markets 74 Annual Percentage Rates / Continuous Compounding
3.7 Trading Costs 76 5.3 Bills and Inflation, 1926–2012 125
3.8 Buying on Margin 76 5.4 Risk and Risk Premiums 127
3.9 Short Sales 80 Holding-Period Returns / Expected Return and Standard
Deviation / Excess Returns and Risk Premiums
3.10 Regulation of Securities Markets 83
5.5 Time Series Analysis of Past Rates of Return 130
Self-Regulation / The Sarbanes-Oxley Act / Insider Trading
Time Series versus Scenario Analysis / Expected Returns
End of Chapter Material 87–91
and the Arithmetic Average / The Geometric (Time-
Weighted) Average Return / Variance and Standard
CHAPTER 4 Deviation / Mean and Standard Deviation Estimates
Mutual Funds and Other Investment from Higher-Frequency Observations / The Reward-to-
Companies 92 Volatility (Sharpe) Ratio
5.6 The Normal Distribution 135
4.1 Investment Companies 92
5.7 Deviations from Normality and Risk Measures 137
4.2 Types of Investment Companies 93
Value at Risk / Expected Shortfall / Lower Partial
Unit Investment Trusts / Managed Investment Companies /
Standard Deviation and the Sortino Ratio / Relative
Other Investment Organizations
Frequency of Large, Negative 3-Sigma Returns
Commingled Funds / Real Estate Investment Trusts
5.8 Historic Returns on Risky Portfolios 141
(REITs) / Hedge Funds
Portfolio Returns / A Global View of the Historical
4.3 Mutual Funds 96
Record
Investment Policies
5.9 Long-Term Investments 152
Money Market Funds / Equity Funds / Sector Funds /
Normal and Lognormal Returns / Simulation of Long-
Bond Funds / International Funds / Balanced Funds /
Term Future Rates of Return / The Risk-Free Rate
Asset Allocation and Flexible Funds / Index Funds
Revisited / Where Is Research on Rates of Return
How Funds Are Sold Headed? / Forecasts for the Long Haul
4.4 Costs of Investing in Mutual Funds 99 End of Chapter Material 161–167
Fee Structure
Operating Expenses / Front-End Load / Back-End CHAPTER 6
Load / 12b-1 Charges
Fees and Mutual Fund Returns
Capital Allocation to Risky Assets 168
4.5 Taxation of Mutual Fund Income 103 6.1 Risk and Risk Aversion 168
4.6 Exchange-Traded Funds 103 Risk, Speculation, and Gambling / Risk Aversion and
4.7 Mutual Fund Investment Performance: A First Look 107 Utility Values / Estimating Risk Aversion
4.8 Information on Mutual Funds 110 6.2 Capital Allocation across Risky and Risk-Free
Portfolios 175
End of Chapter Material 112–116
6.3 The Risk-Free Asset 177
6.4 Portfolios of One Risky Asset and a Risk-Free
PART II
Asset 178
6.5 Risk Tolerance and Asset Allocation 182
Portfolio Theory Nonnormal Returns
and Practice 117 6.6 Passive Strategies: The Capital Market Line 187
End of Chapter Material 190–199
CHAPTER 5 Appendix A: Risk Aversion, Expected Utility, and the
Risk, Return, and the Historical Record 117 St. Petersburg Paradox 199

ix
 Contents

Appendix B: Utility Functions and Equilibrium Prices 8.5 Practical Aspects of Portfolio Management with the
of Insurance Contracts 203 Index Model 278
Appendix C: The Kelly Criterion 203 Is the Index Model Inferior to the Full-Covariance
Model? / The Industry Version of the Index Model /
CHAPTER 7 Predicting Betas / Index Models and Tracking Portfolios
End of Chapter Material 284–290
Optimal Risky Portfolios 205
7.1 Diversification and Portfolio Risk 206
7.2 Portfolios of Two Risky Assets 208
PART III
7.3 Asset Allocation with Stocks, Bonds, and Bills 215
Asset Allocation with Two Risky Asset Classes Equilibrium in Capital
7.4 The Markowitz Portfolio Optimization Model 220 Markets 291
Security Selection / Capital Allocation and the Separation
Property / The Power of Diversification / Asset Allocation CHAPTER 9
and Security Selection / Optimal Portfolios and The Capital Asset Pricing
Nonnormal Returns Model 291
7.5 Risk Pooling, Risk Sharing, and the Risk of Long-
Term Investments 230 9.1 The Capital Asset Pricing Model 291
Risk Pooling and the Insurance Principle / Risk Sharing / Why Do All Investors Hold the Market Portfolio? /
Investment for the Long Run The Passive Strategy Is Efficient / The Risk Premium of
the Market Portfolio / Expected Returns on Individual
End of Chapter Material 234–244
Securities / The Security Market Line / The CAPM and
Appendix A: A Spreadsheet Model for Efficient the Single-Index Market
Diversification 244
9.2 Assumptions and Extensions of the CAPM 302
Appendix B: Review of Portfolio Statistics 249
Assumptions of the CAPM / Challenges and Extensions
to the CAPM / The Zero-Beta Model / Labor Income
CHAPTER 8 and Nontraded Assets / A Multiperiod Model and Hedge
Index Models 256 Portfolios / A Consumption-Based CAPM / Liquidity and
the CAPM
8.1 A Single-Factor Security Market 257
9.3 The CAPM and the Academic World 313
The Input List of the Markowitz Model / Normality of
9.4 The CAPM and the Investment Industry 315
Returns and Systematic Risk
End of Chapter Material 316–323
8.2 The Single-Index Model 259
The Regression Equation of the Single-Index Model / CHAPTER 10
The Expected Return–Beta Relationship / Risk and
Covariance in the Single-Index Model / The Set of Arbitrage Pricing Theory and
Estimates Needed for the Single-Index Model / The Index Multifactor Models of Risk
Model and Diversification and Return 324
8.3 Estimating the Single-Index Model 264 10.1 Multifactor Models: An Overview 325
The Security Characteristic Line for Hewlett-Packard / Factor Models of Security Returns
The Explanatory Power of the SCL for HP / Analysis
10.2 Arbitrage Pricing Theory 327
of Variance / The Estimate of Alpha / The Estimate
of Beta / Firm-Specific Risk / Correlation and Arbitrage, Risk Arbitrage, and Equilibrium / Well-
Covariance Matrix Diversified Portfolios / Diversification and Residual Risk
in Practice / Executing Arbitrage / The No-Arbitrage
8.4 Portfolio Construction and the Single-Index
Equation of the APT
Model 271
10.3 The APT, the CAPM, and the Index Model 334
Alpha and Security Analysis / The Index Portfolio as an
Investment Asset / The Single-Index-Model Input List / The APT and the CAPM / The APT and Portfolio
The Optimal Risky Portfolio in the Single-Index Model / Optimization in a Single-Index Market
The Information Ratio / Summary of Optimization 10.4 A Multifactor APT 338
Procedure / An Example 10.5 The Fama-French (FF) Three-Factor Model 340
Risk Premium Forecasts / The Optimal Risky Portfolio End of Chapter Material 342–348

x
 Contents

CHAPTER 11 Limits to Arbitrage and the Law of One Price

“Siamese Twin” Companies / Equity Carve-Outs /
The Efficient Market Hypothesis 349
Closed-End Funds
11.1 Random Walks and the Efficient Market Bubbles and Behavioral Economics / Evaluating the
Hypothesis 350 Behavioral Critique
Competition as the Source of Efficiency / Versions of the 12.2 Technical Analysis and Behavioral Finance 400
Efficient Market Hypothesis
Trends and Corrections
11.2 Implications of the EMH 354
Momentum and Moving Averages / Relative Strength /
Technical Analysis / Fundamental Analysis / Active Breadth
versus Passive Portfolio Management / The Role of
Sentiment Indicators
Portfolio Management in an Efficient Market / Resource
Allocation Trin Statistic / Confidence Index / Put/Call Ratio
11.3 Event Studies 359 A Warning
11.4 Are Markets Efficient? 362 End of Chapter Material 407–413
The Issues
CHAPTER 13
The Magnitude Issue / The Selection Bias Issue / The
Lucky Event Issue Empirical Evidence on Security
Weak-Form Tests: Patterns in Stock Returns Returns 414
Returns over Short Horizons / Returns over Long 13.1 The Index Model and the Single-Factor APT 415
Horizons The Expected Return–Beta Relationship
Predictors of Broad Market Returns / Semistrong Tests: Setting Up the Sample Data / Estimating the SCL /
Market Anomalies Estimating the SML
The Small-Firm-in-January Effect / The Neglected- Tests of the CAPM / The Market Index / Measurement
Firm Effect and Liquidity Effects / Book-to-Market Error in Beta
Ratios / Post–Earnings-Announcement Price Drift
13.2 Tests of the Multifactor CAPM and APT 421
Strong-Form Tests: Inside Information / Interpreting the
Labor Income / Private (Nontraded) Business / Early
Anomalies
Versions of the Multifactor CAPM and APT / A Macro
Risk Premiums or Inefficiencies? / Anomalies or Data Factor Model
Mining? / Anomalies over Time
13.3 Fama-French-Type Factor Models 426
Bubbles and Market Efficiency
Size and B/M as Risk Factors / Behavioral Explanations /
11.5 Mutual Fund and Analyst Performance 375 Momentum: A Fourth Factor
Stock Market Analysts / Mutual Fund Managers / So, Are 13.4 Liquidity and Asset Pricing 433
Markets Efficient?
13.5 Consumption-Based Asset Pricing and the Equity
End of Chapter Material 380–387 Premium Puzzle 435
Consumption Growth and Market Rates of Return /
CHAPTER 12 Expected versus Realized Returns / Survivorship Bias /
Behavioral Finance and Technical Extensions to the CAPM May Resolve the Equity Premium
Analysis 388 Puzzle / Liquidity and the Equity Premium Puzzle /
Behavioral Explanations of the Equity Premium Puzzle /
12.1 The Behavioral Critique 389
End of Chapter Material 442–444
Information Processing
Forecasting Errors / Overconfidence / Conservatism /
Sample Size Neglect and Representativeness PART IV
Behavioral Biases
Framing / Mental Accounting / Regret Avoidance
Fixed-Income Securities 445
Affect
CHAPTER 14
Prospect Theory
Limits to Arbitrage
Bond Prices and Yields 445
Fundamental Risk / Implementation Costs / Model 14.1 Bond Characteristics 446
Risk Treasury Bonds and Notes

xi
 Contents

Accrued Interest and Quoted Bond Prices 16.2 Convexity 525

Corporate Bonds Why Do Investors Like Convexity? / Duration and
Call Provisions on Corporate Bonds / Convertible Convexity of Callable Bonds / Duration and Convexity of
Bonds / Puttable Bonds / Floating-Rate Bonds Mortgage-Backed Securities
Preferred Stock / Other Domestic Issuers / International 16.3 Passive Bond Management 533
Bonds / Innovation in the Bond Market Bond-Index Funds / Immunization / Cash Flow Matching
Inverse Floaters / Asset-Backed Bonds / Catastrophe and Dedication / Other Problems with Conventional
Bonds / Indexed Bonds Immunization
14.2 Bond Pricing 452 16.4 Active Bond Management 543
Bond Pricing between Coupon Dates Sources of Potential Profit / Horizon Analysis
14.3 Bond Yields 458 End of Chapter Material 545–556
Yield to Maturity / Yield to Call / Realized Compound
Return versus Yield to Maturity PART V
14.4 Bond Prices over Time 463
Yield to Maturity versus Holding-Period Return / Zero- Security Analysis 557
Coupon Bonds and Treasury Strips / After-Tax Returns
14.5 Default Risk and Bond Pricing 468 CHAPTER 17
Junk Bonds / Determinants of Bond Safety / Bond Macroeconomic and Industry
Indentures Analysis 557
Sinking Funds / Subordination of Further Debt / 17.1 The Global Economy 558
Dividend Restrictions / Collateral
17.2 The Domestic Macroeconomy 560
Yield to Maturity and Default Risk / Credit Default Swaps /
17.3 Demand and Supply Shocks 562
Credit Risk and Collateralized Debt Obligations
17.4 Federal Government Policy 563
End of Chapter Material 479–486
Fiscal Policy / Monetary Policy / Supply-Side Policies
17.5 Business Cycles 566
CHAPTER 15 The Business Cycle / Economic Indicators / Other
The Term Structure of Interest Rates 487 Indicators

15.1 The Yield Curve 487 17.6 Industry Analysis 571

Bond Pricing Defining an Industry / Sensitivity to the Business Cycle /

15.2 The Yield Curve and Future Interest Rates 490 Sector Rotation / Industry Life Cycles

The Yield Curve under Certainty / Holding-Period Start-Up Stage / Consolidation Stage / Maturity Stage /
Returns / Forward Rates Relative Decline

15.3 Interest Rate Uncertainty and Forward Rates 495 Industry Structure and Performance

15.4 Theories of the Term Structure 497 Threat of Entry / Rivalry between Existing Competi-
tors / Pressure from Substitute Products / Bargaining
The Expectations Hypothesis / Liquidity Preference
Power of Buyers / Bargaining Power of Suppliers
15.5 Interpreting the Term Structure 501
End of Chapter Material 582–590
15.6 Forward Rates as Forward Contracts 504
End of Chapter Material 506–514 CHAPTER 18
Equity Valuation Models 591
CHAPTER 16
18.1 Valuation by Comparables 591
Managing Bond Portfolios 515 Limitations of Book Value
16.1 Interest Rate Risk 516 18.2 Intrinsic Value versus Market Price 593
Interest Rate Sensitivity / Duration / What Determines 18.3 Dividend Discount Models 595
Duration? The Constant-Growth DDM / Convergence of Price
Rule 1 for Duration / Rule 2 for Duration / Rule 3 to Intrinsic Value / Stock Prices and Investment
for Duration / Rule 4 for Duration / Rule 5 for Opportunities / Life Cycles and Multistage Growth
Duration Models / Multistage Growth Models

xii
 Contents

18.4 Price–Earnings Ratio 609 Index Options / Futures Options / Foreign Currency
The Price–Earnings Ratio and Growth Opportunities / Options / Interest Rate Options
P/E Ratios and Stock Risk / Pitfalls in P/E Analysis / 20.2 Values of Options at Expiration 685
Combining P/E Analysis and the DDM / Other Call Options / Put Options / Option versus Stock
Comparative Valuation Ratios Investments
Price-to-Book Ratio / Price-to-Cash-Flow Ratio / 20.3 Option Strategies 689
Price-to-Sales Ratio Protective Put / Covered Calls / Straddle / Spreads /
18.5 Free Cash Flow Valuation Approaches 617 Collars
Comparing the Valuation Models / The Problem with 20.4 The Put-Call Parity Relationship 698
DCF Models 20.5 Option-Like Securities 701
18.6 The Aggregate Stock Market 622 Callable Bonds / Convertible Securities / Warrants /
End of Chapter Material 623–634 Collateralized Loans / Levered Equity and Risky Debt
20.6 Financial Engineering 707
CHAPTER 19 20.7 Exotic Options 709
Financial Statement Analysis 635 Asian Options / Barrier Options / Lookback Options /
19.1 The Major Financial Statements 635 Currency-Translated Options / Digital Options
The Income Statement / The Balance Sheet / The End of Chapter Material 710–721
Statement of Cash Flows
19.2 Measuring Firm Performance 640 CHAPTER 21
19.3 Profitability Measures 641 Option Valuation 722
Return on Assets, ROA / Return on Capital, ROC / 21.1 Option Valuation: Introduction 722
Return on Equity, ROE / Financial Leverage and ROE /
Intrinsic and Time Values / Determinants of Option Values
Economic Value Added
21.2 Restrictions on Option Values 725
19.4 Ratio Analysis 645
Restrictions on the Value of a Call Option / Early Exercise
Decomposition of ROE / Turnover and Other Asset
and Dividends / Early Exercise of American Puts
Utilization Ratios / Liquidity Ratios / Market Price
Ratios: Growth versus Value / Choosing a Benchmark 21.3 Binomial Option Pricing 729
19.5 An Illustration of Financial Statement Two-State Option Pricing / Generalizing the Two-State
Analysis 655 Approach / Making the Valuation Model Practical
19.6 Comparability Problems 658 21.4 Black-Scholes Option Valuation 737
Inventory Valuation / Depreciation / Inflation and Interest The Black-Scholes Formula / Dividends and Call Option
Expense / Fair Value Accounting / Quality of Earnings Valuation / Put Option Valuation / Dividends and Put
and Accounting Practices / International Accounting Option Valuation
Conventions 21.5 Using the Black-Scholes Formula 746
19.7 Value Investing: The Graham Technique 665 Hedge Ratios and the Black-Scholes Formula / Portfolio
End of Chapter Material 665–677 Insurance / Option Pricing and the Crisis of 2008–2009 /
Option Pricing and Portfolio Theory / Hedging Bets on
Mispriced Options
PART VI 21.6 Empirical Evidence on Option Pricing 758
End of Chapter Material 759–769
Options, Futures, and
Other Derivatives 678 CHAPTER 22
Futures Markets 770
CHAPTER 20
22.1 The Futures Contract 771
Options Markets: Introduction 678 The Basics of Futures Contracts / Existing Contracts
20.1 The Option Contract 679 22.2 Trading Mechanics 775
Options Trading / American and European Options / The Clearinghouse and Open Interest / The Margin
Adjustments in Option Contract Terms / The Options Account and Marking to Market / Cash versus Actual
Clearing Corporation / Other Listed Options Delivery / Regulations / Taxation

xiii
 Contents

22.3 Futures Markets Strategies 781 The Role of Alpha in Performance Measures / Actual
Hedging and Speculation / Basis Risk and Hedging Performance Measurement: An Example / Performance
22.4 Futures Prices 785 Manipulation and the Morningstar Risk-Adjusted Rating /
Realized Returns versus Expected Returns
The Spot-Futures Parity Theorem / Spreads / Forward
versus Futures Pricing 24.2 Performance Measurement for Hedge Funds 851
22.5 Futures Prices versus Expected Spot Prices 791 24.3 Performance Measurement with Changing Portfolio
Composition 854
Expectations Hypothesis / Normal Backwardation /
Contango / Modern Portfolio Theory 24.4 Market Timing 855
End of Chapter Material 793–798 The Potential Value of Market Timing / Valuing Market
Timing as a Call Option / The Value of Imperfect Forecasting
CHAPTER 23 24.5 Style Analysis 861
Style Analysis and Multifactor Benchmarks / Style
Futures, Swaps, and Risk Management 799 Analysis in Excel
23.1 Foreign Exchange Futures 799 24.6 Performance Attribution Procedures 864
The Markets / Interest Rate Parity / Direct versus Indirect Asset Allocation Decisions / Sector and Security Selection
Quotes / Using Futures to Manage Exchange Rate Risk Decisions / Summing Up Component Contributions
23.2 Stock-Index Futures 806 End of Chapter Material 870–881
The Contracts / Creating Synthetic Stock Positions: An
Asset Allocation Tool / Index Arbitrage / Using Index CHAPTER 25
Futures to Hedge Market Risk
International Diversification 882
23.3 Interest Rate Futures 813
Hedging Interest Rate Risk 25.1 Global Markets for Equities 883
23.4 Swaps 815 Developed Countries / Emerging Markets / Market
Capitalization and GDP / Home-Country Bias
Swaps and Balance Sheet Restructuring / The Swap
Dealer / Other Interest Rate Contracts / Swap Pricing / 25.2 Risk Factors in International Investing 887
Credit Risk in the Swap Market / Credit Default Swaps Exchange Rate Risk / Political Risk
23.5 Commodity Futures Pricing 822 25.3 International Investing: Risk, Return, and Benefits
Pricing with Storage Costs / Discounted Cash Flow from Diversification 895
Analysis for Commodity Futures Risk and Return: Summary Statistics / Are Investments
End of Chapter Material 825–834 in Emerging Markets Riskier? / Are Average Returns
Higher in Emerging Markets? / Is Exchange Rate Risk
Important in International Portfolios? / Benefits from
PART VII International Diversification / Misleading Representation
of Diversification Benefits / Realistic Benefits from
Applied Portfolio International Diversification / Are Benefits from
International Diversification Preserved in Bear Markets?
Management 835 25.4 Assessing the Potential of International
Diversification 911
CHAPTER 24
25.5 International Investing and Performance
Portfolio Performance Evaluation 835 Attribution 916
24.1 The Conventional Theory of Performance Constructing a Benchmark Portfolio of Foreign Assets /
Evaluation 835 Performance Attribution
Average Rates of Return / Time-Weighted Returns versus End of Chapter Material 920–925
Dollar-Weighted Returns / Dollar-Weighted Return and
Investment Performance / Adjusting Returns for Risk / CHAPTER 26
The M2 Measure of Performance / Sharpe’s Ratio Is Hedge Funds 926
the Criterion for Overall Portfolios / Appropriate
Performance Measures in Two Scenarios 26.1 Hedge Funds versus Mutual Funds 927
Jane’s Portfolio Represents Her Entire Risky Invest- 26.2 Hedge Fund Strategies 928
ment Fund / Jane’s Choice Portfolio Is One of Many Directional and Nondirectional Strategies / Statistical
Portfolios Combined into a Large Investment Fund Arbitrage

xiv
 Contents

26.3 Portable Alpha 931 CHAPTER 28

An Example of a Pure Play
Investment Policy and the Framework
26.4 Style Analysis for Hedge Funds 933 of the CFA Institute 977
26.5 Performance Measurement for Hedge Funds 935
28.1 The Investment Management Process 978
Liquidity and Hedge Fund Performance / Hedge Fund
Objectives / Individual Investors / Personal Trusts /
Performance and Survivorship Bias / Hedge Fund
Mutual Funds / Pension Funds / Endowment Funds / Life
Performance and Changing Factor Loadings / Tail Events
Insurance Companies / Non–Life Insurance Companies /
and Hedge Fund Performance
Banks
26.6 Fee Structure in Hedge Funds 943
28.2 Constraints 983
End of Chapter Material 946–950
Liquidity / Investment Horizon / Regulations / Tax
Considerations / Unique Needs
CHAPTER 27
28.3 Policy Statements 985
The Theory of Active Portfolio Sample Policy Statements for Individual Investors
Management 951
28.4 Asset Allocation 992
27.1 Optimal Portfolios and Alpha Values 951 Taxes and Asset Allocation
Forecasts of Alpha Values and Extreme Portfolio Weights / 28.5 Managing Portfolios of Individual Investors 994
Restriction of Benchmark Risk
Human Capital and Insurance / Investment in Residence /
27.2 The Treynor-Black Model and Forecast Precision 958 Saving for Retirement and the Assumption of Risk /
Adjusting Forecasts for the Precision of Alpha / Retirement Planning Models / Manage Your Own
Distribution of Alpha Values / Organizational Structure Portfolio or Rely on Others? / Tax Sheltering
and Performance The Tax-Deferral Option / Tax-Deferred Retirement
27.3 The Black-Litterman Model 962 Plans / Deferred Annuities / Variable and Universal
Black-Litterman Asset Allocation Decision / Step 1: The Life Insurance
Covariance Matrix from Historical Data / Step 2: 28.6 Pension Funds 1000
Determination of a Baseline Forecast / Step 3: Integrating Defined Contribution Plans / Defined Benefit Plans /
the Manager’s Private Views / Step 4: Revised (Posterior) Pension Investment Strategies
Expectations / Step 5: Portfolio Optimization
Investing in Equities / Wrong Reasons to Invest in
27.4 Treynor-Black versus Black-Litterman: Complements, Equities
Not Substitutes 968
28.7 Investments for the Long Run 1003
The BL Model as Icing on the TB Cake / Why Not Replace
Target Investing and the Term Structure of Bonds /
the Entire TB Cake with the BL Icing?
Making Simple Investment Choices / Inflation Risk and
27.5 The Value of Active Management 970 Long-Term Investors
A Model for the Estimation of Potential Fees / Results End of Chapter Material 1004–1014
from the Distribution of Actual Information Ratios /
Results from Distribution of Actual Forecasts / Results
with Reasonable Forecasting Records REFERENCES TO CFA PROBLEMS 1015
27.6 Concluding Remarks on Active Management 972 GLOSSARY G-1
End of Chapter Material 973–974 NAME INDEX I-1
Appendix A: Forecasts and Realizations of Alpha 974 SUBJECT INDEX I-4
Appendix B: The General Black-Litterman Model 975

xv
 Preface

W
e’ve just ended three decades of rapid and pro- become an investment professional, or simply a sophisti-
found change in the investments industry as cated individual investor, you will find these skills essen-
well as a financial crisis of historic magnitude. tial, especially in today’s rapidly evolving environment.
The vast expansion of financial markets during this period Our primary goal is to present material of practical
was due in part to innovations in securitization and credit value, but all three of us are active researchers in finan-
enhancement that gave birth to new trading strategies. cial economics and find virtually all of the material in this
These strategies were in turn made feasible by develop- book to be of great intellectual interest. Fortunately, we
ments in communication and information technology, as think, there is no contradiction in the field of investments
well as by advances in the theory of investments. between the pursuit of truth and the pursuit of money.
Yet the financial crisis also was rooted in the cracks Quite the opposite. The capital asset pricing model, the
of these developments. Many of the innovations in secu- arbitrage pricing model, the efficient markets hypothesis,
rity design facilitated high leverage and an exaggerated the option-pricing model, and the other centerpieces of
notion of the efficacy of risk transfer strategies. This modern financial research are as much intellectually satis-
engendered complacency about risk that was coupled fying subjects of scientific inquiry as they are of immense
with relaxation of regulation as well as reduced trans- practical importance for the sophisticated investor.
parency, masking the precarious condition of many big In our effort to link theory to practice, we also have
players in the system. Of necessity, our text has evolved attempted to make our approach consistent with that of the
along with financial markets and their influence on CFA Institute. In addition to fostering research in finance,
world events. the CFA Institute administers an education and certifi-
Investments, Tenth Edition, is intended primarily as a cation program to candidates seeking designation as a
textbook for courses in investment analysis. Our guiding Chartered Financial Analyst (CFA). The CFA curriculum
principle has been to present the material in a framework represents the consensus of a committee of distinguished
that is organized by a central core of consistent fundamen- scholars and practitioners regarding the core of knowledge
tal principles. We attempt to strip away unnecessary math- required by the investment professional.
ematical and technical detail, and we have concentrated Many features of this text make it consistent with and
on providing the intuition that may guide students and relevant to the CFA curriculum. Questions from past CFA
practitioners as they confront new ideas and challenges in exams appear at the end of nearly every chapter, and, for
their professional lives. students who will be taking the exam, those same ques-
This text will introduce you to major issues currently tions and the exam from which they’ve been taken are
of concern to all investors. It can give you the skills to listed at the end of the book. Chapter 3 includes excerpts
conduct a sophisticated assessment of watershed current from the “Code of Ethics and Standards of Professional
issues and debates covered by the popular media as well Conduct” of the CFA Institute. Chapter 28, which dis-
as more-specialized finance journals. Whether you plan to cusses investors and the investment process, presents the

xvi
 Preface

CFA Institute’s framework for systematically relating A second theme is the risk–return trade-off. This too
investor objectives and constraints to ultimate investment is a no-free-lunch notion, holding that in competi-
policy. End-of-chapter problems also include questions tive security markets, higher expected returns come
from test-prep leader Kaplan Schweser. only at a price: the need to bear greater investment
In the Tenth Edition, we have continued our systematic risk. However, this notion leaves several questions
collection of Excel spreadsheets that give tools to explore unanswered. How should one measure the risk of
concepts more deeply than was previously possible. These an asset? What should be the quantitative trade-
spreadsheets, available on the Web site for this text (www. off between risk (properly measured) and expected
mhhe.com/bkm), provide a taste of the sophisticated ana- return? The approach we present to these issues is
lytic tools available to professional investors. known as modern portfolio theory, which is another
organizing principle of this book. Modern portfolio
UNDERLYING PHILOSOPHY theory focuses on the techniques and implications of
efficient diversification, and we devote considerable
In the Tenth Edition, we address many of the changes in attention to the effect of diversification on portfolio
the investment environment, including the unprecedented risk as well as the implications of efficient diversi-
events surrounding the financial crisis. fication for the proper measurement of risk and the
At the same time, many basic principles remain impor- risk–return relationship.
tant. We believe that attention to these few important 2. This text places greater emphasis on asset allocation
principles can simplify the study of otherwise difficult than most of its competitors. We prefer this empha-
material and that fundamental principles should orga- sis for two important reasons. First, it corresponds to
nize and motivate all study. These principles are crucial the procedure that most individuals actually follow.
to understanding the securities traded in financial markets Typically, you start with all of your money in a bank
and in understanding new securities that will be intro- account, only then considering how much to invest in
duced in the future, as well as their effects on global mar- something riskier that might offer a higher expected
kets. For this reason, we have made this book thematic, return. The logical step at this point is to consider
meaning we never offer rules of thumb without reference risky asset classes, such as stocks, bonds, or real
to the central tenets of the modern approach to finance. estate. This is an asset allocation decision. Second,
The common theme unifying this book is that security in most cases, the asset allocation choice is far more
markets are nearly efficient, meaning most securities are important in determining overall investment perfor-
usually priced appropriately given their risk and return mance than is the set of security selection decisions.
attributes. Free lunches are rarely found in markets as Asset allocation is the primary determinant of the
competitive as the financial market. This simple observa- risk–return profile of the investment portfolio, and so
tion is, nevertheless, remarkably powerful in its implica- it deserves primary attention in a study of investment
tions for the design of investment strategies; as a result, policy.
our discussions of strategy are always guided by the 3. This text offers a much broader and deeper treat-
implications of the efficient markets hypothesis. While ment of futures, options, and other derivative secu-
the degree of market efficiency is, and always will be, a rity markets than most investments texts. These
matter of debate (in fact we devote a full chapter to the markets have become both crucial and integral to
behavioral challenge to the efficient market hypothesis), the financial universe. Your only choice is to become
we hope our discussions throughout the book convey a conversant in these markets—whether you are to be
good dose of healthy criticism concerning much conven- a finance professional or simply a sophisticated indi-
tional wisdom. vidual investor.
Distinctive Themes
Investments is organized around several important themes: NEW IN THE TENTH EDITION
1. The central theme is the near-informational-efficiency The following is a guide to changes in the Tenth Edition.
of well-developed security markets, such as those in the This is not an exhaustive road map, but instead is meant to
United States, and the general awareness that competi- provide an overview of substantial additions and changes
tive markets do not offer “free lunches” to participants. to coverage from the last edition of the text.

xvii
 Preface

Chapter 1 The Investment Environment concerning the use of financial ratios as tools to evaluate
This chapter contains updated coverage of the consequences firm performance.
of the financial crisis as well as the Dodd-Frank act.
Chapter 21 Option Valuation
Chapter 2 Asset Classes and Financial We have added substantial new sections on risk-neutral
Instruments valuation methods and their implementation in the bino-
We devote additional attention to money markets, includ- mial option-pricing model, as well as the implications
ing recent controversies concerning the regulation of of the option pricing model for tail risk and financial
money market mutual funds as well as the LIBOR scandal. instability.

Chapter 3 How Securities Are Traded Chapter 24 Portfolio Performance Evaluation

We have extensively rewritten this chapter and included New sections on the vulnerability of standard perfor-
new sections that detail the rise of electronic markets, mance measures to manipulation, manipulation-free mea-
algorithmic and high-speed trading, and changes in mar- sures, and the Morningstar Risk-Adjusted Return have
ket structure. been added.
Chapter 5 Risk, Return, and the
Historical Record ORGANIZATION AND CONTENT
This chapter has been updated with considerable attention
The text is composed of seven sections that are fairly inde-
paid to evidence on tail risk and extreme stock returns.
pendent and may be studied in a variety of sequences.
Chapter 9 The Capital Asset Pricing Model Because there is enough material in the book for a two-
We have streamlined the explanation of the simple CAPM semester course, clearly a one-semester course will require
and updated and integrated the sections dealing with the instructor to decide which parts to include.
extensions of the CAPM, tying together extra-market Part One is introductory and contains important insti-
hedging demands and factor risk premia. tutional material focusing on the financial environment.
We discuss the major players in the financial markets,
Chapter 10 Arbitrage Pricing Theory
provide an overview of the types of securities traded in
The chapter contains new material on the practical feasi-
those markets, and explain how and where securities are
bility of creating well-diversified portfolios and the impli-
traded. We also discuss in depth mutual funds and other
cations for asset pricing.
investment companies, which have become an increas-
Chapter 11 The Efficient Market Hypothesis ingly important means of investing for individual inves-
We have added new material documenting the behavior of tors. Perhaps most important, we address how financial
market anomalies over time, suggesting how market inef- markets can influence all aspects of the global economy,
ficiencies seem to be corrected. as in 2008.
The material presented in Part One should make it
Chapter 13 Empirical Evidence on Security
possible for instructors to assign term projects early in
Returns
the course. These projects might require the student to
Increased attention is given to tests of multifactor models
analyze in detail a particular group of securities. Many
of risk and return and the implications of these tests for
instructors like to involve their students in some sort of
the importance of extra-market hedging demands.
investment game, and the material in these chapters will
Chapter 14 Bond Prices and Yields facilitate this process.
This chapter includes new material on sovereign credit Parts Two and Three contain the core of modern
default swaps. portfolio theory. Chapter 5 is a general discussion of risk
and return, making the general point that historical returns
Chapter 18 Equity Valuation Models
on broad asset classes are consistent with a risk–return
This chapter includes a new section on the practical prob-
trade-off, and examining the distribution of stock returns.
lems entailed in using DCF security valuation models and
We focus more closely in Chapter 6 on how to describe
the response of value investors to these problems.
investors’ risk preferences and how they bear on asset
Chapter 19 Financial Statement Analysis allocation. In the next two chapters, we turn to portfolio
We have added a new introduction to the discussion of optimization (Chapter 7) and its implementation using
ratio analysis, providing greater structure and rationale index models (Chapter 8).

xviii
 Preface

After our treatment of modern portfolio theory in Part Part Four is the first of three parts on security valu-
Two, we investigate in Part Three the implications of that ation. This part treats fixed-income securities—bond
theory for the equilibrium structure of expected rates of pricing (Chapter 14), term structure relationships (Chap-
return on risky assets. Chapter 9 treats the capital asset ter 15), and interest-rate risk management (Chapter 16).
pricing model and Chapter 10 covers multifactor descrip- Parts Five and Six deal with equity securities and
tions of risk and the arbitrage pricing theory. Chapter 11 derivative securities. For a course emphasizing security
covers the efficient market hypothesis, including its ratio- analysis and excluding portfolio theory, one may pro-
nale as well as evidence that supports the hypothesis and ceed directly from Part One to Part Four with no loss in
challenges it. Chapter 12 is devoted to the behavioral continuity.
critique of market rationality. Finally, we conclude Part Finally, Part Seven considers several topics important
Three with Chapter 13 on empirical evidence on security for portfolio managers, including performance evalua-
pricing. This chapter contains evidence concerning the tion, international diversification, active management, and
risk–return relationship, as well as liquidity effects on practical issues in the process of portfolio management.
asset pricing. This part also contains a chapter on hedge funds.

xix
 A Guided Tour
This book contains several features designed
to make it easy for students to understand,
absorb, and apply the concepts and techniques
presented.

CHAPTER OPENING VIGNETTES

SERVE TO OUTLINE the upcoming material

1
in the chapter and provide students with a
road map of what they will learn.
CHAPTER ONE
The Investment
Environment

AN INVESTMENT IS the current commitment Broadly speaking, this chapter addresses

of money or other resources in the expecta- three topics that will provide a useful perspec-
tion of reaping future benefits. For example, tive for the material that is to come later. First,
an individual might purchase shares of stock before delving into the topic of “investments,”
anticipating that the future proceeds from the we consider the role of financial assets in the
shares will justify both the time that her money economy. We discuss the relationship between
is tied up as well as the risk of the investment. securities and the “real” assets that actually
The time you will spend studying this text produce goods and services for consumers, and
(not to mention its cost) also is an investment. we consider why financial assets are important
You are forgoing either current leisure or the to the functioning of a developed economy.
income you could be earning at a job in the Given this background, we then take a
expectation that your future career will be suf- first look at the types of decisions that con-
ficiently enhanced to justify this commitment front investors as they assemble a portfolio of
of time and effort. While these two invest- assets. These investment decisions are made
ments differ in many ways, they share one key in an environment where higher returns
attribute that is central to all investments: You usually can be obtained only at the price of

claim and limited liability features.

CONCEPT CHECKS Residual claim means that stockholders are the last in line of all those who have a
claim on the assets and income of the corporation. In a liquidation of the firm’s assets the
shareholders have a claim to what is left after all other claimants such as the tax authorities,
A UNIQUE FEATURE of this book! These employees, suppliers, bondholders, and other creditors have been paid. For a firm not in
liquidation, shareholders have claim to the part of operating income left over after inter-
self-test questions and problems found in CONCEPT CHECK 2.3
est and taxes have been paid. Management can either pay
this residual as cash dividends to shareholders or reinvest
it in the business to increase the value of the shares.
the body of the text enable the students to a. If you buy 100 shares of IBM stock, to what Limited liability means that the most shareholders
are you entitled? can lose in the event of failure of the corporation is their
determine whether they’ve understood the b. What is the most money you can make on original investment. Unlike owners of unincorporated
this investment over the next year? businesses, whose creditors can lay claim to the personal
preceding material. Detailed solutions are c. If you pay $180 per share, what is the most assets of the owner (house, car, furniture), corporate
bod61671_ch01_001-027.indd 1
money you could lose over the year? shareholders may at worst have worthless stock. They
03/05/13 are
12:08 AM

provided at the end of each chapter. not personally liable for the firm’s obligations.

Stock Market Listings

Example 4.2 Fees for Various Classes

NUMBERED EXAMPLES Here are fees for different classes of the Dreyfus High Yield Fund in 2012. Notice the
trade-off between the front-end loads versus 12b-1 charges in the choice between
NUMBERED AND TITLED examples are Class A and Class C shares. Class I shares are sold only to institutional investors and
carry lower fees.

integrated throughout chapters. Using the Class A Class C Class I

0–4.5%a
worked-out solutions to these examples Front-end load
Back-end load 0
0
0–1%b
0
0%b
12b-1 feesc
as models, students can learn how to solve Expense ratio
.25%
.70%
1.0%
.70%
0%
.70%

specific problems step-by-step as well as a

b
Depending on size of investment.
Depending on years until holdings are sold.
bod61671_ch02_028-058.indd 42 c 04/05/13 3:26 AM
Including service fee.
gain insight into general principles by
seeing how they are applied to answer
concrete questions.

xx
bod61671_ch04_092-116.indd 100 03/05/13 12:19 AM
 WORDS FROM THE STREET
Investors Sour on Pro Stock Pickers BOXES

WORDS FROM THE STREET

Investors are jumping out of mutual funds managed by
professional stock pickers and shifting massive amounts of
Morningstar says that when investors have put money
in stock funds, they have chosen low-cost index funds and
SHORT ARTICLES FROM business
money into lower-cost funds that echo the broader market.
Through November 2012, investors pulled $119.3 billion
ETFs. Some index ETFs cost less than 0.1% of assets a year,
while many actively managed stock funds charge 1% a
periodicals, such as The Wall Street
from so-called actively managed U.S. stock funds accord- year or more.
ing to the latest data from research firm Morningstar Inc.
At the same time, they poured $30.4 billion into U.S. stock
While the trend has put increasing pressure lately on
stock pickers, it is shifting the fortunes of some of the big-
Journal, are included in boxes
exchange-traded funds.
The move reflects the fact that many money manag-
gest players in the $14 trillion mutual-fund industry.
Fidelity Investments and American Funds, among the throughout the text. The articles are
ers of stock funds, which charge fees but also dangle the largest in the category, saw redemptions or weak investor
prospect of higher returns, have underperformed the
benchmark stock indexes. As a result, more investors are
interest compared with competitors, according to an anal-
ysis of mutual-fund flows done for The Wall Street Journal
chosen for real-world relevance and
choosing simply to invest in funds tracking the indexes,
which carry lower fees and are perceived as having
by research firm Strategic Insight, a unit of New York-based
Asset International. clarity of presentation.
less risk. At the other end of the spectrum, Vanguard, the
The mission of stock pickers in a managed mutual fund world’s largest provider of index mutual funds, pulled in a
is to outperform the overall market by actively trading net $141 billion last year through December, according to
individual stocks or bonds, with fund managers receiving the company.
higher fees for their effort. In an ETF (or indexed mutual Many investors say they are looking for a way to invest
fund), managers balance the share makeup of the fund cheaply, with less risk.
so it accurately reflects the performance of its underlying Source: Adapted from Kirsten Grind, “Investors Sour on Pro Stock
index, charging lower fees. Pickers” The Wall Street Journal, January 3, 2013.

or a mutual fund company that operates a market index fund. Vanguard, for example, oper-
ates the Index 500 Portfolio that mimics the S&P 500 index fund. It purchases shares of the
firms constituting the S&P 500 in proportion to the market values of the outstanding equity
of each firm, and therefore essentially replicates the S&P 500 index. The fund thus dupli-
cates the performance of this market index. It has one of the lowest operating expenses
(as a percentage of assets) of all mutual stock funds precisely because it requires minimal
managerial effort.
A second reason to pursue a passive strategy is the free-rider benefit. If there are many
active, knowledgeable investors who quickly bid up prices of undervalued assets and force

eXcel APPLICATIONS: Two–Security Model

EXCEL APPLICATIONS
he accompanying spreadsheet can be used to mea- two-security return data from Table 7.1. This spreadsheet is
THE TENTH EDITION features Excel T sure the return and risk of a portfolio of two risky
assets. The model calculates the return and risk for vary-
available at www.mhhe.com/bkm.
Excel Question
Spreadsheet Applications with new ing weights of each security along with the optimal risky
and minimum-variance portfolio. Graphs are automatically 1. Suppose your target expected rate of return is 11%.
generated for various model inputs. The model allows you a. What is the lowest-volatility portfolio that provides that
Excel questions. A sample spreadsheet is to specify a target rate of return and solves for optimal
combinations using the risk-free asset and the optimal
expected return?
b. What is the standard deviation of that portfolio?

presented in the text with an interactive risky portfolio. The spreadsheet is constructed with the c. What is the composition of that portfolio?

Expected
bod61671_ch06_168-204.indd 189 10/05/13 10:06 PM

version available on the book’s Web site 1

A
Asset Allocation Analysis: Risk and Return
B C D E F
Return (%)

2 Expected Standard Correlation

at www.mhhe.com/bkm. 3
4 Security 1
Return
0.08
Deviation
0.12
Coefficient
0.3
Covariance
0.0072
5 Security 2 0.13 0.2
6 T-Bill 0.05 0 11
7
8 Weight Weight Expected Standard Reward to
9 Security 1 Security 2 Return Deviation Volatility
5
10 1 0 0.08000 0.12000 0.25000
11 0.9 0.1 0.08500 0.11559 0.30281
12 0.8 0.2 0.09000 0.11454 0.34922
0
13 0.7 0.3 0.09500 0.11696 0.38474
0 5 10 15 20 25 30 35
14 0.6 0.4 0.10000 0.12264 0.40771 Standard Deviation (%)

A B C D E F
1
2
3
4
5
Period
2001
Implicitly Assumed
Probability = 1/5
.2
HPR (decimal)
−0.1189
Squared
Deviation
0.0196
Gross HPR = Wealth
1 + HPR
0.8811
Index*
0.8811
EXCEL EXHIBITS
6 2002 .2 −0.2210 0.0586 0.7790 0.6864
7
8
2003
2004
2005
.2
.2
.2
0.2869
0.1088
0.0491
0.0707
0.0077
1.2869
1.1088
1.0491
0.8833
0.9794
1.0275
SELECTED EXHIBITS ARE set as Excel
9 0.0008
10 Arithmetic average AVERAGE(C5:C9) =
11 Expected HPR SUMPRODUCT(B5:B9, C5:C9) =
0.0210
0.0210 spreadsheets and are denoted by an icon.
12 Standard deviation SUMPRODUCT(B5:B9, D5:D9)^.5 = 0.1774 Check:
13
14
STDEV(C5:C9) =
Geometric average return
0.1983
GEOMEAN(E5:E9) − 1 = 0.0054
1.0054^5=
1.0275
They are also available on the book’s
15 *The value of $1 invested at the beginning of the sample period (1/1/2001).

Spreadsheet 5.2 eXcel

Web site at www.mhhe.com/bkm.
Please visit us at
Time series of HPR for the S&P 500 www.mhhe.com/bkm

bod61671_ch05_117-167.indd 131 10/05/13 5:18 PM

xxi
bod61671_ch07_205-255.indd 221 10/05/13 8:53 PM
 End-of-Chapter Features

Visit us at www.m
SUMMARY 1. Unit investment trusts, closed-end management companies, and open-end management compa-
nies are all classified and regulated as investment companies. Unit investment trusts are essen-
tially unmanaged in the sense that the portfolio, once established, is fixed. Managed investment
companies, in contrast, may change the composition of the portfolio as deemed fit by the portfo-
lio manager. Closed-end funds are traded like other securities; they do not redeem shares for their
investors. Open-end funds will redeem shares for net asset value at the request of the investor.
2. Net asset value equals the market value of assets held by a fund minus the liabilities of the fund
divided by the shares outstanding.

SUMMARY 3. Mutual funds free the individual from many of the administrative burdens of owning individual
securities and offer professional management of the portfolio. They also offer advantages that are
available only to large-scale investors, such as discounted trading costs. On the other hand, funds
are assessed management fees and incur other expenses, which reduce the investor’s rate of return.
AT THE END of each chapter, a detailed Funds also eliminate some of the individual’s control over the timing of capital gains realizations.
4. Mutual funds are often categorized by investment policy. Major policy groups include money
summary outlines the most important market funds; equity funds, which are further grouped according to emphasis on income versus
growth; fixed-income funds; balanced and income funds; asset allocation funds; index funds; and

concepts presented. A listing of related specialized sector funds.

5. Costs of investing in mutual funds include front-end loads, which are sales charges; back-end
loads, which are redemption fees or, more formally, contingent-deferred sales charges; fund oper-
Web sites for each chapter can also be ating expenses; and 12b-1 charges, which are recurring fees used to pay for the expenses of mar-
keting the fund to the public.
found on the book’s Web site at www. 6. Income earned on mutual fund portfolios is not taxed at the level of the fund. Instead, as long as
the fund meets certain requirements for pass-through status, the income is treated as being earned
mhhe.com/bkm. These sites make it by the investors in the fund.

easy for students to research topics

further and retrieve financial data and
information.
bod61671_ch04_092-116.indd 112 03/05/13 12:19 AM

CHAPTER 5 Risk, Return, and the Historical Record 163

1. The Fisher equation tells us that the real interest rate approximately equals the nominal rate minus PROBLEM SETS

PROBLEM SETS the inflation rate. Suppose the inflation rate increases from 3% to 5%. Does the Fisher equation
imply that this increase will result in a fall in the real rate of interest? Explain.
2. You’ve just stumbled on a new dataset that enables you to compute historical rates of return on Basic
U.S. stocks all the way back to 1880. What are the advantages and disadvantages in using these

WE STRONGLY BELIEVE that practice in data to help estimate the expected rate of return on U.S. stocks over the coming year?
3. You are considering two alternative 2-year investments: You can invest in a risky asset with a
positive risk premium and returns in each of the 2 years that will be identically distributed and
solving problems is critical to understanding uncorrelated, or you can invest in the risky asset for only 1 year and then invest the proceeds in
a risk-free asset. Which of the following statements about the first investment alternative (com-
pared with the second) are true?
investments, so a good variety of problems a.
b.
Its 2-year risk premium is the same as the second alternative.
The standard deviation of its 2-year return is the same.

is provided. For ease of assignment we c.

d.
e.
Its annualized standard deviation is lower.
Its Sharpe ratio is higher.
It is relatively more attractive to investors who have lower degrees of risk aversion.

separated the questions by level of difficulty 4. You have $5,000 to invest for the next year and are considering three alternatives: Intermediate

us at www.mhhe.com/bkm
a. A money market fund with an average maturity of 30 days offering a current yield of 6% per
year.
Basic, Intermediate, and Challenge. b. A 1-year savings deposit at a bank offering an interest rate of 7.5%.
c. A 20-year U.S. Treasury bond offering a yield to maturity of 9% per year.
What role does your forecast of future interest rates play in your decisions?
5. Use Figure 5.1 in the text to analyze the effect of the following on the level of real interest rates:
a. Businesses become more pessimistic about future demand for their products and decide to
reduce their capital spending.
b. Households are induced to save more because of increased uncertainty about their future
Social Security benefits.
c. The Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in
order to increase the supply of money.

5. Characterize each company in the previous problem as underpriced, overpriced, or properly

EXAM PREP QUESTIONS priced.

6. What is the expected rate of return for a stock that has a beta of 1.0 if the expected return on the
market is 15%?

PRACTICE QUESTIONS for the CFA® exams a. 15%.

b. More than 15%.
c. Cannot be determined without the risk-free rate.

provided by Kaplan Schweser, A Global 7. Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of .6. Which of the follow-
ing statements is most accurate?

Leader in CFA® Education, are available in

hhe.com/bkm

a. The expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn, Inc.
b. The stock of Kaskin, Inc., has more total risk than Quinn, Inc.
c. The stock of Quinn, Inc., has more systematic risk than that of Kaskin, Inc.
Intermediate
selected chapters for additional test 8. You are a consultant to a large manufacturing corporation that is considering a project with the
following net after-tax cash flows (in millions of dollars):
Years from Now After-Tax Cash Flow
practice. Look for the Kaplan Schweser bod61671_ch05_117-167.indd 163 10/05/13 5:18 PM

logo. Learn more at www.schweser.com.

xxii
 a. McCracken was correct and Stiles was wrong.

Visit us at www.m
b. Both were correct.

CFA PROBLEMS Challenge

c. Stiles was correct and McCracken was wrong.
17. Assume a universe of n (large) securities for which the largest residual variance is not larger than
ns2M. Construct as many different weighting schemes as you can that generate well-diversified
portfolios.
WE PROVIDE SEVERAL questions from past 18. Derive a more general (than the numerical example in the chapter) demonstration of the APT
security market line:

CFA examinations in applicable chapters. a. For a single-factor market.

b. For a multifactor market.
19. Small firms will have relatively high loadings (high betas) on the SMB (small minus big) factor.
These questions represent the kinds of a. Explain why.
b. Now suppose two unrelated small firms merge. Each will be operated as an independent unit

questions that professionals in the field of the merged company. Would you expect the stock market behavior of the merged firm to
differ from that of a portfolio of the two previously independent firms? How does the merger
affect market capitalization? What is the prediction of the Fama-French model for the risk

believe are relevant to the “real world.” premium on the combined firm? Do we see here a flaw in the FF model?

Located at the back of the book is a list- 1. Jeffrey Bruner, CFA, uses the capital asset pricing model (CAPM) to help identify mispriced
securities. A consultant suggests Bruner use arbitrage pricing theory (APT) instead. In comparing
CAPM and APT, the consultant made the following arguments:
ing of each CFA question and the level and a. Both the CAPM and APT require a mean-variance efficient market portfolio.
b. Neither the CAPM nor APT assumes normally distributed security returns.

year of the CFA exam it was included in c. The CAPM assumes that one specific factor explains security returns but APT does not.

for easy reference when studying for the

exam.
bod61671_ch10_324-348.indd 346 14/05/13 6:39 AM

49.50 800 51.50 100

Visit us a

49.25 500 54.75 300

49.00 200 58.25 100
48.50 600

a. If a market buy order for 100 shares comes in, at what price will it be filled?
b. At what price would the next market buy order be filled?
EXCEL PROBLEMS
c. If you were a security dealer, would you want to increase or decrease your inventory of this stock?
eXcel
Please visit us at
9. You are bullish on Telecom stock. The current market price is $50 per share, and you have
$5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest
SELECTED CHAPTERS CONTAIN prob-
www.mhhe.com/bkm
rate of 8% per year and invest $10,000 in the stock.
a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next
lems, denoted by an icon, specifically
year? The stock currently pays no dividends.
b. How far does the price of Telecom stock have to fall for you to get a margin call if the main- linked to Excel templates that are
tenance margin is 30%? Assume the price fall happens immediately.
eXcel
Please visit us at
10. You are bearish on Telecom and decide to sell short 100 shares at the current market price of
$50 per share.
available on the book’s Web site at
www.mhhe.com/bkm
a. How much in cash or securities must you put into your brokerage account if the broker’s
initial margin requirement is 50% of the value of the short position?
www.mhhe.com/bkm.
b. How high can the price of the stock go before you get a margin call if the maintenance mar-
gin is 30% of the value of the short position?

bod61671_ch03_059-091.indd 88 03/05/13 2:00 AM

Visit us at w

E-INVESTMENTS EXERCISES E-INVESTMENTS BOXES

The Federal Reserve Bank of St. Louis has information available on interest rates and eco-
nomic conditions. A publication called Monetary Trends contains graphs and tables with
information about current conditions in the capital markets. Go to the Web site www. THESE EXERCISES PROVIDE students with
stls.frb.org and click on Economic Research on the menu at the top of the page. Find the
most recent issue of Monetary Trends in the Recent Data Publications section and answer
these questions.
simple activities to enhance their experi-
1. What is the professionals’ consensus forecast for inflation for the next 2 years? (Use the
Federal Reserve Bank of Philadelphia line on the graph to answer this.)
ence using the Internet. Easy-to-follow
2. What do consumers expect to happen to inflation over the next 2 years? (Use the
University of Michigan line on the graph to answer this.) instructions and questions are presented
3. Have real interest rates increased, decreased, or remained the same over the last
2 years? so students can utilize what they have
4. What has happened to short-term nominal interest rates over the last 2 years? What
about long-term nominal interest rates?
5. How do recent U.S. inflation and long-term interest rates compare with those of the
learned in class and apply it to today’s
other countries listed?
6. What are the most recently available levels of 3-month and 10-year yields on Treasury
Web-driven world.
securities?

bod61671_ch05_117-167.indd 166 xxiii 10/05/13 5:18 PM

 Supplements

FO R THE INSTR U C T OR and feedback is provided and EZ Test’s grade book is

designed to export to your grade book.
Online Learning Center www.mhhe.com/bkm • PowerPoint Presentation These presentation slides,
Find a wealth of information online! At this book’s Web also prepared by Anna Kovalenko, contain figures and
site instructors have access to teaching supports such as tables from the text, key points, and summaries in a
electronic files of the ancillary materials. Students have visually stimulating collection of slides that you can
access to study materials created specifically for this text customize to fit your lecture.
and much more. All Excel spreadsheets, denoted by an • Solutions Manual Updated by Marc-Anthony Isaacs,
icon in the text are located at this site. Links to the addi- this Manual provides detailed solutions to the end-of-
tional support material are also included. chapter problem sets. This supplement is also available
for purchase by your students or can be packaged with
• Instructor’s Manual Prepared by Anna Kovalenko,
your text at a discount.
Virginia Tech University, the Manual has been revised
and improved for this edition. Each chapter includes a
F O R T HE S T UD E N T
Chapter Overview, Learning Objectives, and Presenta-
tion of Material. • Excel Templates are available for selected spread-
• Test Bank Prepared by John Farlin, Ohio Dominican sheets featured within the text, as well as those fea-
University, the Test Bank has been revised to improve tured among the Excel Applications boxes. Selected
the quality of questions. Each question is ranked by end-of-chapter problems have also been designated
level of difficulty, which allows greater flexibility in as Excel problems, for which the available tem-
creating a test and also provides a rationale for the plate allows students to solve the problem and gain
solution. experience using spreadsheets. Each template can
• Computerized Test Bank A comprehensive bank of also be found on the book’s Web site www.mhhe.
test questions is provided within a computerized test com/bkm .
bank powered by McGraw-Hill’s flexible electronic • Related Web Sites A list of suggested Web sites is
testing program EZ Test Online (www.eztestonline. provided for each chapter. To keep Web addresses up-
com). You can select questions from multiple McGraw- to-date, the suggested sites as well as their links are
Hill test banks or author your own, and then print the provided online. Each chapter summary contains a ref-
test for paper distribution or give it online. This user- erence to its related sites.
friendly program allows you to sort questions by for- • Online Quizzes These multiple-choice questions are
mat, edit existing questions or add new ones, and provided as an additional testing and reinforcement
scramble questions for multiple versions of the same tool for students. Each quiz is organized by chapter to
test. You can export your tests for use in WebCT, Black- test the specific concepts presented in that particular
board, PageOut, and Apple’s iQuiz. Sharing tests with chapter. Immediate scoring of the quiz occurs upon
colleagues, adjuncts, and TAs is easy! Instant scoring submission and the correct answers are provided.

xxiv
 Supplements

MCGRAW-HILL’S CONNECT improve student engagement in and out of class. You can
select and use any asset that enhances your lecture. The
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xxv
Exploring the Variety of Random
Documents with Different Content
mathematical honours in that university; for when the tripos came
he was only fifth wrangler.
A few months after his arrival in Cambridge he agreed to act as
assistant to the Professor of Chemistry, and he was one of the
founders of the Chemical Society, and occasionally gave very
charming lectures in their rooms. His other pursuits were botany,
natural philosophy, and astronomy, but his most serious study was of
course mathematics.
After taking his degree of B.A. in 1837, he felt himself more at liberty
to follow original speculation, and turned his attention to the general
theory of the combination of symbols. His studies in this subject
appeared from time to time in the Cambridge Mathematical Journal,
of which Duncan Farquharson Gregory was editor, with only an
interval of a few months, from its first appearance till shortly before
his death.
Mr Gregory was in 1840 elected a Fellow of Trinity College, and he
took his M.A. degree in the following year. In that year, too, he was
appointed to fill the office of moderator in the Mathematical Tripos.
This position, which is regarded as one of the most honourable of
those to which the younger members of the university may aspire,
was filled by him with great success.
His most considerable book (though possibly less well known than
his lucid work on solid geometry), appeared about this time. It is
entitled Collection of Examples of the Processes of the Differential
and Integral Calculus, and was thoughtful and original. At first his
plan had been to edit a second edition of a work with a similar title,
which twenty-five years before had come from the pens of Herschel,
Peacocke, and Babbage, but as he considered this, he discovered
what immense strides had been made in the general aspect of
mathematics. The mathematical theories of heat, light, electricity,
and magnetism were all new, and they required a fresh treatment.
Thus he undertook the book which brought him so much honour.
Gregory had an absolute passion for mathematics. ‘All these things
seem to me,’ he said once, while turning over the pages of Fourier’s
great work on heat, ‘to be a kind of mathematical paradise,’ and the
enjoyment comes out all through his book.
He contested unsuccessfully with Professor Kelland the Chair of
Mathematics in the University of Edinburgh, and in 1841 was offered
the corresponding chair in Toronto, which, however, he declined; and
it was well that he did so, for in the following year he had the first
attack of the illness which was to end fatally for him. In the spring
he left Cambridge never to return again.
Up to the last he had taken part in his college work, and in spite of
severe suffering had gone through the irksome labour of
examinations. Months of all but constant pain followed, brightened
only by short intervals of ease. Whenever these occurred he turned
to his old studies for refreshment, and only a little while before his
death he began a paper on the analogy between differential
equations and those in finite differences.
As the weeks passed, the watchful eyes of his sister could see the
gradual failing of his strength, and at five o’clock on the morning of
February 23rd, 1844, he passed away in his sleep. He died at
Canaan Lodge.
His sister, Miss Georgina Gregory, made a collection of the poems
written by her brothers. Some of Mr Duncan Gregory’s verses would
have made delightful children’s poetry. One time when they had
gone to the English lakes together for change of air, they, as is not
an entirely unknown experience in that part of the world, had to
spend most of their time in the inn, and as a last resource fell to
writing doggerel.
 ‘The fields are one extensive bog,
The roads are just as bad;
I wish I were a little frog,
Then rain would make me glad.

But I am of the human race,

Which ever since the flood
Prefers a firm, dry resting-place
To wading in the mud.

But yet at last a little gleam

Of sunshine did appear,
And did most treacherously seem
As if the sky would clear.

And trusting to its specious face

To walk Georgina tried,
But soon returned in piteous case
To have her garments dried.’

He was a delightful brother and a delightful friend. What he might

have done as a mathematician had he but lived it is impossible to
tell. As it is, a writer who has discussed the hereditary qualities of
the family, speaks of the mathematical genius, which had lain
dormant since the time of James Gregorie as ‘blazing forth’ again in
Duncan Farquharson Gregory, and if this writer passes over such
talents as those of David Gregory, the Savilian Professor at Oxford,
he must have held the Fellow of Trinity in great honour. Another
authority on the family, said that if Duncan Gregory were alive,
which he might quite well be as far as dates are concerned, he
would probably have been the most famous pure mathematician of
the day. And a still greater testimony is that of Lord Kelvin, given at
the Bristol meeting of the British Association in 1898, where in a
paper on ‘Graphic Representations of the two Simplest Cases of a
Single Wave,’ he referred to Gregory’s work on this subject. ‘Gregory,’
he said, ‘died too soon,’ and as he turned from the black-board on
which he had been drawing some diagrams, he added, ‘we cannot
tell what we might have known if Gregory had lived.’ His talent was
appreciated when he lived, but the qualities to which his friends
reverted with most tenderness were his unenvious appreciation of
other men’s work, his sweetness and joyfulness, and the patience
with which he bore his last long illness.
 CHAPTER XI

RETROSPECT

‘Whatever he had in himself, he would fain have made out a hereditary claim
for.’—Lockhart, Life of Scott, ch. lxxxiv.

When Pennant on his famous tour through Scotland, came to the

dreary moorland below Craigroyston, he was filled with special
interest by the scene. Here, he was told, was the cradle of the
M’Gregors, a clan so devoid of kindness, that they had been hunted
down like wild beasts, their name suppressed and their remnant
dispersed like Jews over the country. ‘And even now,’ he added,
‘their posterity are still said to be distinguished among the clans in
which they have incorporated themselves, not only by the redness of
their hair, but by their still retaining the mischievous disposition of
their ancestors.’ What then, would Pennant have said, could he have
known that from one descendant of a MacGregor would arise a
family, thirteen of whom would be mentioned in the Encyclopædias
of 1900? After all it should be remembered that even Rob Roy’s
literary tastes have never been sufficiently appreciated, for his name
is found in the original list of the subscribers to Keith’s History of the
Affairs of Church and State in Scotland, published in 1734!
The Gregories, then, were inclined to an academic life. Their
portraits appear oddly and unexpectedly in the public buildings of
this country, their names equally unexpectedly in many books; but
their teaching which was the greatest gift they had to offer to their
fellowmen can of course no longer be adequately appreciated. The
very greatness of a teacher, which leads him to speak directly to the
body of men before him with the needs, the ignorance, the
prejudices, and the fancies of their age, makes his teaching
unintelligible to any time but his own, to a preceding age, if it were
possible, darkness, to a succeeding, platitude.
Going back to the beginning, how many times should we wish to
thank one or other of the Gregories for their hard hitting at the
shams and insincerities of their day! The Rev. John Gregorie, the
founder of the family, began by withstanding Cant in the body, and
overlooking the upturned sand-glass which that divine had set for
him, taught his own views even though they were not accepted by
his self-complacent opponent as the ‘orthodox doctrein.’ He after all,
uninteresting as he perhaps appeared to be, is still the forerunner of
the family greatness, and that not only as their first father, but
because he showed an example of independence in opinion to his
own children and to theirs—when the time should come that their
grandfather’s history would be told them by the fire of a winter’s
night.
One of his sons, David of Kinairdy, possessed the first barometer in
Scotland, an innovation for which he nearly paid with his life.
Another, Professor James Gregorie (the first), because he too rapidly
realised the greatness of Newton’s philosophy, and taught it, came
under the ban of his fellow-professors at St Andrews, and was glad
when the opportunity presented itself to receive the approbation of a
sister university, more ready for his teaching. He, too, invented the
first reflecting telescope, through which things are seen as they
appear to one’s eyes, and not upside down as had been the case
with earlier telescopes. This also in its way was a parable of what
the Gregories were to do in the world of science in making things as
plain as possible, so that the wayfaring men though fools, might not
err therein. David the son and David the grandson both did most of
their work at Oxford, the first teaching mathematics, and
endeavouring to bring Newton’s Principia down to the level of
ordinary mathematicians, while the second, who was Professor of
Modern History and Modern Languages, having been much abroad,
arranged to have the assistance of foreign teachers, whom he
supported, not only with his influence, but with his purse. There
were other mathematicians descended from David of Kinairdy, who,
it may be remembered, had three sons professors of mathematics at
one time, and of this branch of the family also were Alexander Innes
and Thomas Reid, both professors of philosophy.
Reverting to the descendants of Professor James Gregorie—the son,
grandsons, great-grandson, and great-great-grandsons, were
founders or builders, all of them of medical education in Scotland,
each doing his own part for the cause of medicine. James the son,
called the third professor of that name (for one of his mathematical
cousins was the second), was recognised and honoured as ‘the
founder’ of the Medical School at Aberdeen, though the foundations
indeed must lie very deep, for by no amount of digging can traces of
them be discovered. Professor John the grandson (his half-brother,
Professor James the fourth, was inconsiderable), the fellow-worker
with Cullen, accepted and taught that great doctor’s views, and with
his charming good-sense eradicated many of the more prejudicial
items of children’s upbringing. The great-grandson, Professor James
(the fifth), more than took his father’s place as a teacher, and setting
the medical world of Edinburgh at defiance, made one of the most
sweeping reforms that has ever taken place in the history of clinical
teaching in that university. He was also one of the great leaders in
the volunteer movement. The great-great-grandsons, Professor
William Gregory and Professor William Pulteney Alison, were
professors both of them in the Medical Faculty of the Edinburgh
University, and taught their subjects in the lucid and original way,
which was the gift of the whole family. Duncan Farquharson Gregory
was the only one of the descendants of James Gregorie, the great
contemporary of Newton, who followed in his footsteps as a
mathematician. He died in his thirtieth year, but left behind him a
brilliant record of his life’s work, which is only sad because it was so
short.
These Gregories, though they did not care for popularity, or possibly
because they did not care for popularity, and never went out of their
way to attain it, usually ended by being on the winning side—that is
to say, public opinion often changed from being against them to
being with them. They had such a gift of laughing at the right time,
of passing over the bitterness of their adversaries, and even
exposing the partisanship of their allies. Take the story which Sir
Archibald Alison gives us in his autobiography, of how a
mathematical examination was once rearranged for his benefit in the
University of Edinburgh. It was in the time of Professor Leslie, in the
spring of 1808, that this examination in the class of mathematics
took place. Archibald Alison had three very able competitors. These
were Borthwick of Crookston, J. M’Pherson Macleod, and Mr Edward
Irving. Young Alison, nervous and excitable in face of the
examination paper, became suddenly destitute of ideas, and could
only solve two of the six problems which were set. It was all the
more distressing, because he knew that, being by his mother a
member of the great mathematical family of Gregories, he was
expected to come out first. The wretched day came to an end at
last, and the boy went home in the evening literally shedding tears
of vexation. Immediately he was freed from the anxiety of the
lecture-room, he solved the problems rapidly and clearly, in a way
that annoyed and pleased him almost equally. The professor, it
seems, when he read the papers, could not give the first prize to
Alison on the strength of his answers. He therefore decided that the
work of that day should not hold, and appointed a second date for
the trial. The next time the result was all that he and Archibald
Alison could have desired! This little episode entertained Sir
Archibald immensely, and is a curious indication of the lengths to
which their friends were prepared to go for them, but while in many
families, influence, however acceptable it may be to themselves, is
anything but a good to the community, the influence exerted for the
Gregories was always rewarded by the sensible, thorough, and often
brilliant way in which they carried on their work.
The members of the family, who took up the study of medicine were
great healers, but how large was their idea of what that word
meant! To cure the body or to fail in curing it was one thing, but to
get at the reasons of illness in the circumstances and troubles of the
patient, to take away the effect through taking away the cause, was
ever the Gregories’ way. They understood many an unspoken heart
history, and from their own strong natures gave both strength and
comfort to the sick. It is no wonder then to see Burns clinging to the
friendship of his great physician for support and for love, knowing it
was to be found in ‘that man of iron justice, who was made without
compassion for a poor poetic sinner.’ Nor it must in truth be added,
was Dr Gregory any less severe with unpoetic sinners. For there is a
case recorded when a great aldermanic magnate came to consult
him from the west country, expecting his case to be considered as
one of grave importance and significance. What was then his
surprise, when he was shortly but critically surveyed by the doctor,
and shown out of the consulting room with directions equivalent to
this: ‘Have nothing richer than roast mutton and rice pudding for
dinner for the next three months, and then if you care to let me
have the pleasure of seeing you again, you will be a different man’—
a transformation which the doctor evidently thought very desirable!
One can see that life could never be smooth to such a man. But at
least the Gregories in all the struggles of life, in the riots of tongues,
were ever sure of love and quiet by their own fireside. That came to
them because they were such great lovers, just as the difficulties
outside came from the same strong natures seeking their own way
too much. It has to be remembered in connection with this that they
were usually right, but that does not make the contest any less
bitter. If one could only think of them as having had peaceful lives,
as Thomas Reid at least had, but it was always a struggle, if not a
battle with them till the pale conqueror came to still the hubbub for
ever.
They were great men, no mere dreamers. They were workers with
busy minds, to whom life was ever too short for the fulfilment of
their plans, but death never came to them before they had earned
their rest.
All the great universities of this country who received the teaching of
the Gregories, have felt themselves honoured by their service, and
have adorned their annals with their name.

The End.
 INDEX

Aberdeen, University of, 52, 92.

Aberdeen, Grammar School of, 27, 52, 92, 100, 125.
Alison, Sir Archibald, 155, 156.
Alison, William Pulteney, 122, 124, 143, 155.
Anderson, David, of Finzeach, 10.
Anderson, Janet, 10, 26.
Arbuthnot, Dr, 68, 72, 73, 74.

Beattie, 109, 119–21.

Burnet, Bishop, 27, 65.
Burnet, Helen, of Elrick, 99.
Burnet, Mary, 32.
Burns, 129, 133, 134, 135, 157.

Canaan Lodge, 136, 150.

Cambridge University, 70.
Cant, Andrew, 12, 13, 153.
Carlyle, Alexander, 103, 104, 116.
Chalmers, Principal, 98, 100.
Charlett, Dr, 64, 65, 71.
Crichtons, The, 13–18.
Christchurch, 78, 82, 83, 126.
Christison, Sir Robert, 128, 130.
Clerk of Penicuik, quoted, 71.
Cockburn, Lord, 128, 132.
College, Royal, of Physicians, 137.
Collins, John, 28, 29, 31.
Cullen, 101, 111, 113, 114, 115, 122, 126, 127, 130.

Drumoak, 10, 11, 14.

Edinburgh Academy, 147.

Edinburgh, University of, 49–53, 55–58, 84, 85, 86, 92, 100, 113,
114, 115, 126, 127, 128, 130, 139, 145, 147, 149.

Flamsteed, 59, 68, 69.

Flanders, 93.
Forbes, Catherine of Monymusk, 98.
Forbes, Hon. Elizabeth, 107, 111, 117.
Frendraught, Viscount, 15, 16, 18.

Galileo, 29, 30.

Galton, 10.
George, Prince, of Denmark, 68, 69.
Gordon, Isabel, 23, 25.
Gregorie, Alexander, 14, 15, 16, 17, 20.
Gregorie, Charles, 89.
Gregorie, David, of Kinairdy, 19–25, 153.
Gregorie, David, 89–91.
Gregory, David, Sav. Prof., 52–76, 77, 154.
Gregory, Dean, 77–83, 154.
Gregory, Dorothea, 115, 122, 123, 124.
Gregory, Duncan Farquharson, 147–151, 155.
Gregorie, Prof. James, I., 27–51, 53, 153.
Gregorie, Prof. James, II., 84–87.
Gregorie, Prof. James, III., 93–99, 154.
Gregorie, Prof. James, IV., 98, 99.
Gregory, Prof. James, V., 82, 122, 125–140, 155.
Gregorie, John, Rev., 11–14, 153.
Gregory, Prof. John, 100–124, 125, 154.
Gregory, Philip Spencer, 22, 124, 127.
Gregory, Prof. William, 141–147, 155.
Grey, Lady Mary, 81.

Halley, 60, 64, 65.

Hamilton, Professor, 136, 137.
Hearne, quoted, 63, 65.
Holland, 19, 24.
Hudson, 64, 65.
Hume, David, 109, 116, 119, 120.
Huygens, 29, 34, 35, 50.
Infirmary, Royal, of Edinburgh, 136, 137.
Innes, Prof., 23.

Jameson, George, 33.

Johnson, Samuel, 69, 108.

Keill, 62.
Kelvin, Lord, quoted, 151.
Kinairdy, 13, 14, 20, 21, 22, 24, 84.
King’s College, Aberdeen, 20, 24, 96, 97, 98, 100, 105, 108, 109,
112, 126, 142, 143.

Leyden, 102, 103, 104, 127.

Liebig, 142, 146.
Lyttelton, George, 107.
Lyttelton, Lord, 112.

Macgregors, The, 9, 152.

Macgregor of Roro, 9, 89.
Mackenzie, George, 18.
Maclaurin, Colin, 76, 86.
M’Leod, Isabella, of Geanies, 132.
Mallet, David, 87, 89.
Marischal College, Aberdeen, 27, 86.
Monboddo, 112, 135.
Monro, Professor, Primus, 100, 101.
Monro, Principal, 58.
Montague, Mrs, 107, 108, 115, 116, 123.

Newton, Sir Isaac, 23, 29, 34, 50, 54, 59, 60, 64, 68, 70, 86.

Oliphants of Langton, 61, 87.

Oxford, University of, 58, 61, 63–67, 78, 79, 80.

Padua, 30, 32.

Pennant, quoted, 152.
Pepys, Samuel, 65, 66, 67.
Pitcairne, Dr Archibald, 53, 58, 70, 84.

Regents, 105, 106.

Reid, Prof. Thomas, 23, 25, 90, 91, 106, 109, 119, 130, 131, 132.
Rheims, 93.
Robertson, Principal, 102, 116, 132.
Rob Roy, 94, 95.
Royal Society, 31, 32, 60, 61, 68, 107.
Rutherford, Professor, 101, 111, 112, 113.

Scott, Sir Walter, quoted, 95, 100, 139.

Shelburne, Earl of, quoted, 79, 83.
Sherborne Hospital, 80, 81.
Sinclair, Prof. George, 35, 36, 42.
Skene, Alexander, 47.
Skene, David, 108, 109.
Skene, Robert, 52.
Smalridge, Dr, 64, 75, 76.
Society, Royal Medical, 101.
Spalding, quoted, 12.
St Andrews University, 33, 44–49, 84, 85, 89.
Stewart, Dugald, 130, 132.

Telescope, Achromatic, 62.

Telescope, Reflecting, 28, 29, 31.
Trinity College, Cambridge, 148.

Union Negotiations, 70–73.

Walker, Jean, of Orchiston, 19, 23, 52.

Wallis, Dr, 31, 64, 67.
Westminster School, 77, 78, 83.
Whiston, quoted, 54, 60.
Wilkes, 103.
William and Margaret, 87, 88, 89.
Wise Club, 109, 110.
Witchcraft, 21.
FAMOUS SCOTS SERIES
THOMAS CARLYLE. By Hector C. Macpherson.

ALLAN RAMSAY. By Oliphant Smeaton.

HUGH MILLER. By W. Keith Leask.

JOHN KNOX. By A. Taylor Innes.

ROBERT BURNS. By Gabriel Setoun.

THE BALLADISTS. By John Geddie.

RICHARD CAMERON. By Professor Herkless.

SIR JAMES Y. SIMPSON. By Eve Blantyre Simpson.

THOMAS CHALMERS. By Professor W. Garden Blaikie.

JAMES BOSWELL. By W. Keith Leask.

TOBIAS SMOLLETT. By Oliphant Smeaton.

FLETCHER OF SALTOUN. By G. W. T. Omond.

THE “BLACKWOOD” GROUP. By Sir George Douglas.

NORMAN MACLEOD. By John Wellwood.

SIR WALTER SCOTT. By Professor Saintsbury.

KIRKCALDY OF GRANGE. By Louis A. Barbé.

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MUNGO PARK. By T. Banks Maclachlan.

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THOMAS REID. By Professor Campbell Fraser.

POLLOK AND AYTOUN. By Rosaline Masson.

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THE ACADEMIC GREGORIES. By Agnes Grainger Stewart.

JOHNSTON OF WARRISTON. By William Morison.

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