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Investments
T H I R T E E N T H E D I T I O N

ZVI BODIE
Boston University

ALEX KANE
University of California, San Diego

ALAN J. MARCUS
Boston College
 Final PDF to printer

INVESTMENTS, THIRTEENTH EDITION

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Names: Bodie, Zvi, author. | Kane, Alex, 1942- author. | Marcus, Alan J.,
author.
Title: Investments / Zvi Bodie, Boson University, Alex Kane, University of
California, San Diego, Alan J. Marcus, Boston College.
Description: Thirteenth edition. | New York, NY : McGraw Hill LLC, [2024] |
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 About the Authors

ZVI BODIE
Boston University

Zvi Bodie is Professor ­Emeritus at Boston University. He holds a PhD from the ­Massachusetts Institute of
Technology and has served on the finance faculty at the Harvard Business School and MIT’s Sloan School
of ­Management. He has ­published widely in scholarly and professional journals on pension investment strategy
and life-cycle asset-liability matching. In 2007 the ­Retirement Income Industry Association gave him its ­Lifetime
Achievement Award for applied research.

ALEX KANE
University of California, San Diego

Alex Kane holds a PhD from the Stern School of Business of New York University and has been Visiting
­Professor at the Faculty of Economics, University of Tokyo; Graduate School of Business, Harvard; Kennedy
School of Government, Harvard; and Research Associate, National Bureau of Economic Research. An author
of many articles in finance and management ­journals, Professor Kane’s research is mainly in corporate finance,
portfolio management, and capital markets.

ALAN J. MARCUS
Boston College

Alan Marcus is the Mario J. Gabelli Professor of Finance in the Carroll School of Management at Boston
­College. He received his PhD in economics from MIT. Professor Marcus has been a visiting professor at the
Athens Laboratory of Business Administration and at MIT’s Sloan School of Management and has served as a
research associate at the National Bureau of Economic Research. Professor Marcus has published widely in the
fields of capital markets and portfolio management. He also spent two years at the Federal Home Loan Mortgage
Corporation (Freddie Mac), where he developed models of mortgage pricing and credit risk. He currently serves
on the Research Foundation Advisory Board of the CFA Institute.
Special Contributor
Nicholas Racculia, Saint Vincent College
Nicholas Racculia holds a PhD from Princeton University and serves as Professor of Finance at St. Vincent
­College. Professor Racculia teaches a wide range of classes in Corporate Finance and Investments. He has
­significantly participated in the expansion of Chapter 26 on Alternative Assets. His contributions also play a key
role in the development of online content for the text.

v
 Brief Contents

Preface xvi PART III

PART I Equilibrium in Capital

Introduction 1 Markets 283
1 9
The Investment Environment 1 The Capital Asset Pricing Model 283

2 10
Asset Classes and Financial Instruments 31 Arbitrage Pricing Theory and Multifactor
Models of Risk and Return 315
3
How Securities Are Traded 61 11
The Efficient Market Hypothesis 341
4
Mutual Funds and Other Investment 12
Companies 99 Behavioral Finance and Technical
Analysis 381
PART II 13
Empirical Evidence on Security Returns 409
Portfolio Theory and
Practice 125 PART IV

5 Fixed-Income Securities 439

Risk, Return, and the Historical Record 125 14
6 Bond Prices and Yields 439
Capital Allocation to Risky Assets 167 15
7 The Term Structure of Interest Rates 481
Efficient Diversification 201 16
8 Managing Bond Portfolios 509
Index Models 251

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PART V PART VII

Security Analysis 551 Applied Portfolio

17
Macroeconomic and Industry Analysis 551
Management 827
24
18 Portfolio Performance Evaluation 827
Equity Valuation Models 583
25
19 International Diversification 867
Financial Statement Analysis 629
26
Alternative Assets 895
PART VI 27
The Theory of Active Portfolio
Options, Futures, and Other Management 935

Derivatives 673 28
Investment Policy and the Framework of the
20 CFA Institute 959
Options Markets: Introduction 673
21 REFERENCES TO CFA PROBLEMS 995
Option Valuation 715 GLOSSARY G-1
22 NAME INDEX I
Futures Markets 763
SUBJECT INDEX I-4
23
Futures, Swaps, and Risk Management 791 NOTATION, FORMULAS F-1

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Preface xvi Chapter 2

Asset Classes and Financial Instruments 31
PART I
2.1 The Money Market 31
Introduction 1 Treasury Bills / Certificates of Deposit / Commercial
Paper / Bankers’ Acceptances / Eurodollars / Repos and
Chapter 1 Reverses / Federal Funds / Brokers’ Calls / LIBOR and
Its Replacements / Yields on Money Market Instruments /
The Investment Environment 1 Money Market Funds
1.1 Real Assets versus Financial Assets 2 2.2 The Bond Market 37
1.2 Financial Assets 3 Treasury Notes and Bonds / Inflation-Protected Treasury
1.3 Financial Markets and the Economy 5 Bonds / Federal Agency Debt / International Bonds /
Municipal Bonds / Corporate Bonds / Mortgage and
The Informational Role of Financial Markets /
Asset-Backed Securities
Consumption Timing / Allocation of Risk / Separation of
Ownership and Management / Corporate Governance 2.3 Equity Securities 44
and Corporate Ethics Common Stock as Ownership Shares / Characteristics of
Common Stock / Stock Market Listings / Preferred Stock /
1.4 The Investment Process 10
Depositary Receipts
1.5 Markets Are Competitive 11
2.4 Stock and Bond Market Indexes 47
The Risk–Return Trade-Off / Efficient Markets
Stock Market Indexes / Dow Jones Industrial Average
1.6 The Players 13 / The Standard & Poor’s 500 Index / Russell Indexes /
Financial Intermediaries / Investment Bankers / Other U.S. Market-Value Indexes / Equally Weighted
Venture Capital and Private Equity / Fintech, Indexes / Foreign and International Stock Market Indexes
Financial Innovation, and Decentralized / Bond Market Indicators
Finance 2.5 Derivative Markets 54
 Robo Advice / Blockchains / Cryptocurrencies / Options / Futures Contracts
Digital Tokens / Digital Currency End of Chapter Material 56–60
1.7 The Financial Crisis of 2008–2009 19
Chapter 3
Antecedents of the Crisis / Changes in Housing Finance /
Mortgage Derivatives / Credit Default Swaps / The Rise How Securities Are Traded 61
of Systemic Risk / The Shoe Drops / The Dodd–Frank 3.1 How Firms Issue Securities 61
Reform Act
Privately Held Firms / Publicly Traded Companies / Shelf
1.8 Outline of the Text 27 Registration / Initial Public Offerings / SPACs versus
End of Chapter Material 27–30 ­Traditional IPOs

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3.2 How Securities Are Traded 67 4.6 Exchange-Traded Funds 112

Types of Markets 4.7 Mutual Fund Investment Performance:
 Direct Search Markets / Brokered Markets / Dealer A First Look 115
­Markets / Auction Markets 4.8 Information on Mutual Funds 116
Types of Orders End of Chapter Material 119–124
Market Orders / Price-Contingent Orders
Trading Mechanisms PART II
 Dealer Markets / Electronic Communication Networks
(ECNs) / Specialist/DMM Markets Portfolio Theory
3.3 The Rise of Electronic Trading 72 and Practice 125
3.4 U.S. Markets 74
NASDAQ / The New York Stock Exchange / ECNs Chapter 5
3.5 New Trading Strategies 76 Risk, Return, and the Historical
Algorithmic Trading / High-Frequency Trading / Dark Record 125
Pools / Internalization / Bond Trading
5.1 Measuring Returns over Different Holding Periods 126
3.6 Globalization of Stock Markets 80
Annual Percentage Rates / Continuous Compounding
3.7 Trading Costs 81 5.2 Interest Rates and Inflation Rates 129
3.8 Buying on Margin 82 Real and Nominal Rates of Interest / The Equilibrium
3.9 Short Sales 85 Real Rate of Interest / Interest Rates and Inflation /
3.10 Regulation of Securities Markets 89 Taxes and the Real Rate of Interest / Treasury Bills and
Self-Regulation / The Sarbanes-Oxley Act / Inflation, 1926–2021
Insider Trading 5.3 Risk and Risk Premiums 133
End of Chapter Material 93–98 Holding-Period Returns / Expected Return and Standard
Deviation / Excess Returns and Risk Premiums / The
Chapter 4 Reward-to-Volatility (Sharpe) Ratio
Mutual Funds and Other Investment 5.4 The Normal Distribution 137
Companies 99 5.5 Deviations from Normality and Tail Risk 140
Value at Risk / Expected Shortfall / Lower Partial
4.1 Investment Companies 99 Standard Deviation and the Sortino Ratio / Relative
4.2 Types of Investment Companies 100 Frequency of Large, Negative 3-Sigma Returns
Unit Investment Trusts / Managed Investment 5.6 Learning from Historical Returns 143
Companies / Exchange-Traded Funds / Other Investment Time Series versus Scenario Analysis / Expected Returns
Organizations and the Arithmetic Average / The Geometric (Time-
 Commingled Funds / Real Estate Investment Trusts Weighted) Average Return / Estimating Variance and
(REITs) / Hedge Funds Standard Deviation / Mean and Standard Deviation
4.3 Mutual Funds 104 Estimates from Higher-Frequency Observations
Investment Policies 5.7 Historic Returns on Risky Portfolios 147
 Money Market Funds / Equity Funds / Sector A Global View of the Historical Record
Funds / Bond Funds / International Funds / 5.8 Normality and Long-Term Investments 156
Balanced Funds / Asset Allocation and Flexible Short-Run versus Long-Run Risk / Forecasts for the
Funds / Index Funds Long Haul
How Funds Are Sold End of Chapter Material 160–166
4.4 Costs of Investing in Mutual Funds 107
Chapter 6
Fee Structure
 Operating Expenses / Front-End Load / Back-End Capital Allocation to Risky Assets 167
Load / 12b-1 Charges 6.1 Risk and Risk Aversion 168
Fees and Mutual Fund Returns Risk, Speculation, and Gambling / Risk Aversion and
4.5 Taxation of Mutual Fund Income 111 Utility Values / Estimating Risk Aversion

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6.2 Capital Allocation across Risky and Risk-Free 8.5 Portfolio Construction Using the Single-Index
Portfolios 173 Model 268
6.3 The Risk-Free Asset 176 Alpha and Security Analysis / The Index Portfolio as an
6.4 Portfolios of One Risky Asset and a Risk-Free Investment Asset / The Single-Index Model Input List /
Asset 176 The Optimal Risky Portfolio in the Single-Index Model /
6.5 Risk Tolerance and Asset Allocation 179 The Information Ratio / Summary of Optimization
Procedure / An Example / Correlation and Covariance
Non-normal Returns
Matrix
6.6 Passive Strategies: The Capital Market Line 185
 Risk Premium Forecasts / The Optimal Risky Portfolio /
End of Chapter Material 187–195 Is the Index Model Inferior to the Full-Covariance
Appendix A: Risk Aversion, Expected Utility, and the Model?
St. Petersburg Paradox 196 End of Chapter Material 277–282

Chapter 7
PART III
Efficient Diversification 201
7.1 Diversification and Portfolio Risk 202 Equilibrium in Capital
7.2
7.3
Portfolios of Two Risky Assets 203
Asset Allocation with Stocks, Bonds, and Bills 211
Markets 283
Asset Allocation with Two Risky Asset Classes Chapter 9
7.4 The Markowitz Portfolio Optimization Model 216
The Capital Asset Pricing Model 283
Security Selection / Capital Allocation and the
Separation Property / The Power of Diversification / 9.1 The Capital Asset Pricing Model 283
Asset Allocation and Security Selection The Market Portfolio / The Passive Strategy Is Efficient
7.5 Risk Pooling, Risk Sharing, and Time / The Risk Premium of the Market Portfolio / Expected
Diversification 225 Returns on Individual Securities / The Security Market
Risk Sharing versus Risk Pooling / Time Diversification Line / The CAPM and the Single-Index Market

End of Chapter Material 228–238 9.2 Assumptions and Extensions of the CAPM 294

Appendix A: A Spreadsheet Model for Efficient Identical Input Lists / Risk-Free Borrowing and the
Diversification 238 Zero-Beta Model / Labor Income and Other Nontraded
Assets / A Multiperiod Model and Hedge Portfolios / A
Appendix B: Review of Portfolio Statistics 243
Consumption-Based CAPM / Liquidity and the CAPM
9.3 Issues in Testing the CAPM 304
Chapter 8
9.4 The CAPM and the Investment Industry 305
Index Models 251 End of Chapter Material 306–314
8.1 A Single-Factor Security Market 252
The Input List of the Markowitz Model / Systematic Chapter 10
versus Firm-Specific Risk Arbitrage Pricing Theory
8.2 The Single-Index Model 254 and Multifactor Models of Risk
The Regression Equation of the Single-Index Model / and Return 315
The Expected Return–Beta Relationship / Risk and
10.1 Multifactor Models: A Preview 316
Covariance in the Single-Index Model / The Set of
Estimates Needed for the Single-Index Model / The Index Factor Models of Security Returns
Model and Diversification 10.2 Arbitrage Pricing Theory 318
8.3 Estimating the Single-Index Model 261 Arbitrage, Risk Arbitrage, and Equilibrium / Diversification
The Security Characteristic Line for U.S. Steel / The in a Single-Factor Security Market / Well-Diversified
Explanatory Power of U.S. Steel’s SCL / The Estimate of Portfolios / The Security Market Line of the APT
Alpha / The Estimate of Beta / Firm-Specific Risk Individual Assets and the APT
 Typical Results from Index Model Regressions Well-Diversified Portfolios in Practice
8.4 The Industry Version of the Index Model 265 10.3 The APT and the CAPM 326
Predicting Betas 10.4 A Multifactor APT 326

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 Contents

10.5 The Fama-French (FF) Three-Factor Model 329 Limits to Arbitrage

Estimating and Implementing a Three-Factor SML /  Fundamental Risk / Implementation Costs / Model Risk
Extensions of the Three-Factor Model: A First Look / Limits to Arbitrage and the Law of One Price
Smart Betas and Multifactor Models  “Siamese Twin” Companies / Equity Carve-Outs /
End of Chapter Material 334–340 Closed-End Funds
Bubbles and Behavioral Economics / Evaluating the
Chapter 11
Behavioral Critique
The Efficient Market Hypothesis 341 12.2 Technical Analysis and Behavioral Finance 394
11.1 Random Walks and Efficient Markets 342 Trends and Corrections
Competition as the Source of Efficiency / Versions of the  Momentum and Moving Averages / Relative Strength /
Efficient Market Hypothesis Breadth
11.2 Implications of the EMH 346 Machine Leaning and Technical Analysis / Sentiment
Technical Analysis / Fundamental Analysis / Active versus Indicators
Passive Portfolio Management / The Role of Portfolio  Trin Statistic / Confidence Index / Short Interest / Put/
Management in an Efficient Market / Resource Allocation Call Ratio
11.3 Event Studies 351 A Warning
11.4 Are Markets Efficient? 354 End of Chapter Material 401–408
The Issues
 The Magnitude Issue / The Selection Bias Issue / The Chapter 13
Lucky Event Issue Empirical Evidence on Security Returns 409
Weak-Form Tests: Patterns in Stock Returns
13.1 Two-Pass Tests of Asset Pricing 410
 Returns over Short Horizons / Returns over Long Horizons
Testing the Single-Factor SML
Predictors of Broad Market Returns / Semistrong Tests:
 Setting Up the Sample Data / Estimating the SCL /
Market Anomalies
Estimating the SML
 The Small-Firm Effect / The Neglected-Firm and
The Market Index / Measurement Error in Beta
Liquidity Effects / Book-to-Market Ratios / Post–
Earnings-Announcement Price Drift / Other Predictors 13.2 Tests of the Multifactor Models 415
of Stock Returns Labor Income / Private (Nontraded) Business /
Strong-Form Tests: Inside Information / Interpreting the Macroeconomic Risk Factors
Anomalies 13.3 Fama-French-Type Factor Models 419
 Risk Premiums or Inefficiencies? / Anomalies or Data Size and B/M as Risk Factors / Behavioral Explanations /
Mining? / Anomalies over Time Momentum: A Fourth Factor / The Factor Zoo
Bubbles and Market Efficiency 13.4 Liquidity and Asset Pricing 427
11.5 Mutual Fund and Analyst Performance 368 13.5 The Equity Premium Puzzle 429
Stock Market Analysts / Mutual Fund Managers / So, Are Expected versus Realized Returns / Survivorship Bias /
Markets Efficient? Extensions to the CAPM May Mitigate the Equity Premium
End of Chapter Material 374–380 Puzzle / Liquidity and the Equity Premium Puzzle /
Behavioral Explanations of the Equity Premium Puzzle
Chapter 12 End of Chapter Material 435–438
Behavioral Finance and Technical
Analysis 381 PART IV
12.1 The Behavioral Critique 382 Fixed-Income Securities 439
Information Processing
 Limited Attention, Underreaction, and Overreaction / Chapter 14
Overconfidence / Conservatism / Confirmation Bias /
Extrapolation and Pattern Recognition
Bond Prices and Yields 439
Behavioral Biases 14.1 Bond Characteristics 440
 Framing / Mental Accounting / Regret Avoidance / Treasury Bonds and Notes
Affect and Feelings / Prospect Theory Accrued Interest and Quoted Bond Prices

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Corporate Bonds 16.2 Convexity 519

 Call Provisions on Corporate Bonds / Convertible Why Do Investors Like Convexity? / Duration and
Bonds / Puttable Bonds / Floating-Rate Bonds Convexity of Callable Bonds / Duration and Convexity of
Preferred Stock / Other Domestic Issuers / International Mortgage-Backed Securities
Bonds / Innovation in the Bond Market 16.3 Passive Bond Management 527
 Maturity / Inverse Floaters / Asset-Backed Bonds / Bond-Index Funds / Immunization / Cash Flow Matching
Catastrophe Bonds / Indexed Bonds and Dedication / Other Problems with Conventional
14.2 Bond Pricing 446 Immunization
Bond Pricing between Coupon Dates 16.4 Active Bond Management 536
14.3 Bond Yields 451 Sources of Potential Profit / Horizon Analysis
Yield to Maturity / Yield to Call / Realized Compound End of Chapter Material 539–550
Return versus Yield to Maturity
14.4 Bond Prices over Time 458 PART V
Yield to Maturity versus Holding-Period Return / Zero-
Coupon Bonds and Treasury Strips / After-Tax Returns Security Analysis 551
14.5 Default Risk and Bond Pricing 463
Chapter 17
Junk Bonds / Determinants of Bond Safety / Bond
Indentures Macroeconomic and Industry Analysis 551
 Sinking Funds / Subordination of Further Debt / 17.1 The Global Economy 551
­Dividend Restrictions / Collateral 17.2 The Domestic Macroeconomy 554
Yield to Maturity and Default Risk / Credit Default Key Economic Indicators
Swaps / Credit Risk and Collateralized Debt
 Gross Domestic Product / Employment / Inflation /
Obligations
Interest Rates / Budget Deficit / Sentiment
End of Chapter Material 474–480
17.3 Demand and Supply Shocks 556

Chapter 15 17.4 Federal Government Policy 557

Fiscal Policy / Monetary Policy / Supply-Side Policies
The Term Structure of Interest Rates 481
17.5 Business Cycles 560
15.1 The Yield Curve 481 The Business Cycle / Economic Indicators
Bond Pricing 17.6 Industry Analysis 564
15.2 The Yield Curve and Future Interest Rates 484 Defining an Industry / Sensitivity to the Business Cycle /
The Yield Curve under Certainty / Holding-Period Sector Rotation / Industry Life Cycles
Returns / Forward Rates  Start-Up Stage / Consolidation Stage / Maturity Stage /
15.3 Interest Rate Uncertainty and Forward Rates 489 Relative Decline
15.4 Theories of the Term Structure 491 Industry Structure and Performance
The Expectations Hypothesis / Liquidity Preference  Threat of Entry / Rivalry between Existing Competitors /
Theory / Market Segmentation Pressure from Substitute Products / Bargaining Power
15.5 Interpreting the Term Structure 495 of Buyers / Bargaining Power of Suppliers
15.6 Forward Rates as Forward Contracts 498 End of Chapter Material 574–582
End of Chapter Material 500–508
Chapter 18
Chapter 16 Equity Valuation Models 583
Managing Bond Portfolios 509 18.1 Valuation by Comparables 583
16.1 Interest Rate Risk 510 Limitations of Book Value
Interest Rate Sensitivity / Duration / What Determines 18.2 Intrinsic Value versus Market Price 585
Duration? 18.3 Dividend Discount Models 587
 Rule 1 for Duration / Rule 2 for Duration / Rule 3 for The Constant-Growth DDM / Convergence of Price
Duration / Rule 4 for Duration / Rule 5 for Duration to Intrinsic Value / Stock Prices and Investment

xii
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Opportunities / Life Cycles and Multistage Growth The Options Clearing Corporation / Other
Models / Multistage Growth Models Listed Options
18.4 The Price–Earnings Ratio 601  Index Options / Futures Options / Foreign Currency
The Price–Earnings Ratio and Growth Opportunities / Options / Interest Rate Options
P/E Ratios and Stock Risk / Pitfalls in P/E Analysis / The 20.2 Values of Options at Expiration 679
Cyclically Adjusted P/E Ratio / Combining P/E Analysis Call Options / Put Options / Option versus Stock
and the DDM / Other Comparative Valuation Ratios Investments
 Price-to-Book Ratio / Price-to-Cash-Flow Ratio / 20.3 Option Strategies 683
Price-to-Sales Ratio / Be Creative
Protective Put / Covered Calls / Straddle / Spreads /
18.5 Free Cash Flow Valuation Approaches 611
Collars
Comparing the Valuation Models / The Problem with
20.4 The Put-Call Parity Relationship 691
DCF Models
20.5 Option-like Securities 694
18.6 The Aggregate Stock Market 615
End of Chapter Material 617–628 Callable Bonds / Convertible Securities /
Warrants / Collateralized Loans / Levered Equity
and Risky Debt
Chapter 19
20.6 Financial Engineering 700
Financial Statement Analysis 629 20.7 Exotic Options 702
19.1 The Major Financial Statements 629 Asian Options / Barrier Options / Lookback
The Income Statement / The Balance Sheet / Options / Currency-Translated Options / Digital
The Statement of Cash Flows Options
19.2 Measuring Firm Performance 634 End of Chapter Material 703–714
19.3 Profitability Measures 635
Return on Assets, ROA / Return on Capital, ROC / Chapter 21
Return on Equity, ROE / Financial Leverage and ROE /
Economic Value Added Option Valuation 715
19.4 Ratio Analysis 639 21.1 Option Valuation: Introduction 715
Decomposition of ROE / Turnover and Other Asset Intrinsic and Time Values / Determinants of Option
Utilization Ratios / Liquidity Ratios / Market Price Values
Ratios: Growth versus Value / Choosing a Benchmark 21.2 Restrictions on Option Values 719
19.5 An Illustration of Financial Statement Analysis 650
Restrictions on the Value of a Call Option /
19.6 Comparability Problems 652 Early Exercise and Dividends / Early Exercise of
Inventor y Valuation / Depreciation / Inflation and American Puts
Interest Expense / Fair Value Accounting / Quality of 21.3 Binomial Option Pricing 722
Earnings and Accounting Practices / International
Two-State Option Pricing / Generalizing the
Accounting Conventions
Two-State Approach / Making the Valuation Model
19.7 Value Investing: The Graham Technique 658 Practical
End of Chapter Material 659–672 21.4 Black-Scholes Option Valuation 730
The Black-Scholes Formula / Implied Volatility /
PART VI Dividends and Call Option Valuation / Put

Options, Futures, and Other Option Valuation / Dividends and Put Option
Valuation

Derivatives 673 21.5 Using the Black-Scholes Formula 738

Hedge Ratios and the Black-Scholes Formula /
Chapter 20 Portfolio Insurance / Option Pricing and the
Financial Crisis / Option Pricing and Portfolio
Options Markets: Introduction 673 Theory / Hedging Bets on Mispriced
20.1 The Option Contract 673 Options
Options Trading / American versus European 21.6 Empirical Evidence on Option Pricing 750
Options / Adjustments in Option Contract Terms / End of Chapter Material 751–762

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Chapter 22 Risk-Adjusted Performance Measures / The Sharpe Ratio

for Overall Portfolios
Futures Markets 763
 The M2 Measure and the Sharpe Ratio
22.1 The Futures Contract 763 The Treynor Ratio / The Information Ratio / The Role
The Basics of Futures Contracts / Existing Contracts of Alpha in Performance Measures / Implementing
22.2 Trading Mechanics 769 Performance Measurement: An Example / Realized
The Clearinghouse and Open Interest / The Margin Account Returns versus Expected Returns / Selection Bias and
and Marking to Market / The Convergence Property / Cash Portfolio Evaluation
versus Actual Delivery / Regulations / Taxation 24.2 Style Analysis 839
22.3 Futures Markets Strategies 773 24.3 Performance Measurement with Changing Portfolio
Hedging and Speculation / Basis Risk and Hedging Composition 841
22.4 Futures Prices 777 Performance Manipulation and the Morningstar Risk-
The Spot-Futures Parity Theorem / Spreads / Forward Adjusted Rating
versus Futures Pricing
24.4 Market Timing 845
22.5 Futures Prices versus Expected Spot Prices 784
The Potential Value of Market Timing / Valuing Market
Expectations Hypothesis / Normal Backwardation /
Timing as a Call Option / The Value of Imperfect
Contango / Modern Portfolio Theory
Forecasting
End of Chapter Material 786–790
24.5 Performance Attribution Procedures 850
Chapter 23 Asset Allocation Decisions / Sector and Security Selection
Decisions / Summing Up Component Contributions
Futures, Swaps, and Risk Management 791
End of Chapter Material 855–866
23.1 Foreign Exchange Futures 791
The Markets / Interest Rate Parity / Direct versus Indirect Chapter 25
Quotes / Using Futures to Manage Exchange Rate Risk
International Diversification 867
23.2 Stock-Index Futures 799
The Contracts / Creating Synthetic Stock Positions: An 25.1 Global Markets for Equities 867
Asset Allocation Tool / Index Arbitrage / Using Index Developed Countries / Emerging Markets / Market
Futures to Hedge Market Risk Capitalization and GDP / Home-Country Bias
23.3 Interest Rate Futures 804 25.2 Exchange Rate Risk and International
Hedging Interest Rate Risk Diversification 871
23.4 Swaps 806 Exchange Rate Risk / Investment Risk in International
Swaps and Balance Sheet Restructuring / The Swap Markets / International Diversification / Are Benefits
Dealer / Other Interest Rate Contracts / Swap Pricing / from International Diversification Preserved in
Credit Risk in the Swap Market / Credit Default Swaps Bear Markets?
23.5 Commodity Futures Pricing 813 25.3 Political Risk 882
Pricing with Storage Costs / Discounted Cash Flow 25.4 International Investing and Performance
Analysis for Commodity Futures Attribution 885
End of Chapter Material 817–826 Constructing a Benchmark Portfolio of Foreign Assets /
Performance Attribution
PART VII End of Chapter Material 889–894

Applied Portfolio Chapter 26

Management 827 Alternative Assets 895
26.1 Alternative Assets 896
Chapter 24
The Alternative Asset Universe
Portfolio Performance Evaluation 827  Hedge Funds / Private Equity / Real Assets / Structured
24.1 The Conventional Theory of Performance Products
Evaluation 827 Alternative Assets versus Traditional Assets
Average Rates of Return / Time-Weighted Returns versus  Transparency / Investors / Investment Strategies /
Dollar-Weighted Returns / Adjusting Returns for Risk / Liquidity / Investment Horizon / Fee Structure

xiv
 Contents

Role of Alternative Assets in Diversified Portfolios / 27.4 Treynor-Black versus Black-Litterman: Complements,
Growth of Alternative Assets Not Substitutes 951
26.2 Hedge Funds 900 The BL Model as Icing on the TB Cake / Why Not
Hedge Fund Strategies / Statistical Arbitrage / High- Replace the Entire TB Cake with the BL Icing?
Frequency Strategies / 27.5 The Value of Active Management 953
 Electronic News Feeds / Cross-Market Arbitrage / A Model for the Estimation of Potential Fees /
Electronic Market Making / Electronic “Front Running” Results from the Distribution of Actual Information
Portable Alpha Ratios / Results from Distribution of Actual Forecasts
26.3 Venture Capital and Angel Investors 905 27.6 Concluding Remarks on Active Management 955
Angel Investors / Venture Capital / Venture Capital and End of Chapter Material 955–956
Investment Stages / Fund Life Cycle / Private Equity Appendix A: Forecasts and Realizations of Alpha 956
Valuation / Venture Syndication / Venture Capital and Appendix B: The General Black-Litterman Model 957
Innovation
26.4 Leveraged Buyout Funds 913 Chapter 28
Leveraged Buyout Firm Structure / The Deal / Exits / Investment Policy and the Framework of the
Leveraged Buyouts and Innovation CFA Institute 959
26.5 Performance Measurement for Alternative
Investment Funds 916 28.1 The Investment Management Process 960

Liquidity and Performance 28.2 Investor Objectives 962

 Liquidity and Hedge Fund Performance / Liquidity and Individual Investors

Private Equity
Survivorship Bias and Backfill Bias / Tail Events /
Historical Hedge Fund Performance / Style Analysis /
Historical Performance of Private Equity
Grandstanding / Industry Specialization
Efficient Frontier
 Personal Trusts / Mutual Funds / Pension Funds /
Endowment Funds / Life Insurance Companies /
Non–Life Insurance Companies / Banks
28.3 Investor Constraints 966
Liquidity / Investment Horizon / Regulations / Tax
Considerations / Unique Needs

26.6 Fee Structure in Alternative Investments 926 28.4 Policy Statements 969

Incentive Fees / Private Equity Chasing Waterfalls / Sample Policy Statements for Individual Investors
Funds of Funds 28.5 Asset Allocation 973
End of Chapter Material 928–934 Top-Down Asset Allocation for Institutional Investors /
Monitoring and Revising the Portfolio
28.6 Managing Portfolios of Individual Investors 975
Chapter 27
Investment in Residence / Saving for Retirement and
The Theory of Active Portfolio the Assumption of Risk / Retirement Planning Models /
Management 935 Target Date Funds / Tax Sheltering and Asset Allocation
27.1 Optimal Portfolios and Alpha Values 935  The Tax-Deferral Option / Tax-Protected Retirement
Plans / Deferred Annuities / Variable and Universal
Forecasts of Alpha Values and Extreme Portfolio Weights /
Life Insurance
Restriction of Tracking Risk
28.7 Pension Funds 981
27.2 The Treynor-Black Model and Forecast
Precision 942 Defined Contribution Plans / Defined Benefit Plans /
Pension Investment Strategies
Adjusting Forecasts for the Precision of Alpha /
Distribution of Alpha Values / Organizational Structure Investing in Equities
and Performance End of Chapter Material 984–994
27.3 The Black-Litterman Model 946
Black-Litterman Asset Allocation Decision / Step 1: The REFERENCES TO CFA PROBLEMS 995
Covariance Matrix from Historical Data / Step 2:
GLOSSARY G-1
Determination of a Baseline Forecast / Step 3:
Integrating the Manager’s Private Views / Step 4: NAME INDEX I
Revised (Posterior) Expectations / Step 5: Portfolio SUBJECT INDEX I-4
Optimization NOTATION, FORMULAS F-1

xv
 Preface
T
he past three decades witnessed rapid and pro-
found change in the investments industry as well
as a financial crisis of historic magnitude. The vast
expansion of financial markets during this period was due
in part to innovations in securitization and credit enhance-
ment that gave birth to new trading strategies. 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 of 2008–2009 also was rooted in
the cracks of these developments. Many of the innovations
in security design facilitated high leverage and an exagger-
ated notion of the efficacy of risk transfer strategies. This
engendered complacency about risk that was coupled with
relaxation of regulation as well as reduced transparency,
masking the precarious condition of many big players in
the system. Of necessity, our text has evolved along with
financial markets and their influence on world events.
Investments, Thirteenth Edition, is intended primar-
ily as a textbook for courses in investment analysis. Our
guiding principle has been to present the material in a
framework that is organized by a central core of consistent
fundamental principles. We attempt to strip away unnec-
essary mathematical and technical detail, and we have
concentrated on providing the intuition that may guide
students and practitioners as they confront new ideas and
challenges in their professional lives.
This text will introduce you to major issues currently of
concern to all investors. It can give you the skills to assess
watershed current issues and debates covered by both the pop-
ular media and more-specialized finance journals. Whether
you plan to become an investment professional, or simply a
sophisticated individual investor, you will find these skills
essential, especially in today’s rapidly evolving environment.
Our primary goal is to present material of p­ ractical value,
but all three of us have spent our careers as researchers in
financial economics and find virtually all of the material
xvi
in this book to be of great intellectual interest. The capital
asset pricing model, the arbitrage pricing model, the effi-
cient markets hypothesis, the option-­pricing model, and the
other centerpieces of modern financial theory are as much
intellectually engaging subjects as they are of immense
practical importance for the sophisticated investor.
In our effort to link theory to practice, we also have
attempted to make our approach consistent with that of
the CFA Institute. In addition to fostering research in
finance, the CFA Institute administers an education and
certification program to candidates seeking designation
as a Chartered Financial Analyst (CFA). The CFA cur-
riculum represents the consensus of a committee of dis-
tinguished scholars and practitioners regarding the core of
knowledge required by the investment professional.
Many features of this text make it consistent with and
relevant to the CFA curriculum. Questions adapted from
past CFA exams appear at the end of nearly every chapter,
and references 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,
which discusses investors and the investment process,
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 the Thirteenth Edition, we have continued our sys-
tematic presentation of Excel spreadsheets that will allow
you to explore concepts more deeply. These spreadsheets,
available in Connect and on the student resources site
(www.mhhe.com/Bodie13e), provide a taste of the sophis-
ticated analytic tools available to professional investors.
UNDERLYING PHILOSOPHY
While the financial environment is constantly evolving,
many basic principles remain important. We believe that
 Preface
fundamental principles should organize and motivate all
study and that attention to these few central ideas can sim-
plify the study of otherwise difficult material. These prin-
ciples 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 the-
matic, meaning we never offer rules of thumb without refer-
ence 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 observa-
tion is, nevertheless, remarkably powerful in its implica-
tions for the design of investment strategies; as a result, our
discussions of strategy are always guided by the implica-
tions of the efficient 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 behavioral
challenge to the efficient market hypothesis), we hope our
discussions throughout the book convey a good dose of
healthy skepticism concerning much conventional wisdom.
Distinctive Themes
Investments is organized around several important themes:
1. The central theme is the near-informational-efficiency
of well-developed security markets, such as those in the
United States, and the general awareness that competi-
tive 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 competi-
tive security markets, higher expected returns come
only at a price: the need to bear greater investment
risk. However, this notion leaves several questions un-
answered. How should one measure the risk of an as-
set? What should be the quantitative trade-off between
risk (properly measured) and expected return? The ap-
proach 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 implica-
tions of efficient diversification for the proper measure-
ment of risk and the risk–return relationship.
2. This text places great emphasis on asset ­allocation.
We prefer this emphasis for two important r­ easons. First,
it corresponds to the procedure that most i­ ndividuals actu-
ally follow. Typically, you start with all of your money in
xvii
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. S­ econd, 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 broad and deep treatment of
futures, options, and other derivative security
­markets. These markets are both crucial and inte-
gral 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 THIRTEENTH EDITION
The following is a guide to changes in the Thirteenth Edi-
tion. 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.
Chapter 1 The Investment Environment
The chapter addresses recent controversies about stake-
holder capitalism and ESG investing. It also further
expands its treatment of Fintech, cryptocurrencies, and
other digital assets.
Chapter 2 Asset Classes and Financial
Instruments
The chapter addresses changes in markets, most notably
the replacement of LIBOR with new rates such as SOFR.
Chapter 3 How Securities Are Traded
New sections on SPACs, order internalization, and the
GameStop squeeze have been added to the chapter.
Chapter 5 Risk, Return, and the Historical Record
In addition to thorough updating, this chapter has been
extensively reorganized to improve flow and understanding.
Chapter 10 Arbitrage Pricing Theory and Multi-
factor Models of Risk and Return
The discussion of multifactor models has been updated
and expanded, with a focus on the adoption of new vari-
ants such as the Fama-French five-factor model.
Chapter 11 The Efficient Market Hypothesis
The debate on efficient markets has been further devel-
oped. The chapter now includes a discussion of Shiller’s
fads hypothesis, as well as new material on extra-market
risk factors, and a discussion of the challenges posed by
 Preface
data snooping for the interpretation of empirical evidence
on risk and return.
Chapter 12 Behavioral Finance and Technical
Analysis
The material on behavioral finance now includes confir-
mation bias. The section on technical analysis includes a
new discussion of machine learning.
Chapter 13 Empirical Evidence on Security
Returns
This chapter has been extensively rewritten. Older mate-
rial has been replaced with treatments of issues such as
the so-called factor zoo, appropriate criteria for accepting
a new risk factor, and the implications of disaster risk for
the equity risk premium.
Chapter 15 The Term Structure of Interest Rates
Market segmentation is now included as another potential
explanation of the term structure.
Chapter 17 Macroeconomic and Industry Analysis
The discussion of the macroeconomy has been updated to
include lessons learned during the COVID-19 pandemic,
particularly the implications of supply side and supply
chain issues for inflation.
Chapter 23 Futures, Swaps, and Risk
Management
The treatment of interest rate swaps has been updated to
account for the transition away from the LIBOR rate.
Chapter 26 Alternative Assets
This chapter, originally entitled Hedge Funds now has a
wider focus on Alternative Assets. It includes substantial
coverage of private equity, including angel investing, ven-
ture capital, and leveraged buyouts.
Chapter 28 Investment Policy and the Frame-
work of the CFA Institute
This chapter has been substantially reorganized, in par-
ticular, its treatment of tax sheltering and top-down asset
allocation.
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-semester course will
require the instructor to decide which parts to include.
Part One is introductory and contains important institu-
tional material focusing on the financial environment. We
discuss the major players in the financial markets, provide
xviii
an overview of the types of securities traded in those mar-
kets, 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 possi-
ble for instructors to assign term projects early in the course.
These projects might require the student to analyze in detail
a particular group of securities. Many instructors like to
involve their students in some sort of investment game, and
the material in these chapters will facilitate this process.
Parts Two and Three 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 modern portfolio theory in Part
Two, we investigate in Part Three 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 descrip-
tions of risk and the arbitrage pricing theory. Chapter 11
covers the efficient market hypothesis, including its ratio-
nale as well as evidence that supports the hypothesis and
challenges it. Chapter 12 is devoted to the behavioral cri-
tique of market rationality. Finally, we conclude Part Three
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 Four is the first of three parts on security valu-
ation. This part treats fixed-income securities—bond
pricing (Chapter 14), term structure relationships (Chap-
ter 15), and interest-rate risk management (Chapter 16).
Parts Five and Six deal with equity securities and deriva-
tive securities. For a course emphasizing security analysis
and excluding portfolio theory, one may proceed directly
from Part One to Part Four with no loss in continuity.
Finally, Part Seven considers several topics important
for portfolio managers, including performance evaluation,
international diversification, active management, and
practical issues in the process of portfolio management.
This part also contains a chapter on alternative assets,
with an emphasis on hedge funds and private equity.
 Distinctive Features
This book contains several features designed to
Confirming Pages
make it easy for students to understand, ­absorb, and
apply the concepts and techniques presented.
288 PART III Equilibrium in Capital Markets

CONCEPT CHECKS Concept Check 9.2

Data from the last 95 years for the broad U.S. equity market yield the following statistics: average excess return,
A unique feature of this book! These self- 8.9%; standard deviation, 20.3%.
a. To the extent that these averages approximated investor expectations for the period, what must have been
test questions and problems found in the the average coefficient of risk aversion?

body of the text enable the students to b. If the coefficient of risk aversion were actually 3.5, what risk premium would have been consistent with the
market’s historical standard deviation?
Confirming Pages
determine whether they’ve understood
Expected Returns on Individual Securities
the preceding material. Detailed solutions The CAPM is built on the insight that the appropriate risk premium on an asset will be
determined by its contribution to the risk of investors’ overall portfolios. Portfolio risk is
are provided at the end of each chapter. what matters to investors and is what governs the risk premiums they demand.
Remember that in the CAPM, all investors use the same input list, that is, the same esti-
590 PART V Security Analysis mates of expected returns, variances, and covariances, and, therefore, all end up using the
market as their optimal risky portfolio. To calculate the variance of the market portfolio,
we use the bordered covariance matrix with the market portfolio weights, as discussed in
Chapter 7. We highlight GE in this depiction of the n stocks in the market portfolio so that
Example 18.3 The Constant-Growth DDM we can measure the contribution of GE to the risk of the market portfolio.
Recall that we calculate the variance of the portfolio by summing over all the elements
High Flyer Industries has just paid its annual dividend of $3 per share. The dividend is NUMBERED EXAMPLES
of the covariance matrix, first multiplying each element by the portfolio weights from the
row and the column. The contribution of one stock to portfolio variance therefore can be
expected to grow at a constant rate of 8% indefinitely. The beta of High Flyer stock is 1.0, expressed as the sum of all the covariance terms in the column corresponding to the stock,
the risk-free rate is 6%, and the market risk premium is 8%. What is the intrinsic value of the are integrated throughout chapters.
where each covariance is first multiplied by both the stock’s weight from its row and the
stock? What would be your estimate of intrinsic value if you believed that the stock was weight from its column.5
riskier, with a beta of 1.25? Using the worked-out solutions to these
Because a $3 dividend has just been paid and the growth rate of dividends is 8%, the Portfolio
forecast for the year-end dividend is $3 × 1.08 = $3.24. The market capitalization rate (using examples
Weights w 1 as models,
w 2 . . . students
w can
... wlearn
GE n

the CAPM) is 6% + 1.0 × 8% = 14%. Therefore, the value of the stock is

w
w
1

2
how to solve
Cov(R , R )
1
Cov(R , R )
2
1

1
specific
Cov(R , R )
1
Cov(R , R )
2
...
...
2

2
problems
Cov(R , R )
Cov(R , R )
step-by-
...
...
Cov(R , R )
1

2
GE
Cov(R , R )
GE
1

2
n

n
D1 $3.24
.step as well as gain insight into general
.. .. .. .. ..
V0 = _____ = _______ = $54 . . . .
k − g .14 − .08
w Cov(R , R ) Cov(R , R ) ... Cov(R , R ) ... Cov(R , R )
..principles by ... seeing how they are applied
GE GE 1 GE 2 GE GE GE n

If the stock is perceived to be riskier, its value must be lower. At the higher beta, the .. ... ..
. . .
market capitalization rate is 6% + 1.25 × 8% = 16%, and the stock is worth only nw
to answer Cov(R , R )
n 1concrete
Cov(R , R )
n questions.
...2 Cov(R , R ) ... Cov(R , R )
n GE n n

$3.24
_______ = $40.50 Thus, the contribution of GE’s stock to the variance of the market portfolio is
.16 − .08
w GE[w 1Cov(R 1, R GE) + w 2Cov(R 2, R GE) + · · · + w GE Cov(R GE, R GE) + · · ·
(9.3)
+ w nCov(R n , R GE)]
5
An alternative approach would be to measure GE’s contribution to market variance as the sum of the elements
in the row and the column corresponding to GE. In this case, GE’s contribution would be twice the sum in
The constant-growth DDM is valid only when g is less than k. If dividends were Equation 9.3. The approach that we take allocates contributions to portfolio risk among securities in a con-
Confirming Pages
venient manner in that the sum of the contributions of each stock equals the total portfolio variance, whereas
expected to grow forever at a rate faster than k, the value of the stock would be infinite. If the alternative measure of contribution would sum to twice the portfolio variance. This results from a type of
an analyst derives an estimate of g greater than k, that growth rate must be unsustainable double-counting because adding both the rows and the columns for each stock would result in each entry in the
matrix being added twice. Using either approach, GE’s contribution to the variance of the market return would
in the long run. The appropriate valuation model to use in this case is a multistage DDM
WORDS FROM THE
such as those discussed below.
be directly proportional to the covariance of its returns with the market.

What Level of Risk Is Right for You?

WORDS FROM THE STREET

The constant-growth DDM is so widely used by stock market analysts that it is worth
STREET BOXES
exploring some of its implications and limitations. The constant-growth rate DDM implies
No risk, no reward. Most people intuitively understand that they 4. At the end of the month, you find yourself:
that a stock’s value will be greater: have to bear some risk to achieve an acceptable return on their
Short articles and financial coverage
a. Short of cash and impatiently waiting for your next
investment portfolios. paycheck.
1. The larger its expected dividend per share. But how much risk is right for you? If your investments turn b. Not overspending your salary, but not saving very much.
adapted from
2. The lower business
the market periodicals,
capitalization rate, k. such sour, you may put at jeopardy your ability to retire, to pay for
bod12665_ch09_283-314.indd 288
your kid’s college education, or to weather an unexpected
06/07/22
c. With a comfortable surplus of funds to put into
ings account.
01:25 PM
your sav-
need for cash. These worst-case scenarios focus our attention
as The
3. The Wall Street
higher the growth rate ofare
expectedJournal, included
dividends. on how to manage our exposure to uncertainty.
Assessing—and quantifying—risk aversion is, to put it mildly,
5. You are 30 years old and enrolling in your company’s
retirement plan, and you need to allocate your contribu-

Another implication
ingrow
boxes throughout of the constant-growth
the text. The model is that the stock price is expected to
articles difficult. It requires confronting at least these two big questions. tions across 3 funds: a money market account, a bond
fund, and a stock fund. Which of these allocations sounds
First, how much investment risk can you afford to take?
at the same rate as dividends. To see this, suppose Steady State stock is selling at its If you have a steady high-paying job, for example, you have best to you?

are chosen
intrinsic value of for real-world
$57.14, so that V0 = P0.relevance
Then and greater ability to withstand investment losses. Conversely, if
you are close to retirement, you have less ability to adjust your
a. Invest everything in a safe money-market fund.
b. Split your money evenly between the bond fund and

clarity of presentation. P0 = _____

lifestyle in response to bad investment outcomes. stock fund.
D1 Second, you need to think about your personality and c. Put everything into the stock fund, reasoning that by the
k−g decide how much risk you can tolerate. At what point will you
be unable to sleep at night?
time you retire, the year-to-year fluctuations in stock,
returns will have evened out.
To help clients quantify their risk aversion, many financial
Notice that price is proportional to dividends. Therefore, next year, when the dividends firms have designed quizzes to help people determine whether
6. You are a contestant on Let’s Make a Deal, and have just
won $1,000. But you can exchange the winnings for two
paid to Steady State stockholders are expected to be higher by g = 5%, price also should they are conservative, moderate, or aggressive investors.
random payoffs. One is a coin flip with a payoff of $2,500
These quizzes try to get at clients’ attitudes toward risk and
increase by 5%. To confirm this, we can write their capacity to absorb investment losses.
if the coin comes up heads. The other is a flip of two coins
with a payoff of $6,000 if both coins come up heads. What
Here is a sample of the sort of questions that can shed light
will you do?
D2 = $4(1.05) = $4.20 on an investor’s risk tolerance.
a. Keep the $1,000 in cash.

D2 $4.20 MEASURING YOUR RISK TOLERANCE b. Choose the single coin toss.
P1 = _____ = ________ = $60.00 Circle the letter that corresponds to your answer. c. Choose the double coin toss.
k − g .12 − .05 1. The stock market fell by more than 30% in 2008. If you had 7. Suppose you have the opportunity to invest in a start-up
been holding a substantial stock investment in that year, firm. If the firm is successful, you will multiply your invest-
which is 5% higher than the current price of $57.14. To generalize, which of the following would you have done? ment by a factor of ten. But if it fails, you will lose everything.
You think the odds of success are around 20%. How much
a. Sold off the remainder of your investment before it had
D2 D1(1 + g) _____
D1 would you be willing to invest in the start-up?
P1 = _____ = _________ = (1 + g) = P0(1 + g) the chance to fall further.
a. Nothing
k−g k−g k−g b. Stayed the course with neither redemptions nor
purchases. b. 2 months’ salary

c. Bought more stock, reasoning that the market is now c. 6 months’ salary
cheaper and therefore offers better deals. 8. Now imagine that to buy into the start-up you will need to
2. The value of one of the funds in your 401(k) plan (your pri- borrow money. Would you be willing to take out a $10,000
mary source of retirement savings) increased 30% last year. loan to make the investment?
What will you do? a. No
a. Move your funds into a money market account in case b. Maybe
the price gains reverse. c. Yes
b. Sit tight and do nothing.
c. Put more of your assets into that fund, reasoning that its SCORING YOUR RISK TOLERANCE
value is clearly trending upward. For each question, give yourself one point if you answered (a),
bod12665_ch18_583-628.indd 590 06/30/22 10:27 AM
xix 3. How would you describe your non-investment sources of
income (e.g., your salary)?
two points if you answered (b), and three points for a (c). The
higher your total score, the greater is your risk tolerance, or,
a. Highly uncertain equivalently, the lower is your risk aversion.
b. Moderately stable
c. Highly stable
 Confirming Pages
Confirming Pages
EXCEL APPLICATIONS
The Thirteenth Edition features Excel
eXcel APPLICATIONS: Two–Security Model Spreadsheet Applications with Excel513
C H A P T E R 1 6 Managing Bond Portfolios

T he accompanying spreadsheet can be used to analyze

the return and risk of a portfolio of two risky assets. The
Table 7.1. This spreadsheet is available in Connect or through
your course instructor.
questions. A sample spreadsheet is
Duration
model calculates expected return and volatility for varying
weights of each security as well as the optimal risky and mini- Excel Question
presented in the text with an interactive
To measure the effective maturity of a bond making many payments, we average over
version
Frederickavailable
Macaulay called inthis Connect and on the
mum-variance portfolios. Graphs are automatically generated 1. Suppose your target expected rate of return is 11%. 3
for various model inputs. The model allows you to specify a the maturity of each of the bond’s cash flows. average the
a. What is the lowest-volatility portfolio that provides that
target rate of return and solves for optimal complete portfolios duration of the bond. Macaulay’s duration equals the weighted average of the times to
each coupon or principal payment, with student
weights relatedresources
to the “importance”site pay-www.mhhe
of thatat
composed of the risk-free asset and the optimal risky portfo- expected return?
lio. The spreadsheet is constructed using the two-security b. What is the standard deviation of that portfolio?
return data (expressed as decimals, not percentages) from c. What is the composition of that portfolio? ment to the value of the bond. Specifically, the weight applied to each payment time is the
.com/Bodie13e.
proportion of the total value of the bond accounted for by that payment, that is, the present
value of the payment divided by the bond price.
A B C D E F
We define the weight, wt , associated with the cash flow made at time t (denoted CFt) as
1
CF t / (1 + y)t
Asset Allocation Analysis: Risk and Return
2 Expected Standard Correlation
w t = __________
3 Return Deviation Coefficient Covariance Bond price
4 Security 1 0.08 0.12 0.3 0.0072
Expected Return (%)

5 Security 2 0.13 0.2

11
where y is the bond’s yield to maturity. The numerator on the right-hand side of this equa-
6 T-Bill 0.05 0
7 tion is the present value of the cash flow occurring at time t while the denominator is the
8 Weight Weight Expected Standard Reward to value of all the bond’s payments. These weights sum to 1.0 because the sum of the cash
9 Security 1 Security 2 Return Deviation Volatility
10 1 0 0.08000 0.12000 0.25000
5
flows discounted at the yield to maturity equals the bond price.
11 0.9 0.1 0.08500 0.11559 0.30281 Using these values to calculate the weighted average of the times until the receipt of
12 0.8 0.2 0.09000 0.11454 0.34922
13 0.7 0.3 0.09500 0.11696 0.38474
0
0 5 10 15
each
20
of25the 30
bond’s
35
payments, we obtain Macaulay’s duration formula:
14 0.6 0.4 0.10000 0.12264 0.40771 Standard Deviation (%) T
D = ∑ t × wt (16.1)
t=1
Confirming Pages
Spreadsheet 16.1 uses Equation 16.1 to find the durations of an 8% coupon and zero-
1. Specify the return characteristics of all securities (expected returns, variances, coupon bond, each with two years to maturity and yield to maturity of 10%, or 5% per
covariances).
2. Establish the risky portfolio (asset allocation):
a. Calculate the optimal risky portfolio, P (Equation 7.13). A B C D E F G
b. Calculate the properties ofCportfolio
H A P T EPRusing
5 theRisk, Return,determined
and the Historical
in step Record 161
EXCEL EXHIBITS
weights (a) 1 Time until PV of CF Column (C)
and Equations 7.2 and 7.3. 2 Payment (Discount rate times
3. Allocate funds between the risky portfolio and the risk-free asset (capital 3 Period (Years) Cash Flow 5% per period) Weight* Column (F)
allocation):risk-free rate
effective annual rate (EAR) expected shortfall (ES) 4 A. 8% coupon bond 1 0.5 40 38.095 0.0395 0.0197
Selected exhibits are set as Excel
annual percentage ratea. Calculaterisk
(APR) thepremium conditional
fraction of the complete portfolio tail expectation
allocated
KEY TERMS
to portfolio P (the risky 5 2 1.0 40 36.281 0.0376 0.0376
nominal interest rate portfolio)excess
and toreturn (CTE) 7.14).
T-bills (the risk-free asset) (Equation 6 3 1.5 40 34.554 0.0358 0.0537
spreadsheets, and the accompanying
real interest rate
dividend yield
b. Calculaterisk aversion
the lower partial
share of the complete portfolio standard
invested
deviation (LPSD)
in each asset and in 7 4 2.0 1040 855.611 0.8871 1.7741
T-bills. normal distribution 8 Sum: 964.540 1.0000 1.8852
files are available in Connect and on the
scenario analysis skew
mean rate of return Recall that ourkurtosis
two risky assets, the bond and stock
Sortino ratio
lognormal
mutualdistribution
funds, are already diversi-
9
10 B. Zero-coupon 1 0.5 0 0.000 0.0000 0.0000
student resources site at www.mhhe
variance
standard deviation
taildiversification
fied portfolios. The risk
valuereduction
good deal of the risk at risk (VaR)
within each of these portfolios must be credited for a
compared to undiversified single securities. For example,
11 2 1.0 0 0.000 0.0000 0.0000
the standard deviation of the rate of return on an average stock in the last 10 years has 12 3 1.5 0 0.000 0.0000 0.0000
.com/Bodie13e. been about 28% (see Figure 7.2). In contrast, the standard deviation of the S&P 500 in this 13 4 2.0 1000 822.702 1.0000 2.0000
period was considerably lower, around 17%. This is evidence of the importance of diversi- 14 Sum: 822.702 1.0000 2.0000
Arithmetic average of n returns: (r1 + r2 + · · · + rn ) / n KEY EQUATIONS
15
fication within each asset class.
Geometric average of n returns: [(1 + r1) (1 + r2) · · · (1 + rn)]1/n − 1 16 Semiannual int rate: 0.05
17
Continuously compounded rate of return, rcc = ln(1 + Effective annual rate) 215
18 *Weight = Present value of each payment (column E) divided by the bond price.
Expected return: ∑ [prob(Scenario) × Return in scenario]
Spreadsheet 16.1
Variance: ∑[prob(Scenario) × (Deviation from mean in scenario)2]
________ Calculating the duration of two bonds
Standard deviation: √Variance
bod12665_ch07_201-250.indd 215 Column sums
06/07/22subject
01:17 PM to rounding error.
Portfolio risk premium E(rP) − rf
Sharpe ratio: _____________________________ = _________
Standard deviation of excess return σP
3
Frederick Macaulay, Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields,
1 + Nominal return
Real rate of return: ________________ − 1 and Stock Prices in the United States Since 1856 (New York: National Bureau of Economic Research, 1938).
1 + Inflation rate
Real rate of return (continuous compounding): rnominal − Inflation rate

1. The Fisher equation tells us that the real interest rate approximately equals the nominal rate minus
PROBLEM SETS Confirming Pages
PROBLEM SETS
the inflation rate. Suppose the inflation rate increases from 3% to 5%. Does the Fisher equation
imply that this increase will result in a fall in the real rate of interest? Explain. We strongly believe that practice in solving
2. You’ve just stumbled on a new dataset that enables you to compute historical rates of return on
U.S. stocks all the way back to 1880. What are the advantages and disadvantages in using these problems is critical to understanding invest-
data to help estimate the expected rate of return on U.S. stocks over the coming year?
ments, so each chapter provides a good
bod12665_ch16_509-550.indd 513 06/25/22 08:50 AM

3. The Narnian stock market had a rate of return of 45% last year, but the inflation rate was 30%. 308 PART III Equilibrium in Capital Markets
What was the real rate of return to Narnian investors?
4. You have $5,000 to invest for the next year and are considering three alternatives: variety of problems. Select problems and
4. Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%.
a. A money market fund with an average maturity of 30 days offering a current yield of 3% per year.
b. A 1-year savings deposit at a bank offering an interest rate of 4%. algorithmicCompany versions $1are assignable
Discount Store within
Everything $5
c. A 20-year U.S. Treasury bond offering a yield to maturity of 5% per year.
What role does your forecast of future interest rates play in your decisions? Connect. Forecasted return
Standard deviation of returns
12%
8%
11%
10%
5. Use Figure 5.1 in the text to analyze the effect of the following on the level of real interest rates: Beta 1.5 1.0
a. Businesses become more pessimistic about future demand for their products and decide to
reduce their capital spending. What would be the fair return for each company according to the capital asset pricing model (CAPM)?

EXAM PREP QUESTIONS

b. Households are induced to save more because of increased uncertainty about their future
Social Security benefits.
c. The Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in
5. Characterize each company in the previous problem as underpriced, overpriced, or properly priced.
6. What is the expected rate of return for a stock that has a beta of 1.0 if the expected return on the
market is 15%?
order to increase the supply of money. ®
Practice questions for the CFA exams pro- a. 15%.
b. More than 15%.
vided by Kaplan Schweser, A Global Leader c. Cannot be determined without the risk-free rate.

in CFA® Education, are available in selected

7. Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of .6. Which of the follow-
ing statements is most accurate?
a. The expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn,
chapters for additional test practice. Look Inc.
b. The stock of Kaskin, Inc., has more total risk than the stock of Quinn, Inc.
for the Kaplan Schweser logo. Learn more at
bod12665_ch05_125-166.indd 161 06/07/22 01:40 PM
c. The stock of Quinn, Inc., has more systematic risk than that of Kaskin, Inc.
eXcel 8. You are a consultant to a large manufacturing corporation that is considering a project with the
www.schweser.com. Please visit us at
www.mhhe.com/Bodie13e
following net after-tax cash flows (in millions of dollars):
Years from Now After-Tax Cash Flow

0 −40
1–10 15

xx The project’s beta is 1.8.

a. Assuming that rf = 8% and E(rM) = 16%, what is the net present value of the project?
b. What is the highest possible beta estimate for the project before its NPV becomes negative?
9. Consider the following table, which gives a security analyst’s expected return on two stocks in
two particular scenarios for the rate of return on the market:
 expected rate of return?
c. In what sense does the discount bond offer “implicit call protection”?
31. A newly issued bond pays its coupons once annually. Its coupon rate is 5%, its maturity is
20 years, and its yield to maturity is 8%.
a. Find the holding-period return for a 1-year investment period if the bond is selling at a yield
to maturity of 7% by the end of the year.
b. If you sell the bond after one year, what taxes will you owe if the tax rate on interest income
is 40% and the tax rate on capital gains income is 30%? The bond is subject to original-issue-
discount tax treatment.
c. What is the after-tax holding-period return on the bond?
d. Find the realized compound yield before taxes for a 2-year holding period, assuming that
(i) you sell the bond after two years, (ii) the bond yield is 7% at the end of the second year,
and (iii) the coupon can be reinvested for one year at a 3% interest rate.
e. Use the tax rates in part (b) to compute the after-tax 2-year realized compound yield. Remem-
ber to take account of OID tax rules.

CFA PROBLEMS 1. Leaf Products may issue a 10-year maturity fixed-income security, which might include a sinking
fund provision and either refunding or call protection.

We provide several questions adapted a. Describe a sinking fund provision.

b. Explain the impact of a sinking fund provision on:

for this text from past CFA examinations i. The expected average life of the proposed security.
ii. Total principal and interest payments over the life of the proposed security.

in applicable chapters. These questions c. From the investor’s point of view, explain the rationale for demanding a sinking fund provision.
2. Bonds of Zello Corporation with a par value of $1,000 sell for $960, mature in five years, and

represent the kinds of questions that have a 7% annual coupon rate paid semiannually.
a. Calculate the:

professionals in the field believe are i. Current yield.

ii. Yield to maturity to the nearest whole percent (i.e., 3%, 4%, 5%, etc.).

relevant to the “real world.” Located at iii. Realized compound yield for an investor with a 3-year holding period and a reinvestment
rate of 6% over the period. At the end of three years, the 7% coupon bonds with two years
remaining will sell to yield 7%.
the back of the book is a listing of each b. Cite one major shortcoming for each of the following fixed-income yield measures:
i. Current yield.
CFA question and the level and year ii. Yield to maturity.
iii. Realized compound yield.
of the CFA exam it was included in for 3. On May 30, 2023, Janice Kerr is considering one of the newly issued 10-year AAA corporate
bonds shown in the following exhibit.
easy reference. Description Coupon Price Callable Call Price
Sentinal, due May 30, 2033 4.00% 100 Noncallable NA
Colina, due May 30, 2033 4.20% 100 Currently callable Confirming
102 Pages

CHAPTER 3 How Securities Are Traded 95

bod12665_ch14_439-480.indd 478 06/20/22 10:49 AM

8. Consider the following limit-order book for FinTrade stock. The last trade in the stock occurred
at a price of $50.

Limit Buy Orders Limit Sell Orders

Price Shares Price Shares

EXCEL PROBLEMS $49.75

49.50
500
800
$50.25
51.50
100
100
49.25 500 54.75 300
Selected chapters contain problems, 49.00 200 58.25 100
48.50 600
denoted by an icon, specifically linked to
a. If a market buy order for 100 shares comes in, at what price will it be filled?
Excel templates that are available in Con- b. At what price would the next market buy order be filled?
c. If you were a security dealer, would you want to increase or decrease your inventory of this
nect and on the student resource site at stock?
9. You are bullish on Telecom stock. The current market price is $50 per share, and you have eXcel
www.mhhe.com/Bodie13e. $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest
rate of 8% per year and invest $10,000 in the stock.
Please visit us at
www.mhhe.com/Bodie13e

a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next
year? The stock currently pays no dividends.
b. How far does the price of Telecom stock have to fall for you to get a margin call if the main-
tenance margin is 30%? Assume the price fall happens immediately.
10. You are bearish on Telecom and decide to sell short 100 shares at the current market price of eXcel
$50 per share. Please visit us at
www.mhhe.com/Bodie13e
a. How much in cash or securities must you put into your brokerage account if the broker’s
initial margin requirement is 50% of the value of the short position?
b. How high can the price of the stock go before you get a margin call if the maintenance
margin is 30% of the value of the short position?
11. Suppose that Xtel currently is selling at $20 per share. You buy 1,000 shares using $15,000 of eXcel
Confirming Pages
your own money, borrowing the remainder of the purchase price from your broker. The rate on Please visit us at
the margin loan is 8%. www.mhhe.com/Bodie13e

a. What is the percentage increase in the net worth of your brokerage account if the price of
Xtel immediately changes to: (i) $22; (ii) $20; (iii) $18? What is the relationship between
your percentage return and the percentage change in the price of Xtel?
b. If the maintenance margin is 25%, how low can Xtel’s price fall before you get a
CHAPTER 5 Risk, Return, and the Historical Record margin
165 call?
c. How would your answer to (b) change if you had financed the initial purchase with only
$10,000 of your own money?
E-INVESTMENTS EXERCISES
1. The OECD regularly publishes its economic outlook for the G20 countries as well as the
E-INVESTMENTS BOXES
d. What is the rate of return on your margined position (assuming again that you invest $15,000
of your own money) if Xtel is selling after 1 year at: (i) $22; (ii) $20; (iii) $18? What is the
relationship between your percentage return and the percentage change in the price of Xtel?
world as a whole. You can find a recent report at www.oecd.org/economic-outlook. What is
the forecast for U.S. inflation for the next year?
Assume that Xtel pays no dividends. These exercises provide students with
e. Continue to assume that a year has passed. How low can Xtel’s price fall before you get a
2. What is the one-year nominal interest rate on 1-year Treasury securities? You can find this at
the St. Louis Fed data site fred.stlouisfed.org.
margin call?
simple activities to enhance their experi-
3. What is the expected real rate based on your answers to (1) and (2)?
4. What is the real rate of interest on one-year inflation-protected T-bonds (TIPS)? You can also ence using the Internet. Easy-to-follow
find this at the St. Louis Fed site, or from the online version of The Wall Street Journal, online.
wsj.com. Look for the tab for Markets, then Market Data. instructions and questions are presented so
5. Is the value for the expected real rate that you found in (3) consistent with the value you found
in (4)? students can utilize what they have learned
6. How does the current real rate compare to its historical average?
in class and apply it to today’s data-driven
world.

bod12665_ch03_061-098.indd 95 06/06/22 08:58 AM

SOLUTIONS TO CONCEPT CHECKS
1. a. EAR = (1 + .01)12 − 1 = .1268 = 12.68%
b. EAR = e.12 − 1 = .1275 = 12.75%
Choose the continuously compounded rate for its higher EAR.
2. a. 1 + rnom = (1 + rreal )(1 + i ) = (1.03)(1.08) = 1.1124
rnom = 11.24%
b. 1 + rnom = (1.03)(1.10) = 1.133
rnom = 13.3%
3. Number of bonds bought is 27,000/900 = 30

Interest Rates Probability Year-End Bond Price HPR End-of-Year Value xxi
Higher 0.2 $850 (75 + 850)/900 − 1 = 0.0278 (75 + 850)30 = $27,750
Unchanged 0.5 915 0.1000 $29,700
Lower 0.3 985 0.1778 $31,800
Expected rate of return 0.1089
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xxiv
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 Acknowledgments

Throughout the development of this text, James Cotter Jeremy Goh

experienced instructors have provided crit- Wake Forest University Washington University
ical feedback and suggestions for improve- L. Michael Couvillion Richard Grayson
ment. These individuals deserve a special Plymouth State University Loyola College
thanks for their valuable insights and Anna Craig John M. Griffin
contributions. The following instructors Emory University Arizona State University
played a vital role in the development of Elton Daal Weiyu Guo
this and previous editions of Investments: University of New Orleans University of Nebraska at Omaha
J. Amanda Adkisson David C. Distad Mahmoud Haddad
Texas A&M University University of California at Berkeley Wayne State University
Sandro Andrade Craig Dunbar Greg Hallman
University of Miami at Coral Gables University of Western Ontario University of Texas at Austin
Tor-Erik Bakke David Durr Robert G. Hansen
University of Wisconsin Murray State University Dartmouth College
Richard J. Bauer Jr. Bjorn Eaker Joel Hasbrouck
St. Mary’s University Duke University New York University
Scott Besley John Earl Andrea Heuson
University of Florida University of Richmond University of Miami
John Binder Michael C. Ehrhardt Eric Higgins
University of Illinois at Chicago University of Tennessee at Knoxville Drexel University
Paul Bolster Venkat Eleswarapu Shalom J. Hochman
Northwestern University Southern Methodist University University of Houston
Phillip Braun David Ellis Stephen Huffman
University of Chicago Babson College University of Wisconsin at Oshkosh
Leo Chan Andrew Ellul Eric Hughson
Delaware State University Indiana University University of Colorado
Charles Chang John Farlin Delroy Hunter
Cornell University Ohio Dominican University University of South Florida
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Ludwig Chincarini James Forjan George Jiang
Pomona College York College of Pennsylvania University of Arizona
Stephen Ciccone David Gallagher Richard D. Johnson
University of New Hampshire University of Technology, Sydney Colorado State University

xxvi
 Acknowledgments

Susan D. Jordan Dimitris Papanikolaou Ahmad Sohrabian

University of Kentucky Northwestern University California State Polytechnic
G. Andrew Karolyi Dilip Patro University–Pomona
Ohio State University Rutgers University Eileen St. Pierre
Ajay Khorana Robert Pavlik University of Northern Colorado
Georgia Institute of Technology Southwest Texas State Laura T. Starks
Anna Kovalenko Marianne Plunkert University of Texas
Virginia Tech University University of Colorado at Denver Mick Swartz
Josef Lakonishok Jeffrey Pontiff University of Southern California
University of Illinois at Champaign/Urbana Boston College Manuel Tarrazo
Malek Lashgari Andrew Prevost University of San Francisco
University of Hartford Ohio University Steve Thorley
Dennis Lasser Herbert Quigley Brigham Young University
Binghamton SUNY University of the District of Ashish Tiwari
Hongbok Lee Columbia University of Iowa
Western Illinois University Nicholas Racculia Jack Treynor
Bruce Lehmann Saint Vincent College Treynor Capital Management
University of California at San Diego Murli Rajan Charles A. Trzincka
Jack Li University of Scranton SUNY Buffalo
Northeastern University Speima Rao Yiuman Tse
Larry Lockwood University of Southwestern Louisiana Binghamton SUNY
Texas Christian University Rathin Rathinasamy Joe Ueng
Christopher K. Ma Ball State University University of St. Thomas
Texas Tech University William Reese Gopala Vasuderan
Anil K. Makhija Tulane University Suffolk University
University of Pittsburgh Craig Rennie Joseph Vu
Davinder Malhotra University of Arkansas DePaul University
Philadelphia University Maurico Rodriquez Qinghai Wang
Steven Mann Texas Christian University Georgia Institute of Technology
University of South Carolina Leonard Rosenthal Richard Warr
Deryl W. Martin Bentley College North Carolina State University
Tennessee Technical University Anthony Sanders Simon Wheatley
Jean Masson The Ohio State University University of Chicago
University of Ottawa Gary Sanger Marilyn K. Wiley
Ronald May Louisiana State University Florida Atlantic University
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Rick Meyer University of Arizona University of Denver
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University of Texas at Arlington University of New Hampshire Hofstra University

xxvii

For granting us permission to include
many of its examination questions in the
text, we are grateful to the CFA Institute.
In addition, we would like to thank
Nicholas Racculia, whose authoring
efforts on Chapter 26 as well as our Con-
nect online content will greatly assist both
students and instructors.
Acknowledgments
Much credit is due to the devel-
opment and production team at
McGraw Hill Education: our special
thanks go to Allison McCabe-Carroll,
Senior Product Developer; Jeni ­McAtee,
Core Project Manager; and George
Theofanopoulos, Assessment Project
Manager.
xxviii
Finally, we thank Judy, Hava, and
Sheryl, who contribute to the book with
their support and understanding.
Zvi Bodie
Alex Kane
Alan J. Marcus

The Investment
Environment
AN INVESTMENT IS the current commitment
of money or other resources in the expecta-
tion of reaping future benefits. For example,
you might purchase shares of stock anticipat-
ing that the future proceeds will justify both the
time your money is tied up as well as the risk of
the investment. The time you will spend study-
ing this text (not to mention its cost) also is an
investment. You are forgoing either current lei-
sure or the income you could be earning at a job
in the expectation that your future career will be
sufficiently enhanced to justify this commitment
of time and effort. While these two investments
differ in many ways, they share one key attribute
that is central to all investments: You sacrifice
something of value now, expecting to reap the
benefits later.
This text can help you become an informed
practitioner of investments. We will focus on
investments in securities such as stocks, bonds,
or derivatives contracts, but much of what we
discuss will be useful in the analysis of any type
of investment. The text will provide you with
background in the organization of various secu-
rities markets; will survey the valuation and
risk management principles useful in particular
markets, such as those for bonds or stocks; and
will introduce you to the principles of portfolio
construction.
(continued)
1
CHAPTER
PART I
Broadly speaking, this chapter addresses sev-
eral topics that will provide perspective for the
material that is to come later. First, before delving
into the topic of “investments,” we consider the
role of financial assets in the economy. We dis-
cuss the relationship between securities and the
“real” assets that actually produce goods and ser-
vices for consumers, and we consider why finan-
cial assets are important to the functioning of a
developed economy.
Given this background, we then take a first
look at the types of decisions that confront inves-
tors as they assemble a portfolio of assets. These
investment decisions are made in an environment
where higher returns usually can be obtained only
at the price of greater risk and in which it is rare to
find assets that are so mispriced as to be obvious
­bargains. These themes—the risk–return trade-off
and the efficient pricing of financial assets—are
central to the investment process, so it is worth
pausing for a brief discussion of their implications
as we begin the text. These implications will be
fleshed out in much greater detail in later chapters.
We provide an overview of the organization of
security markets as well as its key participants.
Finally, we discuss the financial crisis that began
playing out in 2007 and peaked in 2008. The
crisis dramatically illustrated the c­onnections
between the financial system and the “real”
1
(concluded)

side of the economy. We look at the origins of about systemic risk. We close the chapter with an
the crisis and the lessons that may be drawn ­overview of the remainder of the text.

1.1 Real Assets versus Financial Assets

The material wealth of a society is ultimately determined by the productive capacity of its
economy, that is, the goods and services its members can create. This capacity is a function
of the real assets of the economy: the land, buildings, machines, and knowledge that can
be used to produce goods and services.
In contrast to real assets are financial assets such as stocks and bonds. Such ­securities
historically were no more than sheets of paper (and today, are far more likely to be,
­computer entries), and they do not contribute directly to the productive capacity of the
economy. Instead, these assets are the means by which individuals in well-developed econ-
omies hold their claims on real assets. Financial assets are claims to the income generated
by real assets (or claims on income from the government). If we cannot own our own auto
plant (a real asset), we can still buy shares in Ford or Toyota (financial assets) and thereby
share in the income derived from the production of automobiles.
While real assets generate net income to the economy, financial assets simply define the
allocation of income or wealth among investors. When investors buy securities issued by
companies, the firms use the money so raised to pay for real assets, such as plant, equip-
ment, technology, or inventory. So investors’ returns ultimately come from the income
produced by the real assets that were financed by the issuance of those securities.
The distinction between real and financial assets is appar-
Concept Check 1.1 ent when we compare the balance sheet of U.S. households,
shown in Table 1.1, with the composition of national wealth
Are the following assets real or financial?
in the United States, shown in Table 1.2. Household wealth
a. Patents includes financial assets such as bank accounts, corporate
b. Lease obligations stock, or bonds. However, these securities, which are finan-
c. Customer goodwill
cial assets of households, are ­liabilities of the issuers of the
securities. For example, a bond that you treat as an asset
d. A college education
because it gives you a claim on interest income and repay-
e. A $5 bill ment of principal from Toyota is a liability of Toyota, which
is obligated to make these p­ ayments. Your asset is Toyota’s
liability. Therefore, when we aggregate over all balance sheets, these claims cancel out,
leaving only real assets as the net wealth of the economy. National wealth consists of struc-
tures, equipment, inventories of goods, and land.1

1
You might wonder why real assets held by households in Table 1.1 amount to $44,599 billion, while total real
assets in the domestic economy (Table 1.2) are far larger, at $86,282 billion. A big part of the difference reflects
the fact that real assets held by firms, for example, property, plant, and equipment, are included as financial
assets of the household sector, specifically through the value of corporate equity and other stock market invest-
ments. Also, Table 1.2 includes assets of noncorporate businesses. Finally, there are some differences in valuation
­methods. For example, equity and stock investments in Table 1.1 are measured by market value, whereas plant
and equipment in Table 1.2 are valued at replacement cost.

2
 CHAPTER 1 The Investment Environment 3

Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total

Real assets Liabilities

Real estate $37,558 24.4% Mortgages $11,331 7.4%
Consumer durables 6362 4.1% Consumer credit 4,163 2.7%
Other 679 0.4% Bank and other loans 1,125 0.7%
   Total real assets $44,599 28.9% Other 624 0.4%
Total liabilities $17,244 11.2%
Financial assets
Deposits and money market shares $17,374 11.3%
Life insurance reserves 1,854 1.2%
Pension reserves 29,876 19.4%
Corporate equity 28,285 18.3%
Equity in noncorp. business 13,114 8.5%
Mutual fund shares 11,661 7.6%
Debt securities 5,772 3.7%
Other 1,626 1.1%
  Total financial assets $109,562 71.1% Net worth 136,917 88.8%
   TOTAL $154,161 100.0% $154,161 100.0%

Table 1.1
Balance sheet of U.S. households
Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2021.

Table 1.2
Assets $ Billion
Domestic net worth
Commercial real estate $20,842.9
Residential real estate 45,816.3
Equipment & intellectual property 10,316.2
Inventories 2,944.5
Consumer durables 6,361.9
TOTAL $86,282

Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the
Federal Reserve System, June 2021.

We will focus almost exclusively on financial assets. But keep in mind that the ­successes
or failures of these financial assets ultimately depend on the performance of the underlying
real assets.

1.2 Financial Assets

It is common to distinguish among three broad types of financial assets: fixed income,
equity, and derivatives. Fixed-income or debt securities promise either a fixed stream of
income or a stream of income determined by a specified formula. For example, a corporate
4 PART I Introduction

bond typically promises the bondholder a fixed amount of interest each year. Other so-
called floating-rate bonds promise payments that depend on current i­nterest rates. For
example, a bond may pay an interest rate fixed at 2 percentage points above the rate paid
on U.S. ­Treasury bills. Unless the borrower is declared bankrupt, the payments on these
securities are either fixed or determined by formula. For this reason, the investment
performance of debt securities typically is least closely tied to the financial condition of
the issuer.
Fixed-income securities come in a tremendous variety of maturities and payment
­provisions. At one extreme, money market securities are short term, highly marketable, and
generally of very low risk, for example, U.S. Treasury bills or bank certificates of deposit
(CDs). In contrast, the fixed-income capital market includes long-term securities such as
Treasury bonds, as well as bonds issued by federal agencies, state and local municipalities,
and corporations. These bonds range from very safe in terms of default risk (e.g., Treasury
securities) to relatively risky (e.g., high-yield or “junk” bonds). They also are designed
with extremely diverse provisions regarding payments provided to the investor and protec-
tion against the bankruptcy of the issuer. We will take a first look at these securities in
Chapter 2 and undertake a more detailed analysis of the debt market in Part Four.
Unlike debt securities, common stock, or equity, represents an ownership share in the
corporation. Equityholders are not promised any particular payment. They receive any
dividends the firm may pay and have prorated ownership in the real assets of the firm. If
the firm is successful, the value of equity will increase; if not, it will decrease. The per-
formance of equity investments, therefore, is tied directly to the success of the firm and its
real assets. For this reason, equity investments tend to be riskier than investments in debt
securities. Equity markets and equity valuation are the topics of Part Five.
Finally, derivative securities such as options and futures contracts provide payoffs that
are determined by the prices of other assets such as bond or stock prices. For example, a
call option on a share of Intel stock might turn out to be worthless if Intel’s share price
remains below a threshold or “exercise” price such as $50 a share, but it can be quite
valuable if the stock price rises above that level.2 Derivative securities are so named
because their values derive from the prices of other assets. For example, the value of the
call option will depend on the price of Intel stock. Other important derivative securities are
futures and swap contracts. We will treat these in Part Six.
Derivatives have become an integral part of the investment environment. One use of
derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties.
This is done successfully every day, and the use of these securities for risk management is
so commonplace that the multitrillion-dollar market in derivative assets is routinely taken
for granted. Derivatives also can be used to take highly speculative positions, however.
Every so often, one of these positions blows up, resulting in well-publicized losses of
hundreds of millions of dollars. While these losses attract considerable attention, they are
in fact the exception to the more common use of such securities as risk management tools.
Derivatives will continue to play an important role in portfolio construction and the
financial system. We will return to this topic later in the text.
Investors and corporations regularly encounter other financial markets as well. Firms
engaged in international trade regularly transfer money back and forth between dollars
and other currencies. In London alone, over $2 trillion of currency is traded each day and
worldwide trading volume exceeds $6 trillion.
2
A call option is the right to buy a share of stock at a given exercise price on or before the option’s expiration
date. If the market price of Intel remains below $50 a share, the right to buy for $50 will turn out to be valueless.
If the share price rises above $50 before the option expires, however, the option can be exercised to obtain the
share for only $50.
 CHAPTER 1 The Investment Environment 5

Investors also might invest directly in some real assets. For example, dozens of
commodities are traded on exchanges such as the New York Mercantile Exchange or the
Chicago Board of Trade. You can buy or sell corn, wheat, natural gas, gold, silver, and so on.
Commodity and derivative markets allow firms to adjust their exposure to various
business risks. For example, a construction firm may lock in the price of copper by buying
copper futures contracts, thus eliminating the risk of a jump in the price of its raw materi-
als. Wherever there is uncertainty, investors may be interested in trading, either to specu-
late or to lay off their risks, and a market may arise to meet that demand.

1.3 Financial Markets and the Economy

We stated earlier that real assets determine the wealth of an economy, while financial
assets merely represent claims on real assets. Nevertheless, financial assets and the mar-
kets in which they trade play several crucial roles in developed economies. Financial assets
allow us to make the most of the economy’s real assets.

The Informational Role of Financial Markets

Stock prices reflect investors’ collective assessment of a firm’s current performance and
future prospects. When the market is more optimistic about the firm, its share price will
rise. That higher price makes it easier for the firm to raise capital and therefore encour-
ages investment. In this manner, stock prices play a major role in the allocation of capital
in market economies, directing it to the firms and applications with the greatest perceived
potential. For example, in 2021, big investors poured huge investments into startup firms
focusing on new battery technologies that could store energy created by renewables such
as wind or solar power.3 The prospect of big profits if this technology pans out prompted
investors to allocate their funds toward these ventures. This dynamic was a good example
of market incentives directing capital to applications where there is the prospect of a large
payoff.
Do capital markets actually channel resources to the most efficient use? At times,
they appear to fail miserably. Companies or whole industries can be “hot” for a period of
time (think about the dot-com bubble that peaked and then collapsed in 2000), attract a
large flow of investor capital, and then fail after only a few years.
The process seems highly wasteful. But we need to be careful about our standard of
efficiency. No one knows with certainty which ventures will succeed and which will fail.
It is therefore unreasonable to expect that markets will never make mistakes. The stock
market encourages allocation of capital to those firms that appear at the time to have the
best prospects. Many smart, well-trained, and well-paid professionals analyze the pros-
pects of firms whose shares trade on the stock market. Stock prices reflect their collective
judgment.
You may well be skeptical about resource allocation through markets. But if you are,
take a moment to think about the alternatives. Would a central planner make fewer mis-
takes? Would you prefer that Congress make these decisions? To paraphrase Winston
Churchill’s comment about democracy, markets may be the worst way to allocate capital
except for all the others that have been tried.

3
Scott Patterson, “Investors Hunt for Battery Advances,” The Wall Street Journal, September 10, 2021, p. B1.
6 PART I Introduction

Consumption Timing
Some individuals are earning more than they currently wish to spend. Others, for example,
retirees, spend more than they currently earn. How can you shift your purchasing power
from high-earnings to low-earnings periods of life? One way is to “store” your wealth in
financial assets. In high-earnings periods, you can invest your savings in financial assets
such as stocks and bonds. In low-earnings periods, you can sell these assets to provide
funds for your consumption needs. By so doing, you can “shift” your consumption over
the course of your lifetime, thereby allocating your consumption to periods that provide
the greatest satisfaction. Thus, financial markets allow individuals to separate decisions
concerning current consumption from constraints that otherwise would be imposed by
current earnings.

Allocation of Risk
Virtually all real assets involve some risk. When Toyota builds its auto plants, for example,
it cannot know for sure what cash flows those plants will generate. Financial markets and
the diverse financial instruments traded in those markets allow investors with the greatest
taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater
extent, stay on the sidelines. For example, if Toyota raises the funds to build its auto plant
by selling both stocks and bonds to the public, the more optimistic or risk-tolerant investors
can buy shares of its stock, while the more conservative ones can buy its bonds. Because
the bonds promise to provide a fixed payment, the stockholders bear most of the business
risk but reap potentially higher rewards. Thus, capital markets allow the risk that is
inherent to all investments to be borne by the investors most willing to bear it.
This allocation of risk also benefits the firms that need to raise capital to finance
their investments. When investors are able to select security types with the risk-return
characteristics that best suit their preferences, each security can be sold for the best
possible price. This facilitates the process of building the economy’s stock of real assets.

Separation of Ownership and Management

Many businesses are owned and managed by the same individual. This simple organiza-
tion is well suited to small businesses and, in fact, was the most common form of business
organization before the Industrial Revolution. Today, however, with global markets and
large-scale production, the size and capital requirements of firms have skyrocketed. For
example, at the end in 2021, Chevron listed on its balance sheet about $156 billion of
property, plant, and equipment and total assets of $240 billion. Corporations of such size
simply cannot exist as owner-operated firms. Chevron actually has tens of thousands of
stockholders with an ownership stake in the firm proportional to their holdings of shares.
Such a large group of individuals obviously cannot actively participate in the day-to-
day management of the firm. Instead, they elect a board of directors that in turn hires and
supervises the management of the firm. This structure means that the owners and manag-
ers of the firm are different parties. This gives the firm a stability that the owner-managed
firm cannot achieve. For example, if some stockholders decide they no longer wish to
hold shares in the firm, they can sell their shares to other investors, with no impact on the
management of the firm. Thus, financial assets and the ability to buy and sell those assets
in the financial markets allow for easy separation of ownership and management.
How can all of the disparate owners of the firm, ranging from large pension funds
holding hundreds of thousands of shares to small investors who may hold only a single
share, agree on the objectives of the firm? Financial markets can provide some guidance.
Stakeholder Capitalism

WORDS FROM THE STREET

The overwhelming orthodoxy in the business community since
the 1970s was that the goal of the firm should be to maximize
value and that corporate governance, for example, incentive
packages for top management, should be designed to encour-
age that goal. The idea is that when value is maximized, we will
all be in a better position to pursue our personal goals including,
if we wish, support for “good causes.” But in 2019, America’s
Business Roundtable, a group of CEOs of the country’s larg-
est corporations, advocated for broader corporate goals that
address the interests of other stakeholders, including employ-
ees, customers, and the communities in which firms operate.
Their argument is that firms need to recognize and respond to
ethical and societal considerations beyond their private pursuit
of profit, in other words, that there is a built-in tension between
shareholder capitalism and stakeholder capitalism.
The critics of value maximization argue that it does not
provide incentives to firms to respond to important societal
and economic challenges and that if firms concern them-
selves only with their own interests, they will ignore potential
value-reducing impacts of their actions on other players. For
example, should a firm increase its value by a trivial amount
if it thereby increases unemployment for a large number of
workers? Should it increase its value by gutting pension plans
established for its former employees? Should it increase profits
by evading the costs of clean production even if that would pol-
lute the environment? These critics argue that firms should be
encouraged and perhaps forced to take a broader view of their
obligations to their many stakeholders.
They argue further that enlightened strategies can actually
be financially beneficial, and that long-term value maximization
requires sustainable investment strategies compatible with a
healthier and more resilient economy in the future. These sus-
tainability criteria are commonly grouped under the umbrella
of environmental, social, and governance, or ESG, investing. In
fact, the ESG sector has exploded in the last few years, with
ESG-oriented mutual and exchange-traded funds in the United
States capturing about one-fourth of new investments in 2020.
On the other hand, traditionalists are wary of an unfocused
commitment to many competing and unspecified interests that
could impede accountability. Should the firm, for example, offer
a better service to its customers if doing so makes the com-
pany a less attractive place to work? Given these sorts of con-
flicting objectives, how should one judge whether managers
have performed well? Who will set these goals, and how much
power is it appropriate to give to nonshareholders with little
skin in the game? What incentives will remain for innovation
and risk taking if corporate goals are set in the political arena?
Is it right to downplay the importance of monetary success?
After all, many institutions devoted to the public good and the
economic security of individuals rely on the success of the
endowment funds and pension funds that help pay for their
activities. Finally, regardless of their preferences, competition
may force firms to pursue value-maximizing strategies—if they
don’t, they run the risk that competitors who do will put them
out of business.
How might one thread this needle? One middle-ground
approach focuses on encouraging enlightened self-interest. It
can be value maximizing to establish a reputation as a good
place to work if that helps the firm attract and retain good
employees. It can be value maximizing to avoid scandal, dis-
ruption, and fines. It can also be value maximizing to provide
products and treat customers in a manner that encourages
repeat business. And if customers want goods produced by
well-treated workers using environmentally responsible prac-
tices, it will be in the firm’s interest to design production pro-
cesses with those goals in mind. Consumers also vote with
their feet, and firms that wish to do well may face pressure to
do good.
Of course, it would be naïve to believe that there will never
be conflicts between value maximization, even maximization of
long-term value, and other social considerations. Potential con-
flicts may call for government intervention to nudge incentives
in one direction or the other. For example, governments may
tax polluting activities to make it value maximizing to reduce
emissions. They may set and enforce antitrust rules to foster
competition and prevent any one firm from becoming powerful
enough to ride roughshod over the interests of customers and
employees. They can demand transparency to allow outsiders
to make informed judgments of how the company is behaving.
The world is full of slippery slopes and competing goals,
and no economic system will at all times and in all places
arrive at the best compromise between narrow self-interest
and broader social impact. Enlightened capitalism that recog-
nizes that long-term success is compatible with, and in fact may
demand, consideration of the wider implications of corporate
actions may strike as good a balance as one can hope for.

While the particular goals of each corporation’s many investors may vary widely, all share-
holders will be better able to achieve those personal goals when the firm acts to enhance
the value of their shares. For this reason, value maximization has for decades been widely
accepted as a useful organizing principle for the firm. More recently, some observers have
questioned this goal, arguing that the firm should attempt to balance the interests of its
many stakeholders, for example, employees, customers, suppliers, and communities. The
nearby box examines this debate.

7
8 PART I Introduction

Do managers really attempt to maximize firm value? It is easy to see how they might be
tempted to engage in activities not in the best interest of shareholders. For example, they
might engage in empire building or avoid risky projects to protect their own jobs or over-
consume luxuries such as corporate jets, reasoning that the cost of such perquisites is largely
borne by the shareholders. These potential conflicts of interest are called agency problems
because managers, who are hired as agents of the shareholders, may pursue their own inter-
ests instead.
Several mechanisms have evolved to mitigate potential agency problems. First, com-
pensation plans tie the income of managers to the success of the firm. A major part of
the total compensation of top executives is often in the form of shares or stock options,
which means that the managers will not do well unless the stock price increases, benefiting
shareholders. (Of course, we’ve learned that overuse of options can create its own agency
problem. Options can create an incentive for managers to manipulate information to prop
up a stock price temporarily, giving them a chance to cash out before the price returns to a
level reflective of the firm’s true prospects. More on this shortly.) Second, while boards of
directors have sometimes been portrayed as defenders of top management, they can, and in
recent years, increasingly have, forced out management teams that are underperforming.
Third, outsiders such as security analysts and large institutional investors such as mutual
funds or pension funds monitor the firm closely and make the life of poor performers at
the least uncomfortable. Such large investors today hold about half of the stock in publicly
listed firms in the United States.
Finally, bad performers are subject to the threat of takeover. If the board of directors
is lax in monitoring management, unhappy shareholders in principle can elect a different
board. They can do this by launching a proxy contest in which they seek to obtain enough
proxies (i.e., rights to vote the shares of other shareholders) to take control of the firm
and vote in another board. Historically, this threat was usually minimal. Shareholders who
attempt such a fight have to use their own funds, while management can defend itself using
corporate coffers.
However, in recent years, the odds of a successful proxy contest have increased along
with the rise of so-called activist investors. These are large and deep-pocketed investors,
often hedge funds, that identify firms they believe to be mismanaged in some respect.
They buy large positions in shares of those firms and then campaign for slots on the board
of directors and/or for specific reforms.

Example 1.1 Activist Investors and Corporate Control

Here are a few of the better-known activist investors, along with a sample of their more
notable initiatives:
• Nelson Peltz, Trian. Trian gained a seat on General Electric’s board of directors and pres-
sured the company to cut costs, to return capital to shareholders, for example, through
stock buybacks, and to downsize the firm.
• William Ackman, Pershing Square. Took 8.3% stake in software company ADP, where he
pushed for management changes.
• Dan Loeb, Third Point. Took large position in Royal Dutch Shell and pressed the company
to split into two independent firms, one focusing on its legacy business lines, such as oil
exploration and refining, and the other on low-carbon and renewable energy sources.
 CHAPTER 1 The Investment Environment 9

• Carl Icahn. One of the earliest and most combative of activist investors. Pushed HP to
accept a takeover bid made by Xerox.
• Christer Gardell, Cevian Capital. Cevian is the largest activist firm in Europe. In 2021,
it built up a 5% stake in the insurer Avian and then pressured the company to
­commit to deeper cost reductions and to pay out £5 billion in dividends or stock
repurchases.
• Paul Singer, Elliott Management. Built up a large stake in the U.K. drug manufacturer
Glaxo­
SmithKline after GSK’s disappointing performance in the development of a
Covid vaccination. Elliott is now expected to demand a large say in the firm’s future
management.
• Engine No. 1. A newcomer to the field, this formerly little-known fund gained the backing
of large institutional investors like BlackRock and Vanguard and won three seats on the
board of ExxonMobil, filling them with candidates with backgrounds in green energy and
operational expertise.

Aside from proxy contests, the real takeover threat is from other firms. If one firm
observes another underperforming, it can acquire the underperforming business and
replace management with its own team. The stock price should rise to reflect the pros-
pects of improved performance, which provides an incentive for firms to engage in such
takeover activity.

Corporate Governance and Corporate Ethics

We’ve argued that securities markets can play an important role in facilitating the deploy-
ment of capital to the most productive uses. But market signals will help to allocate capital
efficiently only if investors are acting on accurate information. We say that markets need
to be transparent for investors to make informed decisions. If firms can mislead the public
about their prospects, then much can go wrong.
Despite the many mechanisms to align incentives of shareholders and managers, the
three years from 2000 through 2002 were filled with a seemingly unending series of
scandals that collectively signaled a crisis in corporate governance and ethics. For
­example, the telecom firm WorldCom overstated its profits by at least $3.8 billion
by improperly classifying expenses as investments. When the true picture emerged,
it resulted in the largest bankruptcy in U.S. history, at least until Lehman Brothers
smashed that record in 2008. The next-largest U.S. bankruptcy was Enron, which used
its now-­notorious “­special-purpose entities” to move debt off its own books and simi-
larly ­present a misleading picture of its financial status. Unfortunately, these firms had
plenty of company. Other firms such as Rite Aid, HealthSouth, Global Crossing, and
Qwest Communications also manipulated and misstated their accounts to the tune of
billions of dollars. And the scandals were hardly limited to the United States. Parmalat,
the Italian dairy firm, claimed to have a $4.8 billion bank account that turned out not to
exist. These episodes suggest that agency and incentive problems are far from solved,
and that transparency is far from complete.
Other scandals of that period included systematically misleading and overly optimistic
research reports put out by stock market analysts. (Their favorable analysis was traded
for the promise of future investment banking business, and analysts were commonly
10 PART I Introduction

compensated not for their accuracy or insight, but for their role in garnering investment
banking business for their firms.) Additionally, initial public offerings were allocated to
corporate executives as a quid pro quo for personal favors or the promise to direct future
business back to the manager of the IPO.
What about the auditors who were supposed to be the watchdogs of the firms?
Here too, incentives were skewed. Recent changes in business practice had made
the consulting businesses of these firms more lucrative than the auditing function.
For example, Enron’s (now-defunct) auditor Arthur Andersen earned more money
­consulting for Enron than by auditing it. Given Arthur Andersen’s incentive to pro-
tect its consulting profits, we should not be surprised that it was overly lenient in its
auditing work.
In 2002, in response to the spate of ethics scandals, Congress passed the S ­ arbanes–
Oxley Act, commonly referred to as SOX, to tighten the rules of corporate gover-
nance and disclosure. For example, the act requires corporations to have more
independent directors, that is, more directors who are not themselves managers (or
affiliated with managers). The act also requires each CFO to personally vouch for the
corporation’s accounting statements, provides for an ­
­ oversight board to oversee
the auditing of public companies, and prohibits auditors from providing various other
services to clients.

1.4 The Investment Process

Investors’ portfolios are simply their collections of investment assets. Once a portfolio
is established, it is updated or “rebalanced” by selling existing securities and using the
proceeds to buy new securities, by investing additional funds to increase the overall size of
the portfolio, or by selling securities to decrease the size of the portfolio.
Investment assets can be categorized into broad asset classes, such as stocks, bonds, real
estate, commodities, and so on. Investors make two types of decisions in constructing their
portfolios. The asset allocation decision is the choice among these broad asset classes,
while the security selection decision is the choice of which particular securities to hold
within each asset class.
“Top-down” portfolio construction starts with asset allocation. For example, an indi-
vidual who currently holds all of his money in a bank account would first decide what
proportion of the overall portfolio ought to be moved into stocks, bonds, and so on. In
this way, the broad features of the portfolio are established. For example, while the aver-
age annual return on the common stock of large firms since 1926 has been about 12%
per year, the average return on U.S. Treasury bills has been less than 4%. On the other
hand, stocks are far riskier, with annual returns (as measured by the Standard & Poor’s
500 index) that have ranged as low as –46% and as high as 55%. In contrast, T-bills
are effectively risk-free: You know what interest rate you will earn when you buy them.
Therefore, the decision to allocate your investments to the stock market or to the money
market where Treasury bills are traded will have great ramifications for both the risk and
the return of your portfolio. A top-down investor first makes this and other crucial asset
allocation decisions before turning to the decision of the particular securities to be held
in each asset class.
 CHAPTER 1 The Investment Environment 11

Security analysis involves the valuation of particular securities that might be included
in the portfolio. For example, an investor might ask whether Merck or Pfizer is more
­attractively priced. Both bonds and stocks must be evaluated for investment attractiveness,
but valuation is far more difficult for stocks because a stock’s performance usually is far
more sensitive to the prospects of the issuing firm.
In contrast to top-down portfolio management is a “bottom-up” strategy in which the
portfolio is constructed from securities that seem attractively priced without as much
concern for the resultant asset allocation. Such a technique can result in unintended bets
on one or another sector of the economy. For example, it might turn out that the portfolio
ends up with a very heavy representation of firms in one industry, from one part of the
country, or with exposure to one source of uncertainty. However, a bottom-up strategy
does focus the portfolio on the assets that seem to offer the most attractive investment
opportunities.

1.5 Markets Are Competitive

Financial markets are highly competitive. Thousands of intelligent and well-backed
analysts constantly scour securities markets searching for the best buys. This competition
means that we should expect to find few, if any, “free lunches,” securities that are so under-
priced that they represent obvious bargains. This no-free-lunch proposition has several
implications. Let’s examine two.

The Risk–Return Trade-Off

Investors invest for anticipated future returns, but those returns rarely can be predicted
precisely. There will almost always be risk associated with investments. Actual or
realized returns will almost always deviate from the expected return anticipated at the start
of the investment period. For example, in 1931 (the worst calendar year for the market
since 1926), the S&P 500 index fell by 46%. In 1933 (the best year), the index gained 55%.
You can be sure that investors did not anticipate such extreme performance at the start of
either of these years.
Naturally, if all else could be held equal, investors would prefer investments with
the highest expected return.4 However, the no-free-lunch rule tells us that all else
cannot be equal. If you want higher expected returns, you will have to pay a price
in terms of accepting higher investment risk. If any particular asset offered a higher
expected return imposing without extra risk, investors would rush to buy it, with the
result that its price would be driven up. Individuals considering investing in the asset
at the now-higher price will find the investment less attractive. The price will rise
until expected return is no more than commensurate with risk. At this point, inves-
tors can anticipate a “fair” return relative to the asset’s risk, but no more. Similarly,

4
The “expected” return is not the return investors believe they necessarily will earn, or even their most likely
return. It is instead the result of averaging across all possible outcomes, recognizing that some outcomes are more
likely than others. It is the average rate of return across possible economic scenarios.
12 PART I Introduction

if returns were independent of risk, there would be a rush to sell high-risk assets and
their prices would fall. The assets would get cheaper (improving their expected future
rates of return) until they eventually were attractive enough to be included again in
investor portfolios. We conclude that there should be a risk–return trade-off in the
securities markets, with higher-risk assets priced to offer higher expected returns than
lower-risk assets.
Of course, this discussion leaves several important questions unanswered. How should
one measure the risk of an asset? What should be the quantitative trade-off between risk
(properly measured) and expected return? One would think that risk would have some-
thing to do with the volatility of an asset’s returns, but this guess turns out to be only
partly correct. When we mix assets into diversified portfolios, we need to consider the
interplay among assets and the effect of diversification on the risk of the entire portfolio.
­Diversification means that many assets are held in the portfolio so that the exposure to
any particular asset is limited. The effect of diversification on portfolio risk, the implica-
tions for the proper measurement of risk, and the risk–return relationship are the topics of
Part Two. These topics are the subject of what has come to be known as modern portfolio
theory. The development of this theory brought two of its pioneers, Harry Markowitz and
William Sharpe, Nobel Prizes.

Efficient Markets
Another implication of the no-free-lunch proposition is that we should rarely expect
to find bargains in the security markets. We will spend all of Chapter 11 examining
the theory and evidence concerning the hypothesis that financial markets process all
available information about securities quickly and efficiently, that is, that the security
price usually reflects all the information available to investors concerning its value.
According to this hypothesis, as new information about a security becomes available, its
price quickly adjusts so that at any time, the security price equals the market consensus
estimate of the value of the security. If this were so, there would be neither underpriced
nor overpriced securities.
One interesting implication of this “efficient market hypothesis” concerns the choice
between active and passive investment-management strategies. Passive management
calls for holding highly diversified portfolios without spending effort or other resources
attempting to improve investment performance through security analysis. Active
­management is the attempt to improve performance either by identifying mispriced
securities or by timing the performance of broad asset classes—for example, increas-
ing one’s commitment to stocks when one is bullish on the stock market. If markets are
efficient and prices reflect all relevant information, perhaps it is better to follow passive
strategies instead of spending resources in a futile attempt to outguess your competitors
in the financial markets.
If the efficient market hypothesis were taken to the extreme, there would be no point in
active security analysis; only fools would commit resources to actively analyze securities.
Without ongoing security analysis, however, prices eventually would depart from “correct”
values, creating new incentives for experts to move in. Therefore, even in ­environments
as competitive as the financial markets, we may observe only near-­efficiency, and profit
opportunities may exist for especially diligent and creative investors. In Chapter 12, we
examine such challenges to the efficient market hypothesis, and this motivates our discus-
sion of active portfolio management in Part Seven. Nevertheless, our discussions of secu-
rity analysis and portfolio construction generally must account for the likelihood of nearly
efficient markets.
 CHAPTER 1 The Investment Environment 13

1.6 The Players

From a bird’s-eye view, there would appear to be three major players in the financial markets:
1. Firms are net demanders of capital. They raise capital now to pay for investments
in plant and equipment. The income generated by those real assets provides the
returns to investors who purchase the securities issued by the firm.
2. Households typically are net suppliers of capital. They purchase the securities
issued by firms that need to raise funds.
3. Governments can be borrowers or lenders, depending on the relationship between tax
revenue and government expenditures. Since World War II, the U.S. government typi-
cally has run budget deficits, meaning that its tax receipts have been less than its expen-
ditures. The government, therefore, has had to borrow funds to cover its budget deficit.
Issuance of Treasury bills, notes, and bonds is the major way that the government bor-
rows funds from the public. In contrast, in the latter part of the 1990s, the government
enjoyed a short-lived budget surplus and was able to retire some ­outstanding debt.
Corporations and governments do not sell all or even most of their securities directly
to individuals. For example, about half of all stock is held by large financial institutions
such as pension funds, mutual funds, insurance companies, and banks. These financial
institutions stand between the security issuer (the firm) and the ultimate owner of the
security (the individual investor). For this reason, they are called financial intermediaries.
Similarly, corporations do not market their own securities to the public. Instead, they hire
agents, called investment bankers, to represent them to the investing public. Let’s examine
the roles of these intermediaries.

Financial Intermediaries
Households want desirable investments for their savings, yet the small (financial) size
of most households makes direct investment difficult. A small investor seeking to lend
money to businesses that need to finance investments doesn’t advertise in the local news-
paper to find a willing and desirable borrower. Moreover, an individual lender would not
be able to diversify across borrowers to reduce risk. Finally, an individual lender is not
equipped to assess and monitor the credit risk of borrowers.
For these reasons, financial intermediaries have evolved to bring the suppliers of
capital (investors) together with the demanders of capital (primarily corporations and the
­federal government). These financial intermediaries include banks, investment companies,
insurance companies, and credit unions. Financial intermediaries issue their own securities
to raise funds to purchase the securities of other corporations.
For example, a bank raises funds by borrowing (taking deposits) and lending that money
to other borrowers. The spread between the interest rates paid to depositors and the rates
charged to borrowers is the source of the bank’s profit. In this way, lenders and borrowers
do not need to contact each other directly. Instead, each goes to the bank, which acts as an
intermediary between the two. The problem of matching lenders with borrowers is solved
when each comes independently to the common intermediary.
Financial intermediaries are distinguished from other businesses in that both their assets
and their liabilities are overwhelmingly financial. Table 1.3 presents the aggregated balance
sheet of commercial banks, one of the largest sectors of financial intermediaries. Notice
that the balance sheet includes only very small amounts of real assets. Compare Table 1.3
to the aggregated balance sheet of the nonfinancial corporate sector in Table 1.4, for which
14 PART I Introduction

Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total

Real assets Liabilities

Equipment and premises $ 187.5 0.8% Deposits $18,458.8 81.8%
Other real estate 4.4 0.0% Debt and other borrowed funds 595.6 2.6%
   Total real assets $ 191.9 0.9% Federal funds and repurchase agreements 297.8 1.3%
Other 959.1 4.3%
  Total liabilities $20,311.2 90.0%
Financial assets
Cash $ 3,628.6 16.1%
Investment securities 5,479.3 24.3%
Loans and leases 10,610.7 47.0%
Other financial assets 1,371.4 6.1%
   Total financial assets $21,090.1 93.5%
Other assets
Intangible assets $ 392.0 1.7%
Other 890.2 3.9%
  Total other assets $ 1,282.2 5.7%   Net worth $ 2,253.0 10.0%
   TOTAL $22,564.2 100.0% $22,564.2 100.0%

Table 1.3
Balance sheet of FDIC-insured commercial banks and savings institutions
Note: Column sums may differ from total because of rounding error.
Source: Federal Deposit Insurance Corporation, www.fdic.gov, June 2021.

Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total

Real assets Liabilities

Equipment & intellectual property $ 8,428 16.6% Debt securities $ 7,387 14.5%
Real estate 14,859 29.2% Bank loans & mortgages 1,772 3.5%
Inventories 2,687 5.3% Other loans 2,077 4.1%
  Total real assets $25,974 51.1% Trade debt 3,121 6.1%
Other 10,319 20.3%
  Total liabilities $24,676 48.5%
Financial assets
Deposits and cash $ 2,326 4.6%
Marketable securities 4,032 7.9%
Trade and consumer credit 4,296 8.4%
Other 14,229 28.0%
  Total financial assets $24,883 48.9%   Net worth $26,181 51.5%
   TOTAL $50,856 100.0% $50,856 100.0%

Table 1.4
Balance sheet of U.S. nonfinancial corporations
Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2021.
 CHAPTER 1 The Investment Environment 15

real assets are about half of all assets. The contrast arises because intermediaries simply
move funds from one sector to another. In fact, the primary social function of such
intermediaries is to channel household savings to the business sector.
Other examples of financial intermediaries are investment companies, insurance
companies, and credit unions. All these firms offer similar advantages in their intermedi-
ary role. First, by pooling the resources of many small investors, they are able to lend
considerable sums to large borrowers. Second, by lending to many borrowers, intermediar-
ies achieve significant diversification, so they can accept loans that individually might be
too risky. Third, intermediaries build expertise through the volume of business they do and
can use economies of scale and scope to assess and monitor risk.
Investment companies, which pool and manage the money of many investors, also
arise out of economies of scale. Here, the problem is that most household portfolios are not
large enough to be spread across a wide variety of securities. In terms of brokerage fees
and research costs, purchasing one or two shares of many different firms is very expensive.
Mutual funds have the advantage of large-scale trading and portfolio management, while
participating investors are assigned a prorated share of the total funds according to the size
of their investment. This system gives small investors advantages they are willing to pay
for via a management fee to the mutual fund operator.
Investment companies also can design portfolios specifically for large investors with
particular goals. In contrast, mutual funds are sold in the retail market, and their investment
philosophies are differentiated mainly by strategies that are likely to attract a large number
of clients.
Like mutual funds, hedge funds also pool and invest the money of many clients.
But they are open only to institutional investors such as pension funds or endowment funds,
or to wealthy individuals. They are more likely to pursue complex and higher-risk strate-
gies. They typically keep a portion of trading profits as part of their fees, whereas mutual
funds charge a fixed percentage of assets under management.
Economies of scale also explain the proliferation of analytic services available to
investors. Newsletters, databases, and brokerage house research services all engage in
research to be sold to a large client base. This setup arises naturally. Investors clearly
want information, but with small portfolios to manage, they do not find it economical to
personally gather all of it. Hence, a profit opportunity emerges: A firm can perform this
service for many clients and charge for it.

Investment Bankers
Just as economies of scale and specialization create profit opportunities for financial
­intermediaries, these economies also create niches for firms that perform specialized
­services for businesses. Firms raise much of their capital by selling securities such as
stocks and bonds to the public. Because these firms do not do so frequently, however,
investment bankers that specialize in such activities can offer their services at a cost
below that of maintaining an in-house security issuance division. In this role, they are
called underwriters.
Investment bankers advise the issuing corporation on the prices it can charge for
the securities issued, appropriate interest rates, and so forth. Ultimately, the investment
banking firm handles the marketing of the security in the primary market, where new
issues of securities are offered to the public. Later, investors can trade previously issued
securities among themselves in the so-called secondary market.
For most of the last century, investment banks and commercial banks in the U.S. were
separated by law. While those regulations were effectively eliminated in 1999, the industry
 Separating Commercial Banking from Investment Banking
WORDS FROM THE STREET

Until 1999, the Glass-Steagall Act had prohibited banks in the
United States from both accepting deposits and underwriting
securities. In other words, it forced a separation of the invest-
ment and commercial banking industries. But when Glass-
Steagall was repealed, many large commercial banks began
to transform themselves into “universal banks” that could offer
a full range of commercial and investment banking services.
In some cases, commercial banks started their own invest-
ment banking divisions from scratch, but more frequently they
expanded through merger. For example, Chase Manhattan
acquired J.P. Morgan to form JPMorgan Chase. Similarly, Citi-
group acquired Salomon Smith Barney to offer wealth manage-
ment, brokerage, investment banking, and asset management
services to its clients. Most of Europe had never forced the sep-
aration of commercial and investment banking, so their giant
banks such as Credit Suisse, Deutsche Bank, HSBC, and UBS
had long been universal banks. Until 2008, however, the stand-
alone investment banking sector in the U.S. remained large and
apparently vibrant, including such storied names as Goldman
Sachs, Morgan-Stanley, Merrill Lynch, and Lehman Brothers.
But the industry was shaken to its core in 2008, when sev-
eral investment banks were beset by enormous losses on
their holdings of mortgage-backed securities. In March, on the
verge of insolvency, Bear Stearns was merged into JPMorgan
Chase. On September 14, 2008, Merrill Lynch, also suffering
steep ­mortgage-related losses, negotiated an agreement to be
acquired by Bank of America. The next day, Lehman Brothers
entered into the largest bankruptcy in U.S. history, having failed to
find an acquirer able and willing to rescue it from its steep losses.
The next week, the only two remaining major independent
investment banks, Goldman Sachs and Morgan Stanley, decided
to convert from investment banks to traditional bank holding
companies. In doing so, they became subject to the supervision of
national bank regulators such as the Federal Reserve and the far
tighter rules for capital adequacy that govern commercial banks.
The firms decided that the greater stability they would enjoy as
traditional banks, particularly the ability to fund their operations
through bank deposits and access to emergency borrowing from
the Fed, justified the conversion. These mergers and conversions
marked the effective end of the independent investment banking
industry—but not of investment banking. Those services are now
supplied by the large universal banks.
The debate about the separation between commercial and
investment banking that seemed to have ended with the repeal
of Glass-Steagall has come back to life. The Dodd-Frank Wall
Street Reform and Consumer Protection Act places new restric-
tions on bank activities.
For example, the Volcker Rule, named after former chair of
the Federal Reserve Paul Volcker, prohibits banks from “propri-
etary trading,” that is, trading securities for their own accounts,
and restricts their investments in hedge funds or private equity
funds. The rule is meant to limit the risk that banks can take
on. While the Volcker Rule is less restrictive than Glass-Steagall
had been, they both are motivated by the belief that banks
enjoying federal guarantees should be subject to limits on the
sorts of activities in which they can engage.
Proprietary trading is a core activity for investment banks,
so limitations on this activity for commercial banks reintroduces
a separation between these business models. However, these
restrictions elicited pushback from the industry, which argued
that it resulted in a brain drain of top traders from banks to
hedge funds. In 2018, the Dodd-Frank bill was in effect par-
tially repealed when new legislation granted all but the largest
banks exemptions from some of its regulations.

known as “Wall Street” until 2008 was still composed of large, independent investment
banks such as Goldman Sachs, Merrill Lynch, and Lehman Brothers. But that stand-alone
model came to an abrupt end in September 2008, when all the remaining major U.S. invest-
ment banks were absorbed into commercial banks, declared bankruptcy, or ­reorganized as
commercial banks. The nearby box presents a brief introduction to these events.

Venture Capital and Private Equity

While large firms can raise funds directly from the stock and bond markets with help from
their investment bankers, smaller and younger firms that have not yet issued securities
to the public do not have that option. Start-up companies rely instead on bank loans and
investors who are willing to invest in them in return for an ownership stake in the firm.
The equity investment in these young companies is called venture capital (VC). Sources
of venture capital are dedicated venture capital funds, wealthy individuals known as angel
investors, and institutions such as pension funds.
Most venture capital funds are set up as limited partnerships. A management company
starts with its own money and raises additional capital from limited partners such as
pension funds. That capital may then be invested in a variety of start-up companies.

16
Another random document with
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 Monazite sands exist on the Brazilian coast, probably in larger
quantities than in all the rest of the world. In 1910 Germany imported
$1,000,000 worth. The thorium in the sands, used in the
manufacture of gas mantles, is extracted in Brazilian factories before
exportation. Two per cent of thorium is in the sand, sometimes nearly
6 per cent. It is found on the coast north of Rio and on some river
banks in Rio, Espirito Santo, Bahia, and Minas.
Graphite exists in several States, especially Minas and Bahia in
rather inaccessible locations, but one deposit in Rio is worked, for a
pencil factory in the city of Rio; others in a small way for local use.
Other Minerals. Platinum is found in gold bearing quartz and in
river alluvium in Pernambuco, Minas, and Parahyba; nickel in Minas,
Santa Catharina, and Rio Grande do Sul; salt in Rio Grande do
Norte, Rio, and Minas, worked in the last two; much is imported.
Other minerals found in various localities are asbestos, antimony
and tin, bismuth, barium, cinnabar, emery, kaolin; marble, white,
rose, onyx, and green; mica, molybdenite, saltpetre, silver and lead,
soapstone and talc, and wolfram. Among the stones garnets, opals,
pearls, rubies, sapphires, emeralds, topaz, and tourmalines are
found in more or less profusion as well as rock crystal, useful to
opticians. Minas contains almost every variety of ore and gem, which
with its good climate and fertile soil have made it the best populated
State, though without a large city.
Petroleum has been discovered in a number of States, among
them São Paulo, Minas, Alagôas, Pernambuco, Bahia, and Sergipe;
some of excellent quality in Bahia; but whether in quantities for large
exploitation is uncertain until further investigation and work are
carried on. Some geologists believe that prospects are highly
favorable. Oil of fine quality is recently reported at Piracicaba, São
Paulo, but as the petroleum is generally in schist rock its extraction
would be expensive. Recent advices state that Brazil has 35 oil fields
in four States with an area of 10,000 square miles; in the entire
country 75,000 square miles with an estimated producing capacity
within ten years of 500 to 600 million barrels.

Investments
 In view of the varied resources of Brazil, to enumerate the
possibilities for investors would be difficult. There is hardly a line of
industry which cannot there be carried on successfully. That of coffee
growing is so well developed as to be somewhat overcrowded, but in
almost any other line there is a field for the investor. Whether it be
mining of gold or diamonds, of coal, iron, or manganese, be it
agriculture, stock raising, the lumber industry, or manufacturing, the
harnessing of the waterfalls to produce hydro-electric power, the
construction of public works, the field for the capitalist, large or small,
is of infinite variety and excellent promise. The present Government
is planning a broad and active development of the electric power
available from its great and numerous water-falls.
 CHAPTER LI
SOUTH AMERICAN TRADE

As to many it may seem presumptuous that one with no practical

experience should venture to discuss foreign trade, I beg with an
apology for my temerity to make a slight explanation.
On my six trips to South America (1903-1916) I saw and heard so
much of the shortcomings of my countrymen there, and meanwhile
perceived such ignorance at home that as early as 1907 I wrote an
article on “Our Commercial Relations with South America,” published
in the Van Norden Magazine, wherein I set forth many points which
prominent men of affairs have repeatedly urged upon the attention of
their fellows, even up to the eighth Annual Trade Convention at
Cleveland, May, 1921.
My personal observation being supplemented by extensive
reading, I venture to hope that my remarks under this heading may
be charitably viewed by those who are wiser than I, and prove of
some slight service to those whose acquaintance with South
American affairs is more limited.

In proportion to our wealth and our domestic activities our export

trade before the Great War was indeed small in comparison to that of
other nationalities. Slight interest was taken in outside matters of any
kind, even our publicists giving little heed to foreign affairs. However,
prior to 1914 there had been a slowly growing interest and a gradual
increase in our export trade, which from 1915 to 1920 showed a
more rapid extension. In 1915 our exports amounted to
$3,500,000,000, in 1920 to $8,228,000,000; to South America in
round numbers, in 1915, $144,000,000, in 1920, $624,000,000, in
1921, $273,000,000.
 As to the past and future of this matter, with especial reference to
South America, two widely divergent opinions prevail; one, that we
have accomplished wonders, and that our trade with that continent
will be permanent and, with improvement in exchange and other
conditions, increasing; the other, that we have not done so well as
we might and ought; and that owing to our indifference, inefficiency,
ignorance, and bumptiousness, we shall be unable to retain anything
like the proportion of trade which we have enjoyed or so much of it
as might seem our reasonable share. With some ground for each
opinion, the truth as usual lying between, there is a possibility of
either result depending upon a variety of circumstances. The first is
whether some of us acquire a willingness to learn, or persist in
certain mistaken notions and practices. Well merited criticism of the
methods of some exporters and salesmen is far from applying to all.
The “S” of a well known concern is as familiar in South America as in
North. Other great corporations are famous the world over. Their
success in foreign sales has meant the employment of many men
abroad and of a large number at home, with the home business
supplemented and steadied by the foreign. In addition to the
extensive pre-war export of some large companies, many small
ones, whose names are less familiar, have long sent their wares to
foreign lands.
A matter of prime importance is that the entire nation and people
become convinced of the value, the necessity even, of our
maintaining a large export and import trade, for we cannot have one
without the other. The provincialism of our thought and education,
which have a reciprocal influence, must be laid aside. Congressmen
should be able to feel that their reëlection will depend upon their
ability to grasp the problems confronting the whole nation, problems
of labor, transportation, commerce, finance, and world interests,
rather than upon their catering to a special class or securing a
sectional advantage. It would be well if they were high-minded
enough to act for the country’s best interests regardless of their
future fate. To demand ability and statesmanship of their
representatives in these crucial times is the privilege and duty of the
people.
 As a nation we have prospered because of the richness of our
natural resources and the enormous extent of our agricultural lands.
The latter being now for the most part occupied, with increasing
population our welfare will depend more largely upon the
development of our manufacturing industries and of our export trade.
That the prosperity of our manufacturing towns and seaports will be
reflected in our agricultural districts and will benefit the entire nation
should be self-evident. Supported by the people the Government will
act in accordance with its best judgment. In any case, every one
should feel that it shows a shameful lack of a sense of duty and of
patriotism to place one’s personal fortune above the nation’s welfare
in peace no less than in war.
For success in foreign trade as well as for safety at home our
Government must and no doubt will see that production is not stifled
for any reason, that our transportation on land and sea, and
communication by wire is unhampered by strikes or otherwise. If
need arises, previous restrictive measures should be removed and
suitable aid granted. With abundance of shipping which we formerly
lacked, equality with European freight rates must be maintained or
competition will be impossible. The establishing by our banks of
needed branches, fortunately made practicable, has been
accomplished. The important question of trademarks and patents
may require further Governmental consideration and diplomatic
action, though some international agreements have already been
made. In certain countries the laws have been unfair, prejudicial to
the interests of honest manufacturers and favoring the unscrupulous;
some of whom have taken advantage of the situation to the
embarrassment of legitimate American business. Trademarks have
been practically stolen, through previous registration by foreigners
without title to use them. We must remember that the same thing has
been done by Americans in the United States, who have registered
here trademarks owned in Europe.
Of immense service would be a few free ports where raw material
could enter, and without paying duty be exported either as entered or
after being manufactured. Foreign countries have fostered
commerce in this way and by allowing favorable freight rates through
subsidies and otherwise. Competition under Government ownership
has produced an enormous deficit. While better results may be
expected under private ownership, our shipping will be at a
disadvantage from difficulties imposed by the Seamen’s Bill. It is said
that American shippers may be able to pay higher wages than
European if relieved of the necessity of employing larger crews and
superfluous engineers. The Bureaus of the Department of
Commerce now perform very valuable service: the Bureau of
Foreign and Domestic Commerce, the Bureau of Standards; also the
Bureau of Markets of the Department of Agriculture. A consistent
foreign policy, undoubtedly to be formulated and pursued by our able
Secretaries of State and Commerce, will be of great service in
relation to foreign trade and for our general prosperity.
To the intelligent sympathy of the country at large and the
coöperation of the Government must be added the eager purpose of
the manufacturer, and the interest of young men who will make of
export trade their chosen field of labor. The manufacturer who
contemplates entering this broader field or who, through peculiar war
conditions, has been brought into it without preliminary investigation,
should recognize the fact that careful intensive study is a
prerequisite for successful permanent trade, a method which has
been followed by many Europeans and by some Americans with
excellent results.
The book here presented it is hoped will furnish a useful
groundwork of information on South America, to be supplemented by
further study of details appropriate to the character of the
prospective exports and to any special conditions. In these countries
generally, we have observed a great diversity in the population and
disparity in their condition. One may hope that the latter will be
diminished by advance in wages and by the education of the Indians,
by means of which their producing and their purchasing power may
be increased; but for a long time two broad classes must be
distinguished and catered to: the cultured and literate, and the poor
and illiterate laborers, especially the Indians of the North and West
Coasts. It is evident that the requirements of a cultivated society
where the customs and dress are European in character, or of a
homogeneous middle-class population, would be quite different from
those of Indians who sleep on the floor, a whole family in one room.
A personal acquaintance with the character of the people, their
manner of life, and their methods of business is extremely desirable.
If the head of a manufacturing industry is able himself to make “The
South American Tour” even in a hasty manner, it will be to his
advantage; if not, his export manager, if he has one, should
personally study the ground. Those who look merely for a slight
supplementary trade may best accomplish this by arranging with a
reliable commission house and following directions. If the
manufacturer decides to undertake the matter himself, he must plan
a careful campaign.
To make haste slowly is a good rule. Unhappily in the past some
who have attempted foreign trade have ignored the advice and
experience of others, and deemed information quite unnecessary.
With the know-it-all attitude, the idea that business is business
everywhere, and that goods and methods successful at home must
be equally good for abroad, before the War they proceeded in such a
manner as either to make an utter failure and abandon the project, or
after large and needless losses to secure profitable business.
Criticism of two different kinds made by South Americans should
lead to the correction of faults; otherwise there will be a complete
loss of trade on the part of those who are guilty, and much injury to
our commerce generally from the resulting bad reputation given to all
Americans. One form of criticism is directed to the character,
methods, and manners of the traveling salesman or agent, the other
to the shortcomings of the home office.
During the War period when at times our goods alone were
available, even poor methods and service brought results. That the
continuance of such a course will be successful in the face of the
severe competition now arising is too much to expect. A friendly
Englishman long engaged in business in South America, in 1916
remarked that he was afraid the Americans would lose 60 per cent of
their business after the War. A Peruvian the same year declared that
they would lose it all; so much had he been disgusted by the
arbitrary manner of some salesmen of the type who said practically,
“There is the stuff. Take it or leave it as you like.” With a correct
atmosphere in the home office and a more careful choice of
salesmen such crudeness would be avoided.
If the heads of the office are unable to visit the countries, there is
greater reason for wide reading. The “Movies,” which seem to
entertain many, present pictures of a few phases of life; but it is not
by such means that one acquires the intimate knowledge of a
country and people essential for a proper conduct of trade. For
agreeable and profitable relationship of any sort with those of other
nationalities we must realize that they also have their point of view;
we need to consider how they regard us. While we may believe our
country to be the greatest and best, and our ways and manner of
living superior, we must bear in mind that others are equally loyal to
their own; though their country may be smaller and in some respects
less advanced, its people are equally patriotic, they prefer their own
way of living and methods of business where these are different.
Many South Americans have a wider knowledge of the world, greater
culture and taste, and these in general are more punctilious in
manners and dress than the majority of Americans. We must
therefore, while preserving our own tastes and ideals, have equal
respect for theirs, cultivating a catholicity, a breadth of view, quite
different from the spirit common among us, that everything different
is thereby inferior, that we can teach the world everything, and that
we have nothing to learn. Such an attitude is merely a mark of
ignorance and provincialism.
Aside from visiting the countries there are many sources of
information in regard to sales possibilities for any class of goods.
The lists of imports of the countries and of some cities are available
in commerce reports, with figures showing the approximate quantity
and ratio of these. While the list of our exports seems to embrace
almost everything, all of the goods are not sold everywhere; a
knowledge of the various markets, of the prices at which goods are
sold, and of trade conditions is necessary, to ascertain whether
competition is possible and if there is a prospective increase of
present business. Detailed information as to many lines of
manufactures and markets may be obtained from consular reports,
from the branches of the Department of Commerce located in a few
cities, or by writing directly to the Bureau of Foreign and Domestic
Commerce in Washington. Many persons have written to our
Consuls in Latin America, often to their great disgust, for information,
not merely such as might be procured in Washington, but what might
be gained by looking in a geography or reading one of many
available books. The Consuls are continually making reports with
suitable information on matters which are within their province.
Membership in certain commercial organizations gives the privilege
of receiving trade information; the Philadelphia Commercial
Museum, the National Association of Manufacturers, and the
American Manufacturers Export Association, chambers of
commerce, commercial clubs, trade associations, such as one of
jewelers and silversmiths, all may be useful in this direction. The Pan
American Union through its Bulletin and otherwise furnishes much
information about Latin America. Export Trade Journals, other
magazines and newspapers, are serviceable.
If from investigation it appears that there is a market for one’s
goods in any section or universally, that quality and prices can be
such as to make competition favorable, that the market can be
enlarged, or should there be none that one can be created, and a
determination is therefore formed to enter export trade, the next
question is how the goods shall be sold. The methods are various,
but of only two kinds: the direct and the indirect.
Direct methods include the establishing of branch houses; the
appointing of a general agent for one or more countries or of a local
agent for a limited territory; the employment of traveling salesmen;
and advertising in circulars, newspapers, or magazines, for mail
orders to be filled by freight or parcel post. The choice of methods,
and the appointing of agents or salesmen demand the greatest care.
Exclusive rights of sale have been given for the whole continent to a
South American, incompetent even to take care of a small district.
Salesmen have been appointed from the home office who perhaps
had done well here but were utterly unfit for work in South America.
It is desirable to have representatives of our own nationality.
Others if employed solely by an American Company may do their
best for it, but we now know that many Germans, possibly others,
have taken agencies for the sole purpose of keeping the goods out
of the market. A good salesman or agent of any sort should have as
his first qualification ability to speak Spanish fluently, unless his work
is confined to Brazil, in which case of course he must speak
Portuguese. Next he should be a gentleman and simpático. The
spirit which led some youths in the early days in Panamá to call the
residents niggers, monkeys, and savages is one which, though not
indulged in outwardly to such a degree, is sufficient to prevent the
harmonious relations necessary to make permanent, satisfactory
business dealings. Unquestioned integrity, unfailing courtesy,
patience, tact, straightforward action, are all highly important
qualities, as well as those essential from a strictly business point of
view, such as critical knowledge of the goods, etc. Confidence and
friendliness count more in South America than at home. Social
qualifications are desirable. It has been said of the British that they
were too cold and exclusive, that the Germans were more friendly.
On the other hand, some Americans have felt that the South
Americans did not care for more than a business acquaintance. This
is doubtless true in many cases, but one who is cultured,
sympathetic, and well mannered is likely to have social opportunities
which he may accept to advantage.
Branch houses will best serve the large manufacturer, giving a
standing not otherwise attained, and best promoting permanent
relations. From these houses salesmen go to neighboring territory.
The manager must be a man of wide experience, familiar not only
with the product and home matters, but with the language, customs,
and business methods of the country in which he is located. Some
corporations engage business houses in different sections as local
representatives or distributors, with exclusive rights in restricted
territory. Such arrangements, supplemented by advice and literature
from the home office may prove effective in securing sales.
Those who cannot afford branch houses or the risk which may
attend the cost of a traveling salesman’s exclusive service are now
able through the Webb-Pomerene law to coöperate with other
houses in the same or in associated lines of industry. Both
investigation and sales may thus be profitably conducted.
Advertising only, without the employment of other agencies, has
been highly profitable to many. It is said that advertising in South
America brings better results than in the United States. To avoid utter
waste of money careful investigation as to sales possibilities and
media should be made before planning a campaign. One large mail
order house has carried on an enormous foreign business. Other
firms have accomplished much in a similar way. Advertising is done
in journals and magazines published here and circulated there, in
local publications of various kinds, in moving-picture houses; also by
means of mailed circulars, and to some extent by electric signs.
The importance of correct technical and idiomatic translation in
advertising in Spanish and Portuguese cannot be over-estimated.
Gross and ridiculous errors have been made in the past. A book
knowledge of languages seldom prepares one adequately for such
work. Foreign translators are more numerous than formerly, but they,
also, too often make egregious blunders; not of the same character,
but caused by their not comprehending exactly the English which
they translate.
If indirect methods of trade are preferred as involving less risk,
trouble, and preliminary expense, and if the medium is carefully
chosen, it may be more profitable. Export commission houses or
export agents will relieve the manufacturer of almost all care. One
large commission house not only acts as selling agent for
manufacturers through its branches in many parts of South America;
it also operates steamship lines, carries on banking and exchange,
and handles important financial transactions for South American
Republics. Certain firms of national or worldwide reputation and
large capital have for many years been satisfied to conduct their
foreign trade through such a house. The opportunity for commission
houses of this sort was not overlooked by foreigners and one
company of these in New York did an annual business of
$30,000,000 before the War.
The experience of a commission house is an asset, which saves
many mistakes. Their experts have a wide range of information
covering American and European competition, and details such as
suitable patterns, correct packing, etc. The commission house may
have its capital tied up for six months in transactions, or did prior to
the more general use of the trade acceptance, while the
manufacturer might receive cash for his goods. For small people this
method of sales has many advantages, especially when first
launching into export trade. Conference and honorable coöperation
are necessary and the protection of the commission house from
direct under-selling or from other unfair dealings. The service of
export agents is preferred by some, these acting as salesmen,
forwarders, or shippers, either for one or more concerns, perhaps on
salary and commission, or as independent agents.
After securing orders, by whatever means employed, the
responsibilities of the shipping department begin. The principles
governing the execution of orders would seem to be rudimentary.
One wonders how a business in this country could achieve even a
small measure of success when violating the most elementary rules
of conduct. Yet this has been and still is done in South American
trade as recent information from various sources shows, despite the
fact that these things should go without saying, and furthermore that
they have been iterated and reiterated for years.
First, the goods to fill an order should be precisely like the sample,
if there was one, not something inferior, as has often happened, nor
something just as good, or even better. If ordered without a sample
strictest attention should be paid to prescribed details. If it is
specified that cloth be 28¹⁄₂ inches wide or 25 centimetres, that is
what is wanted. If two-wheeled vehicles are ordered, what sort of
business is it that permits of sending, by mistake, four-wheeled
vehicles a distance of 5000 miles, even though the bill was made the
same and the goods were more expensive? as was done by a well
known manufacturer to his loss. The loss to the purchaser was
greater, for the vehicles sent could not be used at all in that country.
The assumption that the seller knows better than the buyer what
the latter wants is offensive if true. Generally it is not true. Mistakes
are unpardonable. Requests for particular colors, patterns, size of
bolt, and character of weave must be complied with if trade is
wanted. The willingness of the Germans to oblige in such matters
largely accounted for the rapid growth of their South American trade.
The Latin American business men are as acute and intelligent as
any. They know what they want and are discriminating buyers as to
quality and price.
Criticism of the shortcomings of the home office is the second of
the two forms previously referred to. Lack of accuracy and of
attention to details is a grievous fault, apparently arising from want of
discipline and thoroughness in our homes and schools, a fault
recognized by many heads of offices here. The dishonesty of
sending goods inferior to sample or order, a practice injurious to the
entire national trade as well as to the guilty individual, shows an utter
lack of patriotism, as well as folly if permanent trade is desired.
Another elementary matter is that of packing. Woful tales of
breakage and loss from bad packing have been rife for years, and
volumes have been written and spoken concerning it. In 1916 an
experienced traveling man told me that before his last trip, in view of
war conditions, he had taken on the agency of some new people and
received many orders for them. He had sent explicit instructions as
to packing and other export details. But now he found his new
customers swearing mad and was booking no more orders for his
new patrons: for they had paid not the slightest heed to his directions
either as to packing or forwarding, with disastrous results. In
February, 1919, a letter from Brazil said: “We cannot imagine why
your shippers ever accepted the travesty of an export bale dumped
on you by the spinners, and we must clearly state that our factory will
not accept any yarns which arrive in bad condition due to bad
packing.”
Unwillingness to profit by the knowledge and experience of others,
the belief that one knows everything without learning anything, is
called a peculiarly American trait, though happily it is not universal.
The British not only pack and handle goods in the best manner, but
they are careful to send and land them in all parts of the world by the
best route and with the least expense to the receiver, as the world
knows. Of course we can do the same if we take the trouble. The
packing department for the soldiers overseas showed the highest
excellence. The baling of clothes instead of boxing saved labor, box
material, and two thirds of the space, and goods arrived in better
condition. Fifty-five million dollars were saved at one plant in a year.
Forty-nine million dollars of this was cargo space, other things were
rent, freight, etc. Fifty-eight million feet of lumber of 30 years growth
were spared. The burlap required would be useful in South America.
Square packages instead of round are advantageous. Those who
wish a share in foreign trade must take the pains to do everything
right. The most careful man, familiar with the metric system, should
be in charge. The scales should show pounds and kilograms, and
figures be given for net weight, container, etc. Aside from careful
packing to avoid breakage or other injury as from water, dampness,
or pilfering, instructions are often given as to size and weight of
package. Mules, donkeys, and llamas usually carry two packages,
one on each side; the ordinary load of each is 200, 150, and 100 lbs.
respectively, though some mules will take 300 lbs. for a moderate
distance. For the interior, especially on the North and West Coasts
and in some sections on the East, these animals are the only means
of transport, and goods must be packed accordingly; machinery in
sections, etc. Many boxes of 1000 pounds weight have been left on
the dock or at a railway station, the goods a total loss.
To arrange the packing with an eye to the custom house is
important, both in order that the contents may be easily examined,
and so that fines or exorbitant imposts may be avoided. Directions
and governmental regulations as to giving separate weight of
container and goods, and the separation of different classes of the
latter must be scrupulously followed. Heavy fines are often imposed
for trivial errors in packing or invoice, and corrections of any
mistakes by cable are expensive if frequent.
Obligations of every kind should be fulfilled with fidelity though a
bad bargain has been made resulting in financial loss. On the other
hand consideration for the embarrassments of the buyer should be
shown, whether these are purely personal or the result of national
conditions such as followed the outbreak of the War or the
conclusion of the Armistice. After the unexpected cessation of War
many orders which had been placed here were suddenly cancelled
under the supposition that coöperation such as had always been
extended by European merchants would not be refused here. British
representatives promptly offered to cancel orders for goods that the
buyers might not care to receive under the changed circumstances,
while the majority of Americans made many difficulties: a contrast in
conduct liable to influence unfavorably future trade, especially when
added to the fact that vast numbers here cancelled orders and that
the average American manufacturer had taken advantage of the
situation created by the War to charge exorbitant prices in excess of
those applying to domestic trade. Thus some manufacturers who
have cried out about the bad faith of the South Americans, with no
consideration for their difficulties, have forfeited their confidence and
friendship, with a probable loss of future trade unless able to offer
remarkably attractive bargains.
The utmost care should be taken in the shipping of goods as well
as in the packing. Promptness is an important feature. Where regular
sailings occur space should be engaged in advance, and the
necessary papers accurately made out in good season, in view of
the many copies of the consular invoices, the bills of lading, the
clearance papers, and the short hours of some of the consulates. To
avoid the trouble of attending to these and other elaborate details,
many manufacturers find it convenient to employ a Freight
Forwarder who looks after such matters including insurance of
various kinds covering theft, damage, and total loss. He will know the
most favorable trade routes, look after transfer and storage, and fill
all requirements, if qualified for his job.
No dealings should be initiated in any country until after the
registration of patents and trademarks.
Trouble should be taken to adjust any bona fide complaint and to
satisfy reasonable customers. On account of length of time and
distance, especial pains should be taken to avoid possible difficulty
or disagreement.
The establishing of American banks in South America has been a
boon to manufacturers. The houses of Dun and of Bradstreet
perform much service for their clients in the line of credit information.
It has been suggested that the Government might collect information
for general private use. It may be said that experience shows losses
in foreign trade to be less than in domestic. Yet, as shysters exist
everywhere, suitable precaution should be exercised, guarantees
required, or the reliability of the house made certain.
The use of the trade acceptance, a negotiable note given by the
purchaser to the seller of goods, now becoming general, is of great
assistance to those who were deterred from entering South
American trade on account of the long credits which seemed
necessary. Foreign bankers invest in the commercial bills of other
countries, knowing them to be convertible into cash in those
countries. Private houses handling investments or commercial paper
have added departments for dealing in acceptances. The subject of
foreign exchange should be familiar, the fluctuations having an
important bearing on purchasing power and trade, while exchange
itself is dependent on foreign trade conditions, being an index of
international transactions. Careful consideration of this matter is
necessary in quoting prices. In normal times it was customary on
English imports to reckon the pound as $4.90, and in export as $4.80
to cover incidental expenses.
In certain lines, for example, in hand-made goods, it is impossible
for this country to face European or Asiatic competition. In some
kinds of machine-made goods we excel. In lines where competition
seems difficult the excellent suggestion has been made that costs
may be reduced. The lowering of the daily wage has in some cases
occurred; and more may be accomplished by diminishing overhead
expense. The high salaries of the heads and of numerous assistants
in plants of moderate size and the expenses of salesmen are often
unnecessarily large, giving rise to foolish and injurious extravagance,
which indeed has permeated all classes of society. Carnegie while
building up his Steel Company, and President McKinley smoked
cigars costing five cents each, while some modern salesmen pay 50
cents for one, with other things in proportion. Some hotels charge 40
cents for a potato not costing one; a Washington hotel asks 60 cents
for a slice of watermelon when a whole one is selling on the street
for 15 cents. The head of a company suggests that by reducing one-
third of the personal and family expenses for luxuries they will live
longer and be happier; that one-third of the middle men might be cut
out; that the office and supervising class could accomplish 25 per
cent more and cut down office expenses one-third; that the laboring
man could increase his efficiency and output one-third without injury
and come nearer to earning his wages; and that the unreasonable
waste of material should be diminished. I would however add that
many heads of establishments and departments work harder and
more hours than the ordinary office force or laborer.
One would naturally desire to have his firm name on such goods
as permit this; “Made in U.S.A.” seems desirable where practicable.
It has happened that Germans handling American machinery have
covered such marks with their own. It may be noted that in South
America many of the large mercantile establishments of various
kinds, dry goods and others, are in the hands of British or German
firms. A considerable portion of trade in the large cities is conducted
by other than the native born.
For the best development of our foreign trade it is necessary that
young men entering this field should be of higher type than the
average in domestic affairs, particularly those who will go to foreign
lands. The larger number may not be called upon to go outside of
their town or country, as many must be engaged in the export
department, at the factory or the seaport, or in commission houses
and banks, as export agents or freight forwarders, etc. Others will go
abroad as salesmen on tours, or to reside a few or many years in the
capacity of local agents, in branch houses of large companies, civil
and mining engineers, etc.
Many of both sexes have enough of the spirit of adventure to enjoy
the prospect of at least a temporary residence in another land. It is to
be hoped that those who desire the broader career will enter it not
solely for the pecuniary reward but with something of the spirit which
animated our soldiers, the knowledge that they may extend the
prestige of their country and uphold the best traditions of democracy;
with the feeling that their work, if well done, is patriotic in character,
an essential and splendid vocation, a dignified career for the
development of the commerce and the promotion of the welfare of a
great nation. Character, the manners of a gentleman, and
educational preparation are among the requisite qualifications. Of
prime necessity is a familiarity with one or two foreign languages;
also a training that will develop thoroughness and accuracy and the
consciousness that these are essential. Nothing will accomplish this
better than a good groundwork of Latin; which makes mere play the
acquisition of any derived language like Spanish, French, or
Portuguese. A sound understanding of Latin syntax is needed for
easy comprehension of these languages, with their varied forms and
constructions, so different from our simple English, which indeed one
who is ignorant of any other language hardly comprehends. The
ability to conduct business correspondence correctly and with at
least some degree of the elegance and courteous phraseology
current in other lands where our brusque letters and speech are
disliked if not resented: Knowledge of office routine especially as to
the various papers to be procured and prepared in connection with
foreign transactions: An acquaintance with the requirements of
shipping practices, trade routes, types of vessels, freight rates,
insurance of various kinds, loading and unloading facilities at
different ports, and details as to the arrival and despatch of cargoes
and vessels: A study of the principles of commercial law needed to
enable one to decide business questions, disputes and
misunderstandings, according to equity and international practice: A
close study of the economic conditions which govern the production
of the countries, of the social institutions and customs, of advertising
needs and methods, of shipping facilities, of banking facilities and
methods, credit practices and requirements, and any discrimination
in tariffs or regulations:
A study of the foreign trade practices and methods of those
countries already occupying these markets, the character and style
of their goods and their methods of securing and holding business:
Acquaintance with the financial and investment relations of other
countries as affecting international trade; with foreign banking
practices and with the mechanism of foreign exchange: A study of
physical geography including the natural resources, climatic
conditions, and characteristic peculiarities of each country: A
knowledge of the history and affiliations of the countries, with the
character of their governments as likely to bear on their commerce:
—All these are matters which must not be overlooked by any one
who wishes to become an expert in foreign trade. Some
acquaintance with the racial origin and relations of the nations, with
their social customs, religious tendencies, and traditions may at
times help in determining trade possibilities. It is important to realize
that the cultivation of tact, dignity, and judgment is necessary for
success as a foreign representative, and that such an one may
prove a more valuable ambassador than some of those occupying
such position, to whom a similar training would be of advantage.
Furthermore we must realize that no nation can sell largely abroad
unless it buys also, and that we must purchase from South America
if we expect to sell there. Fortunately they have many agricultural
products, which we do not produce, and other raw material of which
we have not sufficient. Yet probably we cannot take as much from
them as we should like to sell. We must therefore invest, now that
we are a creditor nation, in the securities of others, the bonds of the
countries and cities; we must send our capital to develop public
utilities where these are lacking, as for sewerage and water supply.
Electric lighting plants and power, docks and railways, have proved
excellent investments. The better banking facilities now provided
encourage these on our part. The British, French, and Belgians have
been beforehand in this matter. The British have invested more than
two billions in Argentina, $1,200,000,000 in Brazil, smaller sums in
Uruguay and Chile. The Germans have not invested much money,
their banks bringing chiefly credit and making money by taking part
of the business of local banks, a practice not conducive to popularity.
The United States, i.e., some people, have invested $175,000,000 or
more in Brazil, smaller sums in other countries. Large opportunities
lie open in this direction.
That loans should be made to foreign countries only on condition
that the money be spent here, seems a short-sighted policy, as also
restrictions on our export of gold, when our excessive holding of that
metal is a contributing cause of the unfortunate exchange situation.
Many Republics need railways, for which construction material and
equipment would be here purchased if here financed; but part of the
money must be spent on the ground; so with works of irrigation and
other public or private construction. If we must always be selfish, at
least our selfishness should be enlightened, and we should realize
that in the long run we shall gain more by manifesting a friendly spirit
of service and coöperation rather than by showing intense
eagerness for the “mighty dollar.”