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VI

CONTENTS

Preface xiv 2.2 The Bond Market 35

Government of Canada Bonds 36
PART I Inflation-Protected Bonds 39
Provincial Bonds 40
INTRODUCTION Corporate Bonds 40
Municipal Bonds 41
CHAPTER 1 International Bonds 44
The Investment Environment 1 Mortgages and Mortgage-Backed Securities 44
2.3 Equity Securities 46
1.1 Real Assets versus Financial Assets 2
Common Stock as Ownership Shares 46
1.2 Financial Assets 3
Characteristics of Common Stock 4 7
1.3 Financial Markets and the Economy 4
Stock Market Listings 48
The Informational Role of Financial Markets 4
Income Trusts 48
Consumption Timing 5
Preferred Stock 50
Allocation of Risk 5
Depository Receipts 51
Separation of Ownership and Management 5
2.4 Stock and Bond Market Indexes 51
Corporate Governance and Corporate Ethics 7
Stock Market Indexes 51
1.4 The Investment Process 8
Toronto Stock Exchange Indexes 51
1.5 Markets Are Competitive 9
Dow Jones Averages 53
The Risk-Return Trade-Off 9
Standard & Poor's U.S. Indexes 56
Efficient Markets 1O
Other U.S. Market-Value Indexes 57
1.6 The Players 10
Equally Weighted Indexes 57
Financial Intermediaries 11
Other Foreign and International Stock Market
Investment Bankers 12
Indexes 59
Venture Capital and Private Equity 13
Bond Market Indicators 59
1.7 The Financial Crisis of 2008 13
2.5 Derivative Markets 60
Antecedents of the Crisis 14
Options 60
Changes in Housing Finance 16
Futures Contracts 63
Mortgage Derivatives 17
Other Derivative Assets: Warrants, Swaps,
Credit Default Swaps 18
and Hybrid Securities 65
The Rise of Systemic Risk 18
End of Chapter Material 65
The Shoe Drops 19
The Dodd- Frank Reform Act 20 CHAPTER 3
The Canadian Experience of the Financial Crisis 21
1.8 Outline of the Text 21 How Securities Are Traded 70
End of Chapter Material 22 3. 1 How Firms Issue Securities 70
Privately Held Firms 71
CHAPTER 2 Publicly Traded Companies 72
Shelf Registration 73
Financial Markets, Asset Classes, and Financial Short Form Prospectus Distribution System (SFPD) 73
Instruments 25 Initial Public Offerings 74
2.1 The Money Market 26 3.2 How Securities Are Traded 77
Treasury Bills 26 Types of Markets and Orders 77
Certificates of Deposit 28 Types of Orders 78
Commercial Paper 28 Trading Mechanisms 80
Bankers' Acceptances 28 The Execution of Trades 82
Repos and Reverses 30 Settlement 84
The Bank of Canada Overnight Rate and the The Rise of Electronic Trading 84
U.S. Federal Funds Rate 31 3.3 Securities Markets 86
Brokers' Call Loans 31 The Toronto Stock Exchange 86
The LIBOR Market 31 The Bond Market 89
Yields on Money Market Instruments 32 U.S. Markets 89
T-Bill Yields 33 NASDAQ 90

The New York Stock Exchange 91
ECNs 91
New Trading Strategies 91
Foreign Markets 94
Derivative Markets 95
3.4 Trading Costs 95
Internet Investing 96
3.5 Trading with Margin and Short Sales 97
Trading with Margin 97
Buying on Margin 97
Short Sales 100
3.6 Regulation of Securities Markets 103
Regulatory Responses to Recent Scandals and the
2008-09 Financial Crisis 105
Self-Regulation and Circuit Breakers 106
Short-Selling Circuit Breakers 107
Insider Trading 107
End of Chapter Material 110
Appendix 3A: A Detailed Margin Position 114
CHAPTER 4
Mutual Funds and Other Investment
Companies 116
4.1 Investment Companies 116
4.2 Types of Investment Companies 117
Other Investment Organizations 119
4.3 Mutual Funds 120
Investment Policies 120
How Funds Are Sold 122
4.4 Costs of Investing in Mutual Funds 122
Fee Structure 122
Fees and Mutual Fund Returns 124
4.5 Taxation of Mutual Fund Income 126
4.6 Exchange-Traded Funds 126
4.7 Mutual Fund Investment Performance: A First
Look 130
4.8 Information on Mutual Funds 133
End of Chapter Material 135
PART II
PORTFOLIO THEORY AND PRACTICE
CHAPTER 5
Risk, Return, and the Historical Record 139
5 .1Determinants of the Level of Interest Rates 140
Real and Nominal Rates of Interest 140
The Equilibrium Real Rate of Interest 14 1
The Equilibrium Nominal Rate oflnterest 142
Taxes and the Real Rate of Interest 143
5.2 Comparing Rates of Return for Different
Holding Periods 143
Annual Percentage Rates 144
Continuous Compounding 145
CONTENTS Vil
5.3 Bills and Inflation, 1957-2016 146
5.4 Risk and Risk Premiums 147
Holding-Period Returns 147
Expected Return and Standard Deviation 147
Excess Returns and Risk Premiums 149
5.5 Time Series Analysis of Past Rates of Return 149
Time Series versus Scenario Analysis 149
Expected Returns and the Arithmetic Average 150
The Geometric (Time-Weighted) Average
Return 150
Variance and Standard Deviation 152
Mean and Standard Deviation Estimates
from Higher-Frequency Observations 153
The Reward-to-Volatility (Sharpe) Ratio 153
5.6 The Normal Distribution 154
5.7 Deviations from Normality and Alternative Risk
Measures 156
Value at Risk 158
Expected Shortfall 158
Lower Partial Standard Deviation and the Sortino
Ratio 158
Relative Frequency of Large, Negative 3-Sigma
Returns 159
5.8 Historic Returns on Risky Portfolio 159
A Global View of the Historical Record 165
5.9 Long-Term Investments 166
Short-Run versus Long-Run Risk 168
Forecasts for the Long Haul 169
End of Chapter Material 170
CHAPTER 6
Capital Allocation to Risky Assets 175
6.1 Risk and Risk Aversion 175
Risk, Speculation, and Gambling 176
Risk Aversion and Utility Values 176
Estimating Risk Aversion 180
6.2 Capital Allocation Across Risky and Risk-Free
Portfolios 181
6.3 The Risk-Free Asset 183
6.4 Portfolios of One Risky Asset and a Risk-Free Asset 184
6.5 Risk Tolerance and Asset Allocation 187
Non-normal Returns 191
6.6 Passive Strategies: The Capital Market Line 192
End of Chapter Material 194
Appendix 6A: Risk Aversion, Expected Utility, and the
St. Petersburg Paradox 201
Appendix 6B: Utility Functions and Risk Premiums 204
CHAPTER 7
Optimal Risky Portfolios 205
7.1 Diversification and Portfolio Risk 206
7 .2 Portfolios of Two Risky Assets 207
7.3 Asset Allocation with Stocks, Bonds, and Bills 214
Asset Allocation with Two Risky Asset Classes 214
7.4 The Markowitz Portfolio Optimization Model 219
vm CONTENTS
Security Selection 219
Capital Allocation and the Separation Property 222
The Power of Diversification 224
Asset Allocation and Security Selection 226
Optimal Portfolios and Non-normal Returns 227
7 .5 Risk Pooling, Risk Sharing, and the Risk of Long-Term
Investments 227
Risk Pooling and the Insurance Principle 228
Risk Sharing 229
Diversification and the Sharpe Ratio 230
Time Diversification and the Investment Horizon 230
End of Chapter Material 232
Appendix 7 A: A Spreadsheet Model for Efficient
Diversification 241
Appendix 7B: Review of Portfolio Statistics 244
CHAPTER 8
Index Models 251
8. 1 A Single-Factor Security Market 25 1
The Input List of the Markowitz Model 251
Systematic versus Firm-Specific Risk 252
8.2 The Single-Index Model 254
The Regression Equation of the Single-Index
Model 254
The Expected Return-Beta Relationship 255
Risk and Covariance in the Single-Index
Model 255
The Set of Estimates Needed for the Single-Index
Model 256
The Index Model and Diversification 258
8.3 Estimating the Single-Index Model 260
The Security Characteristic Line for
Suncor 260
The Explanatory Power of the SCL for
Suncor 261
The Estimate of Alpha 262
The Estimate of Beta 263
Firm-Specific Risk 265
8.4 The Industry Version of the Index Model 265
Company Beta Estimates 266
Predicting Betas 267
Index Models and Tracking Portfolios 269
Portfolio Construction Using the Single-Index Model
with a Detailed Example 271
Alpha and Security Analysis 271
The Index Portfolio as an Investment Asset 272
The Single-Index-Model Input List 273
The Optimal Risky Portfolio in the Single-Index
Model 273
The Information Ratio 275
Summary of Optimization Procedure 276
An Example 276
Correlation and Covariance Matrix 276
Is the Index Model Inferior to the Full-Covariance
Models? 280
End of Chapter Material 280
PART Ill
EQUILIBRIUM IN CAPITAL MARKETS
CHAPTER 9
The Capital Asset Pricing Model 285
9 .1 The Capital Asset Pricing Model 285
Why Do All Investors Hold the Market Portfolio? 287
The Passive Strategy Is Efficient 288
The Risk Premium of the Market Portfolio 289
Expected Returns on Individual Securities 290
The Security Market Line 293
The CAPM and the Single-Index Market 295
9.2 Assumptions and Extensions of the CAPM 295
Identical Input Lists 296
Risk-Free Borrowing and the Zero-Beta Model 296
Labour Income and Non-traded Assets 297
A Multi-period Model and Hedge Portfolios 299
A Consumption-Based CAPM 300
Liquidity and the CAPM 302
9.3 The CAPM and the Academic World 305
9 .4 The CAPM and the Investment Industry 306
End of Chapter Material 307
CHAPTER 10
Arbitrage Pricing Theory and Multifactor Models
of Risk and Return 314
10. l Multifactor Models: An Overview 315
Factor Models of Security Returns 315
10.2 Arbitrage Pricing Theory 317
Arbitrage, Risk Arbitrage, and Equilibrium 317
Well-Diversified Portfolios 318
Diversification and Residual Risk in
Practice 320
Executing Arbitrage 321
The No-Arbitrage Equation of the APT 322
10.3 The APT, the CAPM, and the Index Model 324
The APT and the CAPM 324
The APT and Portfolio Optimization in a Single-Index
Market 325
10.4 A Multifactor APT 326
10.5 The Fama- French (FF) Three-Factor Model 328
End of Chapter Material 330
CHAPTER 11
The Efficient Market Hypothesis 336
11.1 Random Walks and the Efficient Market
Hypothesis 336
Competition as the Source of Efficiency 338
Versions of the Efficient Market Hypothesis 340
11.2 Implications of the EMH 342
Technical Analysis 342
Fundamental Analysis 343
Active versus Passive Portfolio Management 344
 CONTENTS IX

The Role of Portfolio Management in an Efficient 13.5 Consumption-Based Asset Pricing and the Equity
Market 345 Premium Puzzle 422
Resource Allocation 346 Consumption Growth and Market Rates of
11.3 Event Studies 347 Return 423
11.4 Are Markets Efficient? 350 Expected versus Realized Returns 425
The Issues 350 Survivorship Bias 426
Weak-Form Tests: Patterns in Stock Returns 352 Extensions to the CAPM May Resolve the Equity
Predictors of Broad Market Returns 354 Premium Puzzle 427
Semistrong Tests: Market Anomalies 355 Liquidity and the Equity Premium Puzzle 428
Strong-Form Tests: Inside Information 360 Behavioural Explanations of the Equity Premium
Interpreting the Anomalies 361 Puzzle 428
Bubbles and Market Efficiency 364 End of Chapter Material 429
11 .5 Mutual Fund and Analyst Performance 365
Stock Market Analysts 365
Mutual Fund Managers 366 PART IV
So, Are Markets Efficient? 370
End of Chapter Material 370 FIXED-INCOME SECURITIES

CHAPTER 12 CHAPTER14

Behavioural Finance and Technical Analysis 377 Bond Prices and Yields 432

12.1 The Behavioural Critique 378 14.1 Bond Characteristics 432

Information Processing 378 Canadian Government Bonds 433
Behavioural Biases 380 Corporate Bonds 434
Affect 38 1 Preferred Stock 436
Limits to Arbitrage 382 International Bonds 437
Limits to Arbitrage and the Law of One Price 383 Innovation in the Bond Market 438
Bubbles and Behavioural Economics 386 14.2 Bond Pricing 440
Evaluating the Behavioural Critique 387 Bond Pricing between Coupon Dates 443
12.2 Technical Analysis and Behavioural Finance 388 14.3 Bond Yields 445
Trends and Corrections 388 Yield to Maturity 445
Sentiment Indicators 392 Yield to Call 447
Indicators of Overall Market Sentiment 393 Realized Compound Return versus Yield to
A Warning 394 Maturity 449
End of Chapter Material 394 14.4 Bond Prices Over Time 450
Yield to Maturity versus Holding-Period Return 452
Zero-Coupon Bonds and Stripped Coupons 453
CHAPTER 13 After-Tax Returns 454
Empirical Evidence on Security Returns 401 14.5 Default Risk and Bond Pricing 455
Junk Bonds 455
13.1 The Index Model and the Single-Factor APT 402 Determinants of Bond Safety 457
The Expected Return- Beta Relationship 402 Bond Indentures 458
Tests of the CAPM 403 Yield to Maturity and Default Risk 460
Canadian Tests of the CAPM 404 Credit Default Swaps 462
Thin Trading 404 Credit Risk and Collateralized Debt Obligations 463
The Market Index 405 End of Chapter Material 464
Measurement Error in Beta 406
13.2 Tests of the Multifactor CAPM and APT 408
Labour Income 409 CHAPTER 15
Private (Non-traded) Business 411
Early Versions of the Multifactor CAPM and APT 412 The Term Structure of Interest Rates 471
A Macro Factor Model 412 15.1 The Yield Curve 47 1
13.3 Fama-French-Type Factor Models 413 Bond Pricing 472
Size and B/M as Risk Factors 416 15.2 The Yield Curve and Future Interest Rates 474
Behavioural Explanations 418 The Yield Curve Under Certainty 474
Momentum: A Fourth Factor 419 Holding-Period Returns 476
13.4 Liquidity and Asset Pricing 420 Forward Rates 477
x CONTENTS
15.3 Interest Rate Uncertainty and Forward Rates 479
15 .4 Theories of the Term Structure 481
The Expectations Hypothesis 481
Liquidity Preference 482
15.5 Interpreting the Term Structure 485
15.6 Forward Rates as Forward Contracts 488
End of Chapter Material 490
CHAPTER16
Managing Bond Portfolios 497
16. l Interest Rate Risk 497
Interest Rate Sensitivity 498
Duration 500
What Determines Duration? 503
16.2 Convexity 507
Why Do Investors Like Convexity? 509
Duration and Convexity of Callable Bonds 509
Duration and Convexity of Mortgage-Backed
Securities 511
16.3 Passive Bond Management 512
Bond-Index Funds 512
Immunization 514
Cash Flow Matching and Dedication 520
Other Problems with Conventional
Immunization 521
16.4 Active Bond Management 522
Sources of Potential Profit 522
Horizon Analysis 523
End of Chapter Material 524
PARTV
SECURITY ANALYSIS
CHAPTER 17
Macroeconomic and Industry Analysis 534
17.1 The Global Economy 535
17.2 The Domestic Macroeconomy 537
Key Economic Indicators 538
17 .3 Demand and Supply Shocks 539
17.4 Federal Government Policy 540
Fiscal Policy 540
Monetary Policy 540
Supply-Side Policies 541
17.5 Business Cycles 542
The Business Cycle 542
Economic Indicators 543
Other Indicators 546
17.6 Industry Analysis 547
Defining an Industry 547
Sensitivity to the Business Cycle 549
Sector Rotation 552
Industry Life Cycles 553
Industry Structure and Performance 555
End of Chapter Material 557
CHAPTER18
Equity Valuation Models 565
18.1 Valuation by Comparables 565
Limitations of Book Value 567
18.2 Intrinsic Value versus Market Price 567
18.3 Dividend Discount Models 569
The Constant-Growth DDM 570
Convergence of Price with Intrinsic Value 573
Stock Prices and Investment Opportunities 574
Life Cycles and Multi-stage Growth Models 576
Multi-stage Growth Models 581
18.4 Price-Earnings Ratio 581
The Price-Earnings Ratio and Growth
Opportunities 581
PIE Ratios and Stock Risk 585
Pitfalls in PIE Analysis 586
Combining P/E Analysis and the DDM 589
Other Comparative Valuation Ratios 589
18.5 Free Cash Flow Valuation Approaches 590
Comparing the Valuation Models 592
The Problem with DCF Models 593
18.6 The Aggregate Stock Market 594
End of Chapter Material 596
CHAPTER 19
Financial Statement Analysis 608
19 .1 The Major Financial Statements 608
The Income Statement 608
The Balance Sheet 610
The Statement of Cash Flows 612
19.2 Measuring Firm Performance 614
19.3 Profitability Measures 614
Return on Assets (ROA) 615
Return on Capital (ROC) 6 15
Return on Equity (ROE) 615
Financial Leverage and ROE 615
Economic Value Added 617
19.4 Ratio Analysis 619
Decomposition of ROE 619
Turnover and Other Asset Utilization Ratios 622
Liquidity Ratios 624
Market Price Ratios: Growth versus Value 625
Choosing a Benchmark 627
19.5 An Illustration of Financial Statement
Analysis 628
19.6 Comparability Problems 631
Inventory Valuation 63 1
Depreciation 631
Inflation and Interest Expense 632
Fair Value Accounting 633
Quality of Earnings and Accounting
Practices 633
International Accounting Conventions 635
19.7 Value Investing: The Graham Technique 637
End of Chapter Material 637

PART VI
OPTIONS, FUTURES, AND OTHER DERIVATIVES
CHAPTER 20
Options Markets: Introduction 651
20.1 The Option Contract 65 1
Options Trading 653
American and European Options 655
Adj ustments in Option Contract Terms 655
Options Clearing 656
Other Listed Options 657
20.2 Values of Options at Expiration 659
Call Options 659
Put Options 659
Option versus Stock Investments 660
20.3 Option Strategies 662
Protective Put 662
Covered Calls 664
Straddle 665
Spreads 667
Collars 669
20.4 The Put-Call Parity Relationship 669
20.5 Option-Like Securities 672
Callable Bonds 672
Convertible Securities 673
Warrants 675
Collateralized Loans 676
Levered Equity and Risky Debt 677
20.6 Financial Engineering 678
20.7 Exotic Options 679
Asian Options 680
Barrier Options 680
Lookback Options 680
Currency-Translated Options 680
Digital Options 680
End of Chapter Material 681
CHAPTER 21
Option Valuation 689
2 1.l Option Valuation: Introduction 689
Intrinsic and Time Values 689
Determinants of Option Values 69 1
21.2 Restrictions on Option Values 692
Restrictions on the Value of a Call
Option 693
Early Exercise and Dividends 694
Early Exercise of American Puts 694
21.3 Binomial Option Pricing 696
Two-State Option Pricing 696
Generalizing the Two-State Approach 698
Making the Valuation Model Practical 700
2 1.4 Black- Scholes Option Valuation 703
The Black-Scholes Formula 704
Dividends and Call Option Valuation 711
CONTENTS xi
Put Option Valuation 711
Dividends and Put Option Valuation 7 12
21.5 Using the Black-Scholes Formula 712
Hedge Ratios and the Black-Scholes Formula 712
Portfolio Insurance 715
Option Pricing and the Crisis of 2008-2009 718
Option Pricing and Portfolio Theory 719
Hedging Bets on Mispriced Options 720
21.6 Empirical Evidence on Option Pricing 723
End of Chapter Materi al 725
CHAPTER 22
Futures Markets 733
22. l The Futures Contract 733
The Basics of Futures Contracts 734
Existing Contracts 737
22.2 Trading Mechanics 740
The Clearinghouse and Open Interest 740
The Margin Account and Marking to Market 74 1
Cash versus Actual Delivery 744
Regulations 745
Taxation 745
22.3 Futures Markets Strategies 746
Hedging and Speculation 746
Basis Risk and Hedging 749
22.4 Futures Prices 750
The Spot- Futures Parity Theorem 750
Spreads 753
Forward versus Futures Pricing 756
22.5 Futures Prices versus Expected Spot Prices 756
Expectations Hypothesis 756
Normal Backwardation 757
Contango 757
Modern Portfolio Theory 757
End of Chapter Material 758
CHAPTER 23
Futures, Swaps, and Risk Management 764
23. l Foreign Exchange Futures 764
The Markets 764
Interest Rate Parity 765
Direct versus Indirect Quotes 768
Using Futures to Manage Exchange Rate Risk 769
23.2 Stock-Index Futures 77 1
The Contracts 77 1
Creating Synthetic Stock Positions: An Asset
Allocation Tool 773
Index Arbitrage 774
Using Index Futures to Hedge Market Risk 775
23.3 Interest Rate Futures 777
Hedging Interest Rate Risk 777
23.4 Swaps 780
Swaps and Balance Sheet Restructuring 781
The Swap Dealer 782
Other Interest Rate Contracts 783
xu CONTENTS
Swap Pricing 784
Credit Risk in the Swap Market 785
Credit Default Swaps 786
23.5 Commodity Futures Pricing 787
Pricing with Storage Costs 787
Discounted Cash Flow Analysis for Commodity
Futures 788
End of Chapter Material 790
PART VII
APPLIED PORTFOLIO MANAGEMENT
CHAPTER 24
Portfolio Performance Evaluation 798
24. 1 The Conventional Theory of Performance
Evaluation 798
Average Rates of Return 798
Time-Weighted Returns versus Dollar-Weighted
Returns 799
Adjusting Returns for Risk 800
The Sharpe Ratio for Overall Portfolios 802
The Treynor Ratio 803
The Information Ratio 805
The Role of Alpha in Performance Measures 806
Implementing Performance Measurement: An
Example 806
Realized Returns versus Expected Returns 808
24.2 Style Analysis 810
24.3 Performance Measurement with Changing Portfolio
Composition 813
Performance Manipulation and the Morningstar
Risk-Adjusted Rating 813
24.4 Market Timing 816
The Potential Value of Market Timing 818
Valuing Market Timing as a Call Option 819
The Value of Imperfect Forecasting 820
24.5 Performance Attribution Procedures 821
Asset Allocation Decisions 823
Sector and Security Selection Decisions 824
Summing Up Component Contributions 826
End of Chapter Material 827
CHAPTER 25
International Diversification 837
25.1 Global Markets for Equities 837
Developed Countries 838
Emerging Markets 840
Market Capitalization and GDP 841
Home-Country Bias 841
25.2 Exchange Rate Risk and International
Diversification 842
Exchange Rate Risk 842
Investment Risk in International Markets 846
International Diversification 848
Are Benefits from International Diversification
Preserved during Bear Markets? 852
25.3 Political Risk 854
25.4 International Investing and Performance
Attribution 857
Constructing a Benchmark Portfolio of Foreign
Assets 857
Performance Attribution 859
End of Chapter Material 861
CHAPTER 26
Hedge Funds 865
26.1 Hedge Funds versus Mutual Funds 866
26.2 Hedge Fund Strategies 867
Directional and Non-directional Strategies 868
Statistical Arbitrage 869
26.3 Portable Alpha 870
An Example of a Pure Play 870
26.4 Style Analysis for Hedge Funds 873
26.5 Performance Measurement for Hedge Funds 874
Liquidity and Hedge Fund Performance 875
Hedge Fund Performance and Survivorship
Bias 878
Hedge Fund Performance and Changing Factor
Loadings 878
Tail Events and Hedge Fund Performance 88 1
26.6 Fee Structure in Hedge Funds 882
End of Chapter Material 885
CHAPTER 27
The Theory of Active Portfolio Management 889
27 .1 Optimal Portfolios and Alpha Values 890
Forecasts of Alpha Values and Extreme Portfolio
Weights 891
Restriction of Benchmark Risk 894
27.2 The Treynor- Black Model and Forecast
Precision 896
Adjusting Forecasts for the Precision of Alpha 896
Distribution of Alpha Values 897
Organizational Structure and Performance 898
27.3 The Black-Litterman Model 900
Black-Litterman Asset Allocation Decision 900
Step 1: The Covariance Matrix from Historical
Data 900
Step 2: Determination of a Baseline Forecast 901
Step 3: Integrating the Manager's Private
Views 902
Step 4: Revised (Posterior) Expectations 902
Step 5: Portfolio Optimization 904
27.4 Treynor-Black versus Black-Litterman: Complements,
Not Substitutes 905
The BL Model as Icing on the TB Cake 905
Why Not Replace the Entire TB Cake
with the BL Icing? 906
27.5 The Value of Active Management 907
A Model for the Estimation of Potential Fees 907
 CONTENTS xm

Results from the Distribution of Actual 28.4 Asset Allocation 925

Information Ratios 908 Taxes and Asset Allocation 926
Results from Distribution of Actual Forecasts 908 28.5 Managing Portfolios of Individual Investors 927
27.6 Concluding Remarks on Active Management 908 Human Capital and Insurance 927
End of Chapter Material 909 Investment in Residence 927
Appendix 27 A: Forecasts and Realizations of Alpha 911 Saving for Retirement and the Assumption of Risk 927
Appendix 27B: The General Black-Litterman Model 911 Retirement Planning Models 928
Manage Your Own Portfolio or Rely on Others? 928
CHAPTER 28 Tax Sheltering 929
Investment Policy and the Framework of the CFA 28.6 Pension Funds 932
Institute 913 Defined Contribution Plans 933
Defined Benefit Plans 933
28 .1 The Investment Management Process 914
Pension Investment Strategies 934
Objectives 914
28.7 Investments for the Long Run 935
Individual Investors 917
Making Simple Investment Choices 935
Personal Trusts 917
Inflation Risk and Long-Term Investors 936
Mutual Funds 917
End of Chapter Material 936
Pension Funds 917
Endowment Funds 918
Life Insurance Companies 918 References to CFA Problems RE-1
Non-life Insurance Companies 918 Glossary GL-1
Banks 918
Name Index IN-1
28.2 Constraints 919
Liquidity 919 Subject Index IN-4
Investment Horizon 920 Commonly Used Notations N0-1
Regulations 920
Useful Formulas F0-1
Tax Considerations 920
Unique Needs 920
28.3 Policy Statements 921
Sample Policy Statements for Individual
Investors 922
XI V

PREFACE

After three decades of rapid and profound change in the investments industry, in addition to a financial
crisis of historic magnitude, the Ninth Canadian Edition of Investments takes a hard look at the here and
now. The vast expansion of financial markets during this tumultuous period, due in part to innovations
in securitization and credit enhancement, gave way to new trading strategies. And these strategies were,
in turn, made feasible by developments in communication and information technology, as well as by
advances in the theory of investments.
Yet the financial crisis persisted and was rooted in the cracks of these developments. Many of
the innovations in security design facilitated high leverage and an exaggerated notion of the efficacy
of risk transfer strategies. This complacency about risk, coupled with the relaxation of regulation
and reduced transparency, masked the precarious condition of many big players in the system. In
turn and out of necessity, our text has evolved along with financial markets and their influence on
world events.
The Ninth Canadian Edition of Investments is intended primarily as a textbook for courses in in-
vestment analysis. Our guiding principle has been and continues to be to present the material in a
framework that is organized by a central core of consistent fundamental principles. We strip away
unnecessary mathematical and technical details, and concentrate on providing the intuition that may
guide students and practitioners as they confront new ideas and challenges in their professional and
personal lives.
This text introduces and explores many issues. It provides the skills to conduct a sophisticated as-
sessment of watershed current issues and debates covered by the popular media and more-specialized
finance journals. Whether you plan to become an investment professional yourself or an individual in-
vestor, these skills are essential, especially in today's rapidly evolving environment.
Our primary goal is to present material of practical value. And for our author team, there is no con-
tradiction in the field of investments between the pursuit of truth and the pursuit of money. Quite the
opposite, actually. The capital asset pricing model, the arbitrage pricing model, the efficient markets
hypothesis, the option-pricing model, and the other centrepieces 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 have made our our approach consistent with that of
the CFA Institute. In addition to fostering research in finance, the CFA Institute administers an
education and certification program for candidates seeking designation as Chartered Financial
Analysts (CFAs). The CFA curriculum is the product of consensus from a committee of distin-
gui shed scholars and practitioners regarding the core knowledge required by the investment
professional.
Many feature s of this text make it consistent with and relevant to the CFA curriculum. Questions
from past CFA exams appear at the end of nearly every chapter, and for students who will be taking the
exam, those same questions are listed at the end of the book. Chapter 3 includes excerpts from the
"Code of Ethics and Standards of Professional Conduct" of the CFA Institute. Chapter 28 discusses
investors and the investment process and presents the CFA Institute's framework for systematically
relating investor objectives and constraints to ultimate investment policy. End-of-chapter problems also
include questions from test-prep leader Kaplan Schweser in select chapters.
In the Ninth Canadian Edition, we have continued our systematic collection of Excel
spreadsheets that give tools to explore concepts more deeply than was previously possible.
These spreadsheets, available on Connect, provide a taste of the sophisticated analytic tools avail-
able to professional investors.

Underlying Philosophy
In the Ninth Canadian Edition, we address many of the changes in the investment environment, includ-
ing the unprecedented events surrounding the financial crisis.
 PREFACE xv

While the financial environment is constantly evolving, many basic principles remain important. We
believe that fundamental principles should organize and motivate all study and that attention to these
few central ideas can simplify the study of otherwise difficult material. These principles are crucial to
understanding the securities traded in financial markets and in understanding new securities that will be
introduced in the future, as well as their effects on global markets. 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. Free lunches
are rarely 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 effi cient markets
hypothesis. While the degree of market efficiency is, and always will be, a matter of debate (in fact
we devote a full chapter to the behavioural challenge to the efficient market hypothesis), we hope
our discussions throughout the book convey a good dose of healthy criticism concerning much
conventional wisdom.

Distinctive Themes
The Ninth Canadian Edition of 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 Canada, 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 we 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 fo llow. 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 risky asset classes, such as stocks, 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. 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 Ninth Canadian Edition

The following is a guide to changes in the Ninth Canadian Edition. This is not an exhaustive road map,
but instead is meant to provide an overview of substantial additions and changes to coverage from the
last edition of the text.
XVI PREFACE

Chapter 1 The Investment Environment This chapter contains updated coverage of the consequences
of the financial crisis as well as the U.S. Dodd-Frank Act. The Canadian experience of the financial
crisis is also discussed.
Chapter 2 Financial Markets, Asset Classes, and Financial Instruments We devote additional
attention to money markets, including recent controversies concerning the regulation of money market
mutual funds as well as the LIBOR scandal, and the Asset Backed Commercial Paper crisis in Canada.
We also discuss the new benchmark money market rate, CDOR which has replaced the Canadian
LIBOR.
Chapter 3 How Securities Are Traded We have extensively rewritten this chapter and included
new sections that detail the rise of electronic markets, algorithmic and high-speed trading, and
changes in market structure. We also provide an update on the latest regulatory developments
concerning short-selling and market circuit breakers. In addition, we introduce a new innovation
for financing small startup companies that considerably lightens the regulatory burden of firms:
equity crowdfunding
Chapter 5 Risk, Return, and the Historical Record This chapter has been updated with considerable
attention paid to evidence on tail risk and extreme stock returns.
Chapter 8 Index Models We illustrate the implementation of the index model by constructing an
optimal portfolio from the S&PffSX Index using a set of stocks traded on the TSX.
Chapter 9 The Capital Asset Pricing Model We have streamlined the explanation of the simple
CAPM and updated and integrated the sections dealing with extensions of the CAPM, tying together
extra-market hedging demands and factor risk premiums.
Chapter 10 Arbitrage Pricing Theory and the Multifactor Models of Risk and Return The
chapter contains new material on the practical feasibility of creating well-diversified portfolios and the
implications for asset pricing.
Chapter 11 The Efficient Market Hypothesis We have added new material documenting the
behaviour of market anomalies over time, suggesting how market inefficiencies seem to be corrected.
Chapter 13 Empirical Evidence on Security Returns Increased attention is given to tests of
multifactor models of risk and return and the implications of these tests for the importance of extra-
market hedging demands.
Chapter 14 Bond Prices and Yields This chapter includes new material on sovereign credit default
swaps.
Chapter 16 Managing Bond Portfolios This chapter now includes information on liability driven
investing for pension plans, a strategy that has gained importance since the financial crisis of 2008/2009.
Chapter 18 Equity Va luation Models This chapter includes a new section on the practical problems
entailed in using DCF security valuation models and the response of value investors to these problems.
Chapter 19 Financial Statement Analysis We have added a new introduction to the discussion of
ratio analysis, providing greater structure and rationale concerning the use of financial ratios as tools to
evaluate firm performance.
Chapter 21 Option Valuation We have added substantial new sections on risk-neutral valuation
methods and their implementation in the binomial option-pricing model, as well as the implications of
the option pricing model for tail risk and financial instability.
Chapter 23 Futures Markets We look at the evolution of trading platforms for Canadian commodities
to the closure of the Winnipeg Exchange and beyond.
 PREFACE xv11

Chapter 24 Portfolio Performance Evaluation New sections on the vulnerability of standard

performance measures to manipulation, manipulation-free measures, and the Morningstar Risk-
Adjusted Return have been added.

Organization and Content

The text is composed of seven sections that are fairly independent and may be studied in a variety of
sequences. Because there is enough material in the book for a two-semester course, clearly a one-semes-
ter 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. Perhaps most
important, we address how financial markets can influence all aspects of the global economy,
as in 2008.
The material presented in Part One 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 ma-
terial 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, and examining the distribution of stock returns. We
focus more closely in Chapter 6 on how to describe investors' risk preferences and how they
bear on asset allocation. In the next two chapters, we turn to portfolio optimization (Chapter 7)
and its implementation using index models (Chapter 8).
After our treatment of modem 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. Chapter 9 treats the
capital asset pricing model and Chapter 10 covers multifactor descriptions of risk and the arbitrage pricing
theory. Chapter 11 covers the efficient market hypothesis, including its rationale as well as evidence that
supports the hypothesis and challenges it. Chapter 12 is devoted to the behavioural critique of market ratio-
nality. Finally, we conclude Part III with Chapter 13 on empirical evidence on security pricing. This chapter
contains evidence concerning the risk-return relationship, as well as liquidity effects on asset pricing.

Part IV is the first of three parts on security valuation. This part treats fi xed-income
securities-bond pricing (Chapter 14), term structure relationships (Chapter 15), and
interest-rate risk management (Chapter 16) .

Parts V and VI deal with equity securities and derivative securities. For a course
emphasizing security analysis and excluding portfolio theory, it is possible to proceed
directly from Part I to Part IV with no loss in continuity.

Finally, Part VII considers several topics important for portfolio managers, including
performance evaluation, international diversification, active management, and practical
iss ues in the process of portfolio management. This part also contains a chapter on
hedge fund s.
xvm A GUIDED TOUR

A GUIDED TOUR

The Ninth Canadian Edition of Investments has several features designed to make it easy for students to
understand, absorb, and apply the concepts and techniques presented.

Chapter Openers

l
C HAPT ER FOU R

Chapter Openers outline the upcom- Mutual Funds and Other

ing material in the chapter and provide Investment Companies
students with a road map of what they
will learn. TH E PREVIOUS CHAPTER introduced you to the mechanics of trad ing securities and the structure of the
markets in which securities trade. Commonly, however, individual investors do not trade securities d irectly
for their own accounts. Instead, they d irect their funds to investment compa nies that purchase securities
on their behalf. The most important of these financial inte rmediaries are open-end investment companies,
more common ly known as mutual funds, to wh ich we devote most of this chapter. We also touch briefly
on other types of funds, such as closed-end funds, hedge funds, and exchange-traded funds.
We begin the chapter by describing and comparing the vario us types of investment companies
available to investors. We then examine the functions of mutual funds, their investment styles and

CONCEPT CHECK 4.2

Concept Checks
The Equity Fund sells two classes of shares. Class A shares have a front-end load of 4% and a
management expense ratio (MER) equal to 2%. Class B shares have an MER of 2.5% as well as
These self-test questions and problems
back-end load fees that start at 5% and fall by 1% for each full yea r the investor holds the port-
fo lio (until the fifth yea r). Assume the rate of return on the fund portfolio before management
found in the body of the text enable the
and operating expenses is 12% annually. What will be the value of a $10,000 investment in
Class A and Class B shares if the shares are sold after (o) 1 year, (b) 4 years, (c) 10 yea rs?
students to determine whether they've
Which fee structure p rovides higher net proceeds at the end of each investment horizon? understood the preceding material. De-
tailed solutions are provided at the end
of each chapter.

Numbered Examples
These numbered and titled examples are integrated throughout chapters. Using the worked-out solutions
to these examples as models, students can learn how to solve specific problems step-by-step as well as
gain insight into general principles by seeing how they are applied to answer concrete questions.

Example 4.1 Net Asset Value

Consid er a mutual fund that manages a portfolio of securit ies worth $120 million.
Su ppose the fund ow es $4 million to its investment advisers and owes another
$1 million for rent, wages due, and miscellaneous expenses. The fund has 5 million
shares outstanding.

Net asset value= $l 2 05m~::~~n~~a~~illion = $23 per share

WORDS FROM THE STREET Words from the Street Boxes

T he Flash C rash of May 2010
At 2:42 New York time on May 6, 2010, the Dow Jones Indus-
trial Average was already down about 300 points for the day.
The market was demonstrating concerns about the European
debt crisis, and nerves were already oo edge. Then, in the next
5 minutes, the Dow dropped an additional 600 points. And
only 20 minutes after that, it had recovered most of these 600
points. Besides the staggering intraday volatility of the broad
market, trading in indMdua1 shares and ETFs was even more
disrupted. The iShares Russell 1000 Value fund temporar'ily fell
from $59 a share to 8 cents. Shares in the large consulting
company Accenture, which had just SOid for $38, traded at 1
cent ooly a minute or two later. At the other extreme, share
prices of Apple and Hewlett-Packard momentarily increased to
CNer $100,000. These markets were dearty broken.
The causes of the flash crash are still debated. An SEC
report issued after the trade points to a $4 billion sale of
market Index futures contracts by a m utual fund. As market
prices began to tumble, many algorithmic trading programs
withdrew from the markets, and those that remained be-
came net sellers, further pushing down equity prices. As
more and more of these algorithmic traders shut down, li-
quidity in these markets ev aporated: buyers for many
stocks simply disappeared.
These short feature articles from business periodicals
Finally, trading was halted for a short period. When it
resumed, buyers decided to take advantage of many se-
verely depressed stock prices, and the market rebounded
are included in boxes throughout the text. The articles
almost as quick ly as it had crashed. Given the intraday tur-
bulence and the clearly distorted pr ices at which some
are chosen for real-world relevance and clarity of pre-
trades had been executed, the NYSE an d NASDAQ de-
cided to cancel all trades that were executed more than
sentation.
60% away from a Rreference priceR close to the opening
price of the day. Almost 70% of those cancelled trades in-
volved ETFs.
The SEC has since approved experimentatioo with new
circuit breakers to halt trading for 5 minutes in large stocks
that rise or fa ll by more than 10% in a 5-minute period. The
idea is to prevent trad ing algorithms from moving share
prices quickly before human trader s have a chance to de-
termine whether those prices are moving in response to
fundamental information.
The flash crash highlighted the fragility of markets in the
face of huge variation in trading volume created by algo-
rithmic traders. The potential for these high-frequency
traders to withdraw from markets In periods of turbulence
remains a concern, and many observers are not convinced
that we are protected from future flash crashes.
 END-OF-CHAPTER FEATURES xix

eXcel APPLICATIONS . Buy ing on Margin Excel Applications

T he following Excel spreadsheet, available In Connect Of through your course In struc-
tor. makes it easy to analyze the Impacts of d ifferent margin levels and the volatility of
st ock pr1ces. It also allows you to compare return on Investment fOf a margin trade with
The Ninth Canadian Edition features Excel Spreadsheet Applica-
a trade using no borrowed funds
tions with new Excel questions. A sample spreadsheet is presented
in the text with additional templates and solutions available on our
Connect site.

Excel Questions
1. Suppose you buy 100 shares of stock lnltlally selling for $50, borrow1ng 25% of the
necessary funds from your broker (i.e., the Initial margin oo your purchase is 25%)
You pay an Interest rate of 8% on margin loans
o. How much of your own money do you Invest? How much do you borrow from
your broker?
b. What wlll be your rate of return for the followlng stock prices at the end of a
1-year holding per1od? (i) $40: (ii) $50: (iii) $60.
2 . Repeat Question I assuming your lnltlal margin was 50%. How does marg in affect
the risk and return of your position.

Excel Exhibits A

Selected exhibits are set as Excel .

..!.
,.!_ Purchase Price ..
' '°o
Squared

spreadsheets and are denoted by D&viations

from Mean
~ Excellent 0.25 126.50 4.50 0.3l00 0.2124 02700 0 .0451
an icon. They are also available ~
~
Good
Poor
0.45
0.2 5
no.oo
89.75
4.oo
3.50
0.1400
-0.0 675
o.0424
-0.1651
0.0018
0 .0 273
0.!000
-0.1075
0 .0018
0 .0 273
11 Crash 0.05 46.00 2.00 -0.5200 --0.6 176 0.3815 --0.5600 0.3815
on our Connect site.

Spreadsheet 5.1 e x cel

Scenario analysis of holding period return of the stock-index fund

END-OF-CHAPTER FEATURES

Summary
At the end of each chapter, a detailed summary outlines
SUMMARY
the most important concepts presented. I. Real uocb create wealth. Financla l •..ct• ..rprncnl oclb 1tSUV1-n >«unhcs1Uthc......ilmvcoton.llM: 1n4cT·
daumioparu ora ll ol th.a1 ,..,.ith. Fi~1ala<r1• ~.,..,....Uocfundsdwsl3H.td.uocsUocproottds
ddcrmonebvoo- thc°""ncnhipcA...,a l as>Cbl$d1>trib- 1u~!Moctthc1 mall 1m·coton.andpr<>f1l •frumthc

111~ """""' 1n'....wn dif k=ntt (the ..,..,ad).

2.Firw>eU1l u-•caabeaup1zcdm; fi.ocdllK'OfTIC.
~1ty. ordcr1>-at 1..., 1nstrummb. Top-downpurtfobo
coaslrucuoa tcchmqua oun with thc ~ allocauoa
dc<:1"'°"~hc alloc..toon of funds .:n:n. bnMd ..~
c b s1u--a nd1hmproc...,ssio......,spcc:1rocsccur1ty-
..,1cc1oondcctsJOa•.
J .Compctm..,..,r...-,1a1marttts1tam 1o an<k-ttt...,
l~.... ..-fudiKCunt>othaofah&clocrC1J><C1~
..,..,. o f rdW11 aho ""f">'<' ~at"" , ..i.... on 1m·n10D
The~nccofr1sl..i.o..-r,.,r.unpbcsUu1tacrual ~
lums cud1ffci-c.,...odaably from the returns C1pccicd
at tho hcp>n•c oflhc 1nvoaar111 pcnod. Compruuoa
amoac >«unty • aly.c:. a lso promotco; financ ial mu-
lceu tha AR rocarly mf......,uonally c fficlC'lll. mean1nc
tha pncn rcllcct all a•"'lablc 1nro.m..toon conccmonc
thc•"alueol thc iCC\11"1ty. P u nve 1n•-otnoc111S1nusin
mll)'mde>CnSC1a11C.tycff1C1CUlmari;;t1•.
s.....'C:!llmCDtbanl.aAcbr""'• ""ficimcylDairp<n1efuad-
""""''· 'm....imcmbankn;di:..:Jopapa11oc111pnc1nc
rrA' """"' Md 1n marVuns them 1U .....,SIDn. By lhc
cndcA2008. all thc"'¥""otand-aloac: U.S.1m"'otmmt
bmbhadbc-rnaboiorbcd 1-C01TV11Cn:cialt.nksorbad
rcoo;m1zcdthcmoctvo ..1ob.nkholdins~ics. ln
Canadaandf.urup<-. bilJ'ti.nk.imaiau.rocdbodl(IOfl"l-
'"""'ialand """CotmcatbiwibasdJ_,-.
'- n.., r.nancialcnS1• oi2008.i.o..'CdU..11Df""'U'K'Cof
~yM<mic...k. S)"'&Cmicmlccanbe bm11cd by1,_.,..-­
mcythaalio..straico;ilal1n•-rot~IOasscssthcml
oflhc1rcoun&crparucs. capital n:cqu1n:cnoc111110prn"Clll
tr.line part1C1pan1> from bc1nc brouJbt duwn by po-
1mua11o...,1. f~111 ortlkmen11 of cain• or looo.cs 11>
pre>TII! lo>M:S frum attumul.t1ns bcyond.n1n!itltu·
t10n°sab1h1yiobcarlhcm. 1 """nt""'"'° d 11eou~
c:KeS"'"'"'"1K1ns. andaocuntc..-.lunb111>Cd.....ty-

Problem Sets
PROBLEM SETS
I. What are some comparative advantages of im'Csling in The fu nd has not bor rowed any funds. but its accrued We strongly believe that practice in solv-
manage me nt fee with the portfolio manager cur rently
a . Open-.end muma l funds
b . Individual m x:ks and bonds that you choose for
tOlals $30.()(X). There are 4 million shares outstanding.
What is the net asset va lue of the fund?
ing problems is essential to understand-
yourself
2. O pen-.end equity mutual funds find it necessary to keep
9. Reconsider the Fingroup Fund in the previous problem. ing investments, so a good variety of
If. during the year. the portfolio manager sells all o f
a sig nificant perce ntage of total investments. typ ically
around 5% of the portfolio. in very liquid mo ney mar-
the ho ldings of stock D and replaces the m with problems is provided.
200.000 s hares o f stock E at $50 per share and
ke t a'isets. C losed-e nd funds do nOl have to mai ntain
200.000 shares of stock F at $25 per share. what is the
such a position in cash-equivale nt securities. What dif-
portfolio turnover rate?
ference between opcn-.end and closed~nd fu nds might
accoum for their d iffering policies? 10. The Closed Fu nd is a closed~nd investment company
with a portfolio currently worth $200 million. It has li-
3. Balanced funds. li fe-cycle fu nds. and asset alloca tion
abilities o f $3 million and 5 million shares
funds a ll invest in both the stock and bond markets .
outsta nding.
What are the differences among these types of funds?
xx END-OF-CHAPTER FEATURES

Exam Prep Questions S. Charac1erize each company in the previous problem as

underpriced. overpriced, or properly priced.

Practice questions for the CFA®exams provided by Kaplan

Schweser, A Global Leader in CFA ® Education, are
available in selected chapters for additional test practice.
These are easily identified by the Kaplan Schweser logos
featured throughout the problem sets. Learn more at
6. What is the expected ra1e of return for a s1ock thal has a
beta of 1.0 if the expected return on the market is 15%?
a. 15%
b. More than 15%
c. Cannot be determined without the risk-free rate

www.schweser.com.

7. Kaskin, Inc. , stock has a beta of 1.2 and Quinn, Inc.,

stock has a beta of .6. Which of the follow ing slate-
ments is mmt accurate?

a. The expected rate of return will be higher for the

stock of Kaskin. Inc .• than thal of Qui nn, Inc.
b. The stock of Kaskin, Inc., has more total risk than
the stock of Quinn. Inc.
c. The stock of Q uinn, Inc., has more systematic risk
than that of Kaskin, Inc.

CFA Problems
Several questions from past CFA examinations are provided
K~OB
FA:\ LEMS

in applicable chapters. These questions represent the kinds of 1. Given $I 00,000 to invest, what is the expected risk pre-
mium in dollars of investing in equities versus risk-free
questions that professionals in the field believe are relevant to T-bills (Canadian Treasury bills) based on the follow-
ing table?
the "real world." Located at the back of the book is a listing of Action Probability Expected Return
each CFA question and the level and year of the CFA exam it Invest in equities =:::::::::::::: 0.6 - - - $50,000
was included in for easy reference when studying for the Invest in risk-free T-bills
0.4 - - - - SJ0,000
t.0 s 5,000
exam.
2. Based on the scenarios below, what is the expected
return for a port folio with t he following return
profile?

Bear No rmal Bull

Ma rket Ma rket Market
Probability 0.2 0 .3 0.5
Rate of return - 25% 10% 24%

Excel Problems
Selected chapters feature Excel problems, denoted by an
e x cel
icon, specifically linked to templates that are available on our Connect site.

E-Investments Boxes
These exercises provide students with simple activities to enhance their experience using the Internet.
Easy-to-follow instructions and questions are presented for students to utilize what they have learned in
class and apply it to today's Web-driven world.

E-INVESTMENTS EXERCISES
1. Use data from finance.yahoo.com to answer the following questions:
a. Collect the following data for 25 firms of your choosing.
i. Book-to-market ratio
ii. Price-earnings ratio
iii. Market capitalization (size)
iv. Price-<:ash flow ratio (i.e., market capitalization/operating cash fl ow)
v. Another criterion that interests you
You can fi nd this information by choosing a company and then clicking on Key Statistics. Rank the firms based o n each of
the criteria separately, and divide the firms into five groups based on their ranking for each criterion. Calculate the average
rate of return for each group of firms.
 MARKET-LEADING TECHNOLOGY xx1

MARKET-LEADING TECHNOLOGY

Learn without Limits

McGraw-Hill Connect®is an award-winning digital teaching and learning platform that gives students the
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Connect Insight is Connect's new one-of-a-kind visual analytics dashboard- now available for
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Connect Insight presents data that helps instructors improve class performance in a way that is efficient
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Simple Assessment Management

With Connect, creating assignments is easier than ever, so instructors can spend more time teaching and less
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xxu MARKET-LEADING TECHNOLOGY

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Instructor Library
The Connect Instructor Library is a repository for additional resources to improve student engagement
in and out of the class. It provides all the crucial resources instructors need to build their course.
• Access Instructor resources.
• View assignments and resources created for past sections.
• Post resources for students to use.

Instructor Resources
• Instructor's Manual Prepared by Lorne N. Switzer, John Molson School of Business, Concordia
University. This manual has been revised and improved for this edition. Each chapter includes a
Chapter Overview, Learning Objectives, and Presentation of Material to help instructors with
classroom prep.
• Test Bank Prepared by Christine Panasian, Sobey School of Business, Saint Mary 's University.
The Test Bank has been revised to improve the quality of questions. Each question is ranked by
level of difficulty, which allows greater flexibility in creating a test and also provides a rationale
for the solution.
• PowerPoint Presentations These presentation slides were prepared by Cagdas Tahaoglu, John
Molson School of Business, Concordia University. They contain figures and tables from the text,
key points, and summaries in a visually stimulating collection of slides that you can customize to
fit your lecture.
• Solutions Manual Updated by our Canadian author team: Lorne N. Switzer, Dana Boyko, Chris-
tine Panasian, and Maureen Stapleton, and meticulously checked for technical accuracy by Cagdas
Tahaoglu. This Manual provides detailed solutions to all end-of-chapter problem sets.

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For more information, please visit us online: http://www.mheducation.ca/he/solutions

 AC KNOWLEDGEMENTS xxm

ACKNOWLEDGEMENTS

For granting us permission to include many of their examination questions in the text, we are grateful to
the CFA Institute.
Also, a sincere thanks to Cagdas Tahaoglu at the John Molson School of Business at Concordia Univer-
sity. Thank you for your technical check of this edition. Your expertise and feedback were invaluable.
Special thanks from Lorne Switzer to Stylianos Perrakis and Peter Ryan who brought him aboard for the
previous (8th) edition of the text. Switzer would also like to thank his current and former students who
have contributed to the journey of developing the Canadian literature in Investments over the years, in-
cluding Diego Cueto, Sandra Dow, Nabil El-Meslemani, Haibo Fan, Derek Hirsch, Katie Kelly, Jinlin
Liu, Seungho Lee, Alan Picard, Easton Sheahan-Lee, Qiao Tu, Jun Wang, Yajing Zhang, and Rana
Zoghaib.
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 well be that each brood has its own characteristic secretion, or "smell," as it
were, slightly different from that of other broods, just as every dog has his, so
easily recognisable by other dogs; and that the cells only react to different
"smells" to their own. Such a secretion from the surface of the female cell
would lessen its surface tension, and thereby render easier the penetration of
the sperm into its substance.
As a rule, one at least of the pair-cells is fresh from division, and it would thus
appear that the union of the nuclei is facilitated when one at least of them is a
"young" one. Of the final mechanism of the union of the nuclei, we know
nothing: they may unite in any of the earlier phases of mitosis, or even in the
"resting state." A fibrillation of the cytoplasm during the process, radiating
around a centrosome or two centrosomes indicates a strained condition.[51]

Regeneration.—Finally, experiments have been made by several

observers as to the effects of removing parts of Protozoa, to see how
far regeneration can take place. The chief results are as follows:—

1. A nucleated portion may regenerate completely, if of sufficient

size. Consequently, multinucleate forms, such as Actinosphaerium
(Heliozoa, Fig. 19, p. 72), may be cut into a number of fragments,
and regenerate completely. In Ciliata, such as Stentor (Fig. 59, p.
156), each fragment must possess a portion of the meganucleus,
and at least one micronucleus (p. 145), and, moreover, must
possess a certain minimum size. A Radiolarian "central-capsule" (p.
75) with its endoplasm and nucleus may regenerate its ectoplasm,
but the isolated ectoplasm being non-nucleate is doomed. A "central
capsule" of one species introduced into the ectoplasm of another,
closely allied, did well. All non-nucleate pieces may exhibit
characteristic movements, but appear unable to digest; and they
survive only a short time.[52]

"Animals" and "Plants"

Hitherto we have discussed the cell as if it were everywhere an
organism that takes in food into its substance, the food being
invariably "organic" material, formed by or for other cells; such
nutrition is termed "holozoic." There are, however, limits to the
possibilities in this direction, as there are to the fabled capacities of
the Scillonians of gaining their precarious livelihood by taking in one
another's washing. For part of the food material taken in in this way
is applied to the supply of the energies of the cell, and is
consequently split up or oxidised into simpler, more stable bodies, no
longer fitted for food; and of the matter remaining to be utilised for
building up the organism, a certain proportion is always wasted in
by-products. Clearly, then, the supply of food under such conditions
is continually lessening in the universe, and we have to seek for a
manufactory of food-material from inorganic materials: this is to be
found in those cells that are known as "vegetal," in the widest sense
of the word. In this, sense, vegetal nutrition is the utilisation of
nitrogenous substances that are more simple than proteids or
peptones, together with suitable organic carbon compounds, etc., to
build up proteids and protoplasm. The simplest of organisms with a
vegetal nutrition are the Schizomycetes, often spoken of loosely as
"bacteria" or "microbes," in which the differentiation of cytoplasm and
nucleus is not clearly recognisable. Some of these can build up their
proteids from the free uncombined nitrogen of the atmosphere,
carbon dioxide, and inorganic salts, such as sulphates and
phosphates. But the majority of vegetal feeders require the nitrogen
to be combined at least in the form of a nitrate or an ammonium salt
—nay, for growth in the dark, they require the carbon also to be
present in some organic combination, such as a tartrate, a
carbohydrate, etc. Acetates and oxalates, "aromatic" compounds[53]
and nitriles are rarely capable of being utilised, and indeed are often
prejudicial to life. In many vegetal feeders certain portions of the
protoplasm are specialised, and have the power of forming a green,
yellow, or brown pigment; these are called "plastids" or
"chromatophores." They multiply by constriction within the cell,
displaying thereby a certain independent individuality. These plastids
have in presence of light the extraordinary power of deoxidising
carbon dioxide and water to form carbohydrates (or fats, etc.) and
free oxygen; and from these carbohydrates or fats, together with
ammonium salts or nitrates, etc., the vegetal protoplasm at large can
build up all necessary food matter. So that in presence of light of the
right quality[54] and adequate intensity, such coloured vegetal beings
have the capacity for building up their bodies and reserves from
purely inorganic materials. Coloured vegetal nutrition, then, is a
process involving the absorption of energy; the source from which
this is derived in the bacteria being very obscure at present. Nutrition
by means of coloured plastids is distinguished as "holophytic," and
that from lower substances, which, however, contain organically
combined carbon, as "saprophytic," for such are formed by the death
and decomposition of living beings. The third mode of nutrition
(found in some bacteria) from wholly inorganic substances, including
free nitrogen, has received no technical name. All three modes are
included in the term "autotrophic" (self-nourishing).

Vegetal feeders have a great tendency to accumulate reserves in

insoluble forms, such as starch, paramylum, and oil-globules on the
one hand, and pyrenoids, proteid crystals, aleurone granules on the
other.

When an animal-feeding cell encysts or surrounds itself with a

continuous membrane, this is always of nitrogenous composition,
usually containing the glucosamide "chitin." The vegetal cell-wall, on
the contrary, usually consists, at least primarily, of the carbohydrate
"cellulose"—the vegetal cell being richly supplied with carbohydrate
reserves, and drawing on them to supply the material for its garment.
This substance is what we are all familiar with in cotton or tissue-
paper.

Again, not only is the vegetal cell very ready to surround itself with a
cell-wall, but its food-material, or rather, speaking accurately, the
inorganic materials from which that food is to be manufactured, may
diffuse through this wall with scarcely any difficulty. Such a cell can
and does grow when encysted: it grows even more readily in this
state, since none of its energies are absorbed by the necessities of
locomotion, etc. Growth leads, of course, to division: there is often
an economy of wall-material by the formation of a mere party-wall
dividing the cavity of the old cell-wall at its limit of growth into two
new cavities of equal size. Thus the division tends to form a colonial
aggregate, which continues to grow in a motionless, and, so far, a
"resting" state. We may call this "vegetative rest," to distinguish it
from "absolute rest," when all other life-processes (as well as
motion) are reduced to a minimum or absolutely suspended.

The cells of a plant colony are usually connected by very fine

threads of protoplasm, passing through minute pores where the new
party-wall is left incomplete after cell-division.[55] In a few plants,
such as most Fungi, the cell-partitions are in abeyance for the most
part, and there is formed an apocyte with a continuous investment,
sometimes, however, chambered at intervals by partitions between
multinucleate units of protoplasm. We started with a purely
physiological consideration, and we have now arrived at a
morphological distinction, very valid among higher organisms.

Higher Plants consist of cells for the most part each isolated in its
own cell-cavity, save for the few slender threads of communication.

Higher Animals consist of cells that are rarely isolated in this way,
but are mostly in mutual contact over the greater part of their
surface.

Again, Plants take in either food or else the material for food in
solution through their surface, and only by diffusion through the cell-
wall. Insectivorous Plants that have the power of capturing and
digesting insects have no real internal cavity. Animal-feeding Protista
take in their food into the interior of their protoplasm and digest it
therein, and the Metazoa have an internal cavity or stomach for the
same purpose. Here again there are exceptions in the case of
certain internal parasites, such as the Tapeworms and
Acanthocephala (Vol. II. pp. 74, 174), which have no stomachs, living
as they do in the dissolved food-supplies of their hosts, but still
possessing the general tissues and organs of Metazoa.
Corresponding with the absence of mouth, and the absorption
instead of the prehension of food, we find that the movements of
plant-beings are limited. In the higher Plants, and many lower ones,
the colonial organism is firmly fixed or attached, and the movements
of its parts are confined to flexions. These are produced by
inequalities of growth; or by inequalities of temporary distension of
cell-masses, due to the absorption of liquid into their vacuoles, while
relaxation is effected by the cytoplasm and cell-wall becoming
pervious to the liquid. We find no case of a differentiation of the
cytoplasm within the cell into definite muscular fibrils. In the lower
Plants single naked motile cells disseminate the species; and the
pairing-cells, or at least the males, have the same motile character.
In higher Cryptogams, Cycads, and Ginkgo (the Maiden-hair Tree),
the sperms alone are free-swimming; and as we pass to Flowering
Plants, the migratory character of the male cells is restricted to the
smallest limits. though never wholly absent. Intracellular movements
of the protoplasm are, however, found in all Plants.

In Plants we find no distinct nervous system formed of cells and

differentiated from other tissues with centres and branches and
sense-organs. These are more or less obvious in all Metazoa, traces
being even found in the Sponges.

We may then define Plants as beings which have the power of

manufacturing true food-stuffs from lower chemical substances than
proteids, often with the absorption of energy. They have the power of
surrounding themselves with a cell-wall, usually of cellulose, and of
growing and dividing freely in this state, in which animal-like changes
of form and locomotion are impossible; their colonies are almost
always fixed or floating; free locomotion is only possible in the case
of their naked reproductive cells, and is transitory even in these. The
movements of motile parts of complex plant-organisms are due to
the changes in the osmotic powers of cells as a whole, and not to the
contraction of differentiated fibrils in the cytoplasm of individual cells.
Plants that can form carbohydrates with liberation of free oxygen
have always definite plastids coloured with a lipochrome[56] pigment,
or else (in the Phycochromaceae) the whole plasma is so coloured.
Solid food is never taken into the free plant-cell nor into an internal
cavity in complex Plants. If, as in insectivorous Plants, it is digested
and absorbed, it is always in contact with the morphological external
surface. In the complex Plants apocytes and syncytes are rare—the
cells being each invested with its own wall, and, at most, only
communicating by minute threads with its neighbours. No trace of a
central nervous system with differentiated connexions can be made
out.

Animals all require proteid food; their cyst-walls are never formed of
cellulose; their cells usually divide in the naked condition only, or if
encysted, no secondary party-walls are formed between the
daughter-cells to unite them into a vegetative colony. Their colonies
are usually locomotive, or, if fixed, their parts largely retain their
powers of relative motion, and are often provided on their free
surfaces with cilia or flagella; and many cells have differentiated in
their cytoplasm contractile muscular fibrils. Their food (except in a
few parasitic groups) is always taken into a distinct digestive cavity.
A complex nervous system, of many special cells, with branched
prolongations interlacing or anastomosing, and uniting superficial
sense-organs with internal centres, is universally developed in
Metazoa. All Metazoa fulfil the above conditions.

But when we turn to the Protozoa we find that many of the

characters evade us. There are some Dinoflagellates (see p. 130)
which have coloured plastids, but which differ in no other respect
(even specific) from others that lack them: the former may have
mouths which are functionless, the latter have functional mouths.
Some colourless Flagellates are saprophytic and absorb nutritive
liquids, such as decomposing infusions of organic matter, possibly
free from all proteid constituents; while others, scarcely different,
take in food after the fashion of Amoeba. Sporozoa in the
persistence of the encysted stage are very plant-like, though they
are often intracellular and are parasitic in living Animals. On the
other hand, the Infusoria for the most part answer to all the
physiological characters of the Animal world, but are single cells, and
by the very perfection of their structure, all due to plasmic not to
cellular differentiation, show that they lie quite off the possible track
of the origin of Metazoa from Protozoa. Indeed, a strong natural line
of demarcation lies between Metazoa and Protista. Of the Protozoa,
certain groups, like the Foraminifera and Radiolaria and the Ciliate
and Suctorial Infusoria are distinctly animal in their chemical
activities or metabolism, their mode of nutrition, and their locomotive
powers. When we turn to the Proteomyxa, Mycetozoa, and the
Flagellates we find that the distinction between these and the lower
Fungi is by no means easy, the former passing, indeed, into true
Fungi by the Chytridieae, which it is impossible to separate sharply
from those Flagellates and Proteomyxa which Cienkowsky and Zopf
have so accurately studied under the name of "Monadineae." Again,
many of the coloured Flagellates can only (if at all) be distinguished
from Plants by the relatively greater prominence and duration of the
mobile state, though classifiers are generally agreed in allotting to
Plants those coloured Flagellates which in the resting state assume
the form of multicellular or apocytial filaments or plates.

On these grounds we should agree with Haeckel in distinguishing

the living world into the Metazoa, or Higher Animals, which are
sharply marked off; the Metaphyta, or Higher Plants, which it is not
so easy to characterise, but which unite at least two or more vegetal
characters; and the Protista, or organisms, whose differentiation is
limited to that within the cell (or apocyte), and does not involve the
cells as units of tissues. These Protista, again, it is impossible to
separate into animal and vegetal so sharply as to treat adequately of
either group without including some of the other: thus it is that every
text-book on Zoology, like the present work, treats of certain
Protophyta. The most unmistakably animal group of the Protista, the
Ciliata, is, as we have seen, by the complex differentiation of its
protoplasm, widely removed from the Metazoa with their relatively
simple cells but differentiated cell-groups and tissues. The line of
probable origin of the Metazoa is to be sought, for Sponges at least,
among the Choanoflagellates (pp. 121 f. 181 f.).
 CHAPTER II

PROTOZOA (CONTINUED): SPONTANEOUS GENERATION—CHARACTERS

OF PROTOZOA—CLASSIFICATION

The Question of Spontaneous Generation

From the first discovery of the Protozoa, their life-history has been
the subject of the highest interest: yet it is only within our own times
that we can say that the questions of their origin and development
have been thoroughly worked out. If animal or vegetable matter of
any kind be macerated in water, filtered, or even distilled, various
forms of Protista make their appearance; and frequently, as
putrefaction advances, form after form makes its appearance,
becomes abundant, and then disappears to be replaced by other
species. The questions suggested by such phenomena are these:
(1) Do the Protista arise spontaneously, that is, by the direct
organisation into living beings of the chemical substances present,
as a crystal is organised from a solution: (2) Are the forms of the
Protista constant from one generation to another, as are ordinary
birds, beasts, and fishes?

The question of the "spontaneous generation" of the Protista was

readily answered in the affirmative by men who believed that Lice
bred directly from the filth of human skins and clothes;[57] and that
Blow-flies, to say nothing of Honey-bees, arose in rotten flesh: but
the bold aphorism of Harvey "omne vivum ex ovo" at once gained
the ear of the best-inspired men of science, and set them to work in
search of the "eggs" that gave rise to the organisms of putrefaction.
Redi (ob. 1699) showed that Blow-flies never arise save when other
Blow-flies gain access to meat and deposit their very visible eggs
thereon. Leeuwenhoek, his contemporary, in the latter half of the
seventeenth century adduced strong reasons for ascribing the origin
of the organisms of putrefaction to invisible air-borne eggs. L. Joblot
and H. Baker in the succeeding half-century investigated the matter,
and showed that putrefaction was no necessary antecedent of the
appearance of these beings: that, as well as being air-borne, the
germs might sometimes have adhered to the materials used for
making the infusion; and that no organisms were found if the
infusions were boiled long enough, and corked when still boiling.
These views were strenuously opposed by Needham in England, by
Wrisberg in Germany, and by Buffon, the great French naturalist and
philosopher, whose genius, unballasted by an adequate knowledge
of facts, often played him sad tricks. Spallanzani made a detailed
study of what we should now term the "bionomical" or "oecological"
conditions of Protistic life and reproduction in a manner worthy of
modern scientific research, and not attained by some who took the
opposite side within living recollection. He showed that infusions kept
sufficiently long at the boiling-point in hermetically sealed vessels
developed no Protistic life. As he had shown that active Protists are
killed at much lower temperatures, he inferred that the germs must
have much higher powers of resistance; and, by modifying the
details of his experiments, he was able to meet various objections of
Needham.

Despite this good work, the advocates of spontaneous generation

were never really silenced; and the widespread belief in the
inconstancy of species in Protista added a certain amount of
credibility to their cause. In 1845 Pineau put forward these views
most strongly; and from 1858 to 1864 they were supported by the
elder Pouchet. Louis Pasteur, who began life as a chemist, was led
from a study of alcoholic fermentation to that of the organisms of
fermentation and of putrefaction and disease. He showed that in
infusions boiled sufficiently long and sealed while boiling, or kept at
the boiling-point in a sealed vessel, no life manifested itself:
objections raised on the score of the lack of access of fresh air were
met by the arrangement, so commonly used in "pure cultures" at the
present day, of a flask with a tube attached plugged with a little
cotton-wool, or even merely bent repeatedly into a zigzag. The
former attachment filtered off all germs or floating solid particles from
the air, the latter brought about the settling of such particles in the
elbows or on the sides of the tube: in neither case did living
organisms appear, even after the lapse of months. Other observers
succeeded in showing that the forms and characters of species were
as constant as in Higher Animals and Plants, allowing, of course, for
such regular metamorphoses as occur in Insects, or alternations of
generations paralleled in Tapeworms and Polypes. The regular
sequences of such alternations and metamorphoses constitute,
indeed, a strong support of the "germ-theory"—the view that all
Protista arise from pre-existing germs. It is to the Rev. W. H.
Dallinger and the late Dr. Charles Drysdale that we owe the first
complete records of such complex life-histories in the Protozoa as
are presented by the minute Flagellates which infest putrefying
liquids (see below, p. 116 f.). The still lower Schizomycetes, the
"microbes" of common speech, have also been proved by the
labours of Ferdinand Cohn, von Koch, and their numerous disciples,
to have the same specific constancy in consecutive generations, as
we now know, thanks to the methods first devised by De Bary for the
study of Fungi, and improved and elaborated by von Koch and his
school of bacteriologists.

And so to-day the principle "omne vivum ex vivo" is universally

accepted by men of science. Of the ultimate origin of organic life
from inorganic life we have not the faintest inkling. If it took place in
the remote past, it has not been accomplished to the knowledge of
man in the history of scientific experience, and does not seem likely
to be fulfilled in the immediate or even in the proximate future.[58]

PROTOZOA
Organisms of various metabolism, formed of a single cell or apocyte,
or of a colony of scarcely differentiated cells, whose organs are
formed by differentiations of the protoplasm, and its secretions and
accretions; not composed of differentiated multicellular tissues or
organs.[59]

This definition, as we have seen, excludes Metazoa (including

Mesozoa, Vol. II. p. 92) sharply from Protozoa, but leaves an
uncertain boundary on the botanical side; and, as systematists share
with nations the desire to extend their sphere of influence, we shall
here follow the lead of other zoologists and include many beings that
every botanist would claim for his own realm. Our present knowledge
of the Protozoa has indeed been largely extended by botanists,[60]
while the study of protoplasmic physiology has only passed from
their fostering care into the domain of General Biology within the last
decade. The study of the Protozoa is little more than two centuries
old, dating from the school of microscopists of whom the Dutchman
Leeuwenhoek is the chief representative: and we English may feel a
just pride in the fact that his most important publications are to be
found in the early records of our own Royal Society.

Baker, in the eighteenth century, and the younger Wallich, Carter,

Dallinger and Drysdale, Archer, Saville Kent, Lankester, and Huxley,
in the last half-century, are our most illustrious names. In France,
Joblot, almost as an amateur, like our own Baker, flourished in the
early part of the eighteenth century. Dujardin in the middle of the
same century by his study of protoplasm, or sarcode as he termed it,
did a great work in laying the foundations of our present ideas, while
Balbiani, Georges Pouchet, Fabre-Domergue, Maupas, Léger, and
Labbé in France, have worthily continued and extended the Gallic
traditions of exact observation and careful deduction. Otto Friedrich
Müller, the Dane, in the eighteenth century, was a pioneer in the
exact study and description of a large number of forms of these, as
of other microscopic forms of life. The Swiss collaborators,
Claparède and Lachmann, in the middle of the nineteenth century,
added many facts and many descriptions; and illustrated them by
most valuable figures of the highest merit from every point of view.
Germany, with her large population of students and her numerous
universities, has given many names to our list; among these,
Ehrenberg and von Stein have added the largest number of species
to the roll. Ehrenberg about 1840 described, indeed, an enormous
number of forms with much care, and in detail far too elaborate for
the powers of the microscope of that date: so that he was led into
errors, many and grave, which he never admitted down to the close
of a long and honoured life. Max Schultze did much good work on
the Protozoa, as well as on the tissues of the Metazoa, and largely
advanced our conceptions of protoplasm. His work was continued in
Germany by Ernst Haeckel, who systematised our knowledge of the
Radiolaria, Greeff, Richard Hertwig, Fritz Schaudinn, and especially
Bütschli, who contributed to Bronn's Thier-Reich a monograph of
monumental conception and scope, and of admirable execution, on
which we have freely drawn. Cienkowsky, a Russian, and James-
Clark and Leidy, both Americans, have made contributions of high
quality.

Lankester's article in the Encyclopædia Britannica was of epoch-

making quality in its philosophical breadth of thought.

Delage and Hérouard have given a full account of the Protozoa in

their Traité de Zoologie Concrète, vol. i. (1896); and A. Lang's
monograph in his Vergleichende Anatomie, 2nd ed. (1901), contains
an admirable analysis of their general structure, habits, and life-
cycles, together with full descriptions of well-selected types. Calkins
has monographed "The Protozoa" in the Columbia University
Biological series (1901). These works of Bütschli, Delage, Lang, and
Calkins contain full bibliographies. Doflein has published a most
valuable systematic review of the Protozoa parasitic on animals
under the title Die Protozoen als Parasiten und Krankheitserreger
(1901); and Schaudinn's Archiv für Protistenkunde, commenced only
four years ago, already forms an indispensable collection of facts
and views.

The protoplasm of the Protozoa (see p. 5 f.) varies greatly in

consistency and in differentiation. Its outer layer may be granular
and scarcely altered in Proteomyxa, the true Myxomycetes, Filosa,
Heliozoa, Radiolaria, Foraminifera, etc.; it is clear and glassy in the
Lobose Rhizopods and the Acrasieae; it is continuous with a firm but
delicate superficial pellicle of membranous character in most
Flagellates and Infusoria; and this pellicle may again be consolidated
and locally thickened in some members of both groups so as to form
a coat of mail, even with definite spines and hardened polygonal
plates (Coleps, Fig. 54, p. 150). Again, it may form transitory or more
or less permanent pseudopodia,[61] (1) blunt or tapering and distinct,
with a hyaline outer layer, or (2) granular and pointed, radiating and
more or less permanent, or (3) branching and fusing where they
meet into networks or perforated membranes. Cilia or flagella are
motile thread-like processes of active protoplasm which perforate the
pellicle; they may be combined into flattened platelets or firm rods, or
transformed into coarse bristles or fine motionless sense-hairs. The
skeletons of the Protozoa, foreign to the cytoplasm, will be treated of
under the several groups.

Most of the fresh-water and brackish forms (and some marine ones)
possess one or more contractile vacuoles, often in relation to a more
or less complex system of spaces or canals in Flagellates and
Ciliates.

The Geographical Distribution of Protozoa is remarkable for the

wide, nay cosmopolitan, distribution of the terrestrial and fresh-water
forms;[62] they owe this to their power of forming cysts, within which
they resist drought, and can be disseminated as "dust." Very few of
them can multiply at a temperature approaching freezing-point; the
Dinoflagellates can, however, and therefore present Alpine and
Arctic forms. The majority breed most freely at summer
temperatures; and, occurring in small pools, can thus achieve their
full development in such as are heated by the sun during the long
Arctic day as readily as in the Tropics. In infusions of decaying
matter, the first to appear are those that feed on bacteria, the
essential organisms of putrefaction. These, again, are quickly
followed and preyed upon by carnivorous species, which prefer
liquids less highly charged with organic matters, and do not appear
until the liquid, hitherto cloudy, has begun to clear. Thus we have
rather to do with "habitat" than with "geographical distribution," just
as with the fresh-water Turbellaria and the Rotifers (vol. ii. pp. 4 f.,
226 f.). We can distinguish in fresh-water, as in marine Protista,
"littoral" species living near the bank, among the weeds; "plankton,"
floating at or near the surface; "zonal" species dwelling at various
depths; and "bottom-dwellers," mostly "limicolous" (or "sapropelic,"
as Lauterborn terms them), and to be found among the bottom ooze.
Many species are "epiphytic" or "epizoic," dwelling on plants or
animals, and sometimes choice enough in their preference of a
single genus or species as host. Others again are "moss-dwellers,"
living among the root-hairs of mosses and the like, or even
"terrestrial" and inhabiting damp earth. The Sporozoa are internal
parasites of animals, and so are many Flagellates, while many
Proteomyxa are parasitic in plant-cells. The Foraminifera (with the
exception of most Allogromidiaceae) are marine, and so are the
Radiolaria; while most Heliozoa inhabit fresh water. Concerning the
distribution in time we shall speak under the last two groups, the only
ones whose skeletons have left fossil remains.

Classification.—The classification of the Protozoa is no easy task.

We omit here, for obvious reasons, the unmistakable Plant Protists
that have a holophytic or saprophytic nutrition; that are, with the
exception of a short period of locomotion in the young reproductive
cells, permanently surrounded with a wall of cellulose or fungus-
cellulose, and that multiply and grow freely in this encysted state: to
these consequently we relegate the Chytridieae, which so closely
allied to the Proteomyxa and the Phycomycetous Fungi; and the
Confervaceae, which in the resting state form tubular or flattened
aggregates and are allied to the green Flagellates; besides the
Schizophyta. At the opposite pole stand the Infusoria in the strict
sense, with the most highly differentiated organisation found in our
group, culminating in the possession of a nuclear apparatus with
nuclei of two kinds, and exhibiting a peculiar form of conjugation, in
which the nuclear apparatus is reorganised. The Sporozoa are
clearly marked off as parasites in living animals, which mostly begin
life as sickle-shaped cells and have always at least two alternating
modes of brood-formation, the first giving rise to aplanospores,
wherein is formed the second brood of sickle-shaped, wriggling
zoospores. The remainder, comprising the Sarcodina, or
Rhizopoda in the old wide sense (including all that move by
pseudopodia during the great part of their active life), and the
Flagellata in the widest sense, are not easy to split up; for many of
the former have flagellate reproductive cells, and many of the latter
can emit pseudopodia with or without the simultaneous retraction of
their flagella. The Radiolaria are well defined by the presence in
the body plasm of a central capsule marking it off into a central and a
peripheral portion, the former containing the nucleus, the latter
emitting the pseudopodia. Again, on the other hand, we find that we
can separate as Flagellata in the strict sense the not very natural
assemblage of those Protista that have flagella as their principle
organs of movement or nutrition during the greater part of their active
life. The remaining groups (which with the Radiolaria compose the
Sarcodina of Bütschli), are the most difficult to treat. The
Rhizopoda, as we shall limit them, are naked or possess a simple
shell, never of calcium carbonate, have pseudopodia that never
radiate abundantly nor branch freely, nor coalesce to form plasmatic
networks, nor possess an axial rod of firmer substance. The
Foraminifera have a shell, usually of calcium carbonate, their
pseudopodia are freely reticulated, at least towards the base; and
(with the exception of a few simple forms) all are marine. The
Mycetozoa are clearly united by their tendency to aggregate more
or less completely into complex resting-groups (fructifications), and
by reproducing by unicellular zoospores, flagellate or amoeboid,
which are not known to pair. The Heliozoa resemble the Radiolaria
in their fine radiating pseudopodia, but have an axial filament always
present in each, and lack the central capsule; and are, for the most
part, fresh-water forms. Finally, the Proteomyxa forms a sort of
lumber-room for beings which are intermediate between the
Heliozoa, Rhizopoda, and Flagellata, usually passing through an
amoeboid stage, and for the most part reproducing by brood-
formation. Zoospores that possess flagella are certainly known to
occur in some forms of Foraminifera, Rhizopoda, Heliozoa, and
Radiolaria, though not by any means in all of each group.[63]

A. Pseudopodia the principal means of

locomotion and feeding; flagella absent
or transitory I. Sarcodina
(1) Plastogamy only leading to an
increase in size, never to the
formation of "fructifications."
(a) Pseudopodia never freely
coalescing into a network nor
fine to the base Rhizopoda.
(*) Ectoplasm clear, free from
granules; pseudopodia,
usually blunt Rhizopoda Lobosa
(**) Ectoplasm finely granular;
pseudopodia slender,
branching, but not forming
a network, passing into
the body by basal
dilatation Rhizopoda Filosa
(b) Pseudopodia branching freely
and coalescing to form
networks; ectoplasm granular;
test usually calcareous or
sandy Foraminifera
(c) Pseudopodia fine to the very
base; radiating, rarely
coalescing.
(i.) Pseudopodia with a central
filament Heliozoa
(ii.) Pseudopodia without a
central filament.
(*) Body divided into a
central and a
peripheral part by a
"central capsule" Radiolaria
(**) Body without a central
capsule Proteomyxa
 (2) Cells aggregating or fusing into Mycetozoa
plasmodia before forming a
complex "fructification"
B. Cells usually moving by "euglenoid"
wriggling or by excretion of a trail of
viscid matter; reproduction by
alternating modes of brood-formation,
rarely by Spencerian fission II. Sporozoa
C. Flagella (rarely numerous) the chief or
only means of motion and feeding III. Flagellata
D. Cilia the chief organs of motion, in the
young state at least; nuclei of two kinds IV. Infusoria

CHAPTER III

PROTOZOA (CONTINUED): SARCODINA

I. Sarcodina.
Protozoa performing most of their life-processes by pseudopodia; nucleus
frequently giving off fragments (chromidia) which may play a part in nuclear
reconstitution on division; sometimes with brood-cells, which may be at first
flagellate; but never reproducing in the flagellate state.[64]

1. Rhizopoda
Sarcodina of simple form, whose pseudopodia never coalesce into
networks (1),[65] nor contain an axial filament (2), which commonly
multiply by binary fission (3), though a brood-formation may occur;
which may temporarily aggregate, or undergo temporary or
permanent plastogamic union, but never to form large plasmodia or
complex fructifications as a prelude to spore-formation (4); test when
present gelatinous, chitinous, sandy, or siliceous, simple and 1-
chambered (5).

Classification.[66]
I. Ectoplasm distinct, clear; pseudopodia blunt or
tapering, but not branching at the apex Lobosa
Amoeba, Auctt.; Pelomyxa, Greeff; Trichosphaerium, A.
Schneid.; Dinamoeba, Leidy; Amphizonella, Greeff;
Centropyxis, Stein; Arcella, Ehr.; Difflugia, Leclercq;
Lecqueureusia, Schlumberger; Hyalosphenia, Stein;
Quadrula, F. E. Sch.; Heleopera, Leidy; Podostoma, Cl. and
L.; Arcuothrix, Hallez.
II. Ectoplasm undifferentiated, containing moving
granules; pseudopodia branching freely towards the
tips Filosa
Euglypha, Duj.; Paulinella, Lauterb.; Cyphoderia, Schlumb.;
Campascus, Leidy; Chlamydophrys, Cienk.; Gromia, Duj. =
Hyalopus, M. Sch.

We have defined this group mainly by negative characters, as such

are the only means for their differentiation from the remaining
Sarcodina; and indeed from Flagellata, since in this group zoospores
are sometimes formed which possess flagella. Moreover, indeed, in
a few of this group (Podostoma, Arcuothrix), as in some Heliozoa,
the flagellum or flagella may persist or be reproduced side by side
with the pseudopodia. The subdivision of the Rhizopoda is again a
matter of great difficulty, the characters presented being so mixed up
that it is hard to choose: however, the character of the outer layer of
the cytoplasm is perhaps the most obvious to select. In Lobosa
there is a clear layer of ectosarc, which appears to be of a greasy
nature at its surface film, so that it is not wetted. In the Filosa, as in
most other Sarcodina, this film is absent, and the ectoplasm is not
marked off from the endoplasm, and may have a granular surface.
Corresponding to this, the pseudopodia of the Lobosa are usually
blunt, never branching and fraying out, as it were, at the tip, as in the
Filosa; nay, in the normal movements of Amoeba limax (Fig. 1, p. 5)
the front of the cell forms one gigantic pseudopodium, which
constantly glides forward. Apart from this distinction the two groups
are parallel in almost every respect.

There may be a single contractile vacuole, or a plurality; or none,

especially in marine and endoparasitic species. The nucleus may
remain single or multiply without inducing fission, thus leading to
apocytial forms. It often gives off "chromidial" fragments, which may
play an important part in reproduction.[67] In Amoeba binucleata
there are constantly two nuclei, both of which divide as an
antecedent to fission, each giving a separate nucleus to either
daughter-cell. Pelomyxa palustris, the giant of the group, attaining a
diameter of 1‴ (2 mm.), has very blunt pseudopodia, an enormous
number of nuclei, and no contractile vacuole, though it is a fresh-
water dweller, living in the bottom ooze of ponds, etc., richly charged
with organic débris. It is remarkable also for containing symbiotic
bacteria, and brilliant vesicles with a distinct membranous wall,
containing a solution of glycogen.[68] Few, if any, of the Filosa are
recorded as plurinuclear.

The simplest Lobosa have no investment, nor indeed any distinction

of front or back. In some forms of Amoeba, however, the hinder part
is more adhesive, and may assume the form of a sucker-like disc, or
be drawn into a tuft of short filaments or villi, to which particles
adhere. Other species of Lobosa and all Filosa have a "test," or
"theca," i.e. an investment distinct from the outermost layer of the
cell-body. The simplest cases are those of Amphizonella,
Dinamoeba, and Trichosphaerium, where this is gelatinous, and in
the two former allows the passage of food particles through it into the
body by mere sinking in, like the protoplasm itself, closing again
without a trace of perforation over the rupture. In Trichosphaerium
(Fig. 9) the test is perforated by numerous pores of constant position
for the passage of the pseudopodia, closing when these are
retracted; and in the "A" form of the species (see below) it is studded
with radial spicules of magnesium carbonate. Elsewhere the test is
more consistent and possesses at least one aperture for the
emission of pseudopodia and the reception of food; to avoid
confusion we call this opening not the mouth but the "pylome": some
Filosa have two symmetrically placed pylomes. When the test is a
mere pellicle, it may be recognised by the limitation of the
pseudopodia to the one pylomic area. But the shell is often hard. In
Arcella (Fig. 10, C), a form common among Bog-mosses and
Confervas, it is chitinous and shagreened, circular, with a shelf
running in like that of a diving-bell around the pylome: there are two
or more contractile vacuoles, and at least two nuclei. Like some
other genera, it has the power of secreting carbonic acid gas in the
form of minute bubbles in its cytoplasm, so as to enable it to float up
to the surface of the water. The chitinous test shows minute
hexagonal sculpturing, the expression of vertical partitions reaching
from the inner to the outer layer.

Fig. 9.—Trichosphaerium sieboldii. 1, Adult of "A" form; 2, its multiplication by

fission and gemmation; 3, resolution into 1-nucleate amoeboid zoospores;
4, development (from zoospores of "A") into "B" form (5); 6, its multiplication
by fission and gemmation; 7, its resolution after nuclear bipartition into
minute 2-flagellate zoospores or (exogametes); 8, liberation of gametes; 9,