MODERN

PORTFOLIO THEORY
A N D INVESTMENT
ANALYSIS
EIGHTH EDITION
INTERNATIONAL STUDENT VERSION

EDWIN J. ELTON
Leonard N. Stern School of Business
New York University

MARTIN J. GRUBER
Leonard N. Stern School of Business
New York University

STEPHEN J. BROWN
Leonard N. Stern School of Business
New York University

WILLIAM N. GOETZMANN
Yale University

WILEY

John Wiley & Sons, Inc.

Contents

About the Authors

Preface
Part 1
Chapter 1

vii

ix

INTRODUCTION

INTRODUCTION

Outline of the Book 2

The Economic Theory of Choice: An Illustration Under Certainty
Conclusion 8
Multiple Assets and Risk 8
Questions and Problems 9
Bibliography
10
Chapter 2

FINANCIAL MARKETS

1 1

Trading Mechanics 11
Margin 14
Markets 18
Trade Types and Costs 25
Conclusion 27
Bibliography 27
Chapter 3

FINANCIAL SECURITIES

28

Types of Marketable Financial Securities 2 8

The Return Characteristics of Alternative Security Types
Stock Market Indexes 3 8
Bond Market Indexes 3 9
Conclusion 4 0

36

Part 2

P O R T F O L I O ANALYSIS

41

Section I

MEAN VARIANCE PORTFOLIO THEORY

43

Chapter 4

THE CHARACTERISTICS OF THE OPPORTUNITY SET UNDER RISK

44

Determining the Average Outcome 4 5

A Measure of Dispersion 4 6
Variance of Combinations of Assets 4 9
Characteristics of Portfolios in General 51
Two Concluding Examples 61
Conclusion 6 4
XIII

CONTENTS

XIV

Questions and Problems

Bibliography 6 6
Chapter 5

64

DELINEATING EFFICIENT PORTFOLIOS

68

Combinations of Two Risky Assets Revisited: Short Sales Not Allowed

The Shape of the Portfolio Possibilities Curve 77
The Efficient Frontier with Riskless Lending and Borrowing 8 4
Examples and Applications 8 8
Three Examples
93
Conclusion 9 6
Questions and Problems 9 6
Bibliography 97
Chapter 6

68

TECHNIQUES FOR CALCULATING THE

EFFICIENT FRONTIER

99

Short Sales Allowed with Riskless Lending and Borrowing

100
Short Sales Allowed: No Riskless Lending and Borrowing
104
Riskless Lending and Borrowing with Short Sales Not Allowed
104
No Short Selling and No Riskless Lending and Borrowing
105
The Incorporation of Additional Constraints
106
An Example 107
Conclusion
110
Appendix A: An Alternative Definition of Short Sales 110
Appendix B: Determining the Derivative
111
Appendix C: Solving Systems of Simultaneous Equations
115
Appendix D: A General Solution
118
Appendix E: Quadratic Programming and Kuhn-Tucker Conditions
122
Questions and Problems 125
Bibliography
126
Section 2

SIMPLIFYING THE PORTFOLIO SELECTION PROCESS

129

Chapter 7

THE CORRELATION STRUCTURE OF SECURITY RETURNS:

THE SINGLE-INDEX MODEL

130

The Inputs to Portfolio Analysis 131

Single-Index Models: An Overview
132
Characteristics of the Single-Index Model
Estimating Beta 139
The Market Model
152
An Example 1 53
Questions and Problems 1 54
Bibliography
156
Chapter 8

137

THE CORRELATION STRUCTURE OF SECURITY RETURNS:

MULTI-INDEX MODELS AND GROUPING TECHNIQUES
Multi-Index Models
160
Average Correlation Models
166
Mixed Models 167
Fundamental Multi-Index Models 167
Conclusion
173
Appendix A: Procedure for Reducing Any Multi-Index Model to a
Multi-Index Model with Orthogonal Indexes 1 73
Appendix B: Mean Return, Variance, and Covariance of a
Multi-Index Model 1 7 4
Questions and Problems 176
Bibliography 177

1 59

CONTENTS

Chapter 9

XV

SIMPLE TECHNIQUES FOR DETERMINING THE EFFICIENT FRONTIER

The Single-Index Model 181
Security Selection with a Purchasable Index 192
The Constant Correlation Model
193
Other Return Structures
196
An Example 1 9 6
Conclusion
197
Appendix A: Single-Index ModelShort Sales Allowed
198
Appendix B: Constant Correlation CoefficientShort
Sales Allowed 2 0 0
Appendix C: Single-Index Model with Short Sales Not Allowed
Appendix D: Constant Correlation CoefficientShort Sales
Not Allowed 2 0 3
Appendix E: Single-Index Model, Short Sales Allowed, and a
Market Asset 2 0 5
Questions and Problems 2 0 5
Bibliography 2 0 6

Chapter 10

INTERNATIONAL DIVERSIFICATION
The World Portfolio 2 0 8
Calculating the Return on Foreign Investments 2 1 0
The Risk of Foreign Securities 2 1 2
Returns from International Diversification 2 1 7
The Effect of Exchange Risk 2 1 8
Return Expectations and Portfolio Performance 2 1 9
Other Evidence on Internationally Diversified Portfolios
Models for Managing International Portfolios 2 2 6
Conclusion 2 2 9
Questions and Problems 2 2 9
Bibliography 2 3 1

Section 3
Chapter 1 1

180

201

208

222

SELECTING THE OPTIMUM PORTFOLIO

235

ESTIMATING EXPECTED RETURNS

236

Aggregate Asset Allocation 2 3 6

Forecasting Individual Security Returns 2 4 0
Portfolio Analysis with Discrete Data 2 4 2
Bibliography 2 4 4
Chapter 1 2

HOW TO SELECT AMONG THE PORTFOLIOS

IN THE OPPORTUNITY SET
Choosing Directly 2 4 5
An Introduction to Prefrerence Functions 2 4 6
Risk Tolerance Functions 2 4 9
Safety First 2 5 1
Maximizing the Geometric Mean Return 2 5 7
Value at Risk (VaR) 2 5 9
Utility and the Equity Risk Premium 2 6 0
Optimal Investment Strategies with Investor Liabilities 2 6 2
Liabilities and Safety-First Portfolio Selection 2 6 6
Simulations in Portfolio Choice 2 6 6
Conclusion 2 7 2
Appendix: The Economic Properties of Utility Functions 2 7 2
Relative Risk Aversion and Wealth
274
Questions and Problems 2 7 4
Bibliography 2 7 5

245

CONTENTS

XVI

Part 3
Chapter 13

M O D E L S O F E Q U I L I B R I U M I N T H E CAPITAL
MARKETS

279

THE STANDARD CAPITAL ASSET PRICING MODEL

280

The Assumptions Underlying the Standard Capital Asset

Pricing Model (CAPM) 2 8 0
The Capital Asset Pricing Model 2 8 1
Prices and the CAPM 2 9 0
Conclusion 2 9 2
Appendix: Appropriateness of the Single-Period Asset
Pricing Model 2 9 4
Questions and Problems 2 9 8
Bibliography 2 9 9
Chapter 14

ALTERNATIVE FORMS OF CAPITAL ASSET PRICING MODELS

Short Sales Disallowed 3 0 2
Modifications of Riskless Lending and Borrowing 3 0 2
Personal Taxes 3 1 2
Nonmarketable Assets 3 1 4
Heterogeneous Expectations 3 1 6
Non-Price-Taking Behavior 3 1 7
Multiperiod CAPM 3 1 7
The Consumption-Oriented CAPM 3 1 8
Inflation Risk and Equilibrium 3 1 9
The Multi-Beta CAPM 31 9
Conclusion 3 2 0
Appendix: Derivation of the General Equilibrium with Taxes
Questions and Problems 3 2 3
Bibliography 3 2 4

Chapter 15

301

321

EMPIRICAL TESTS OF FORMS OF THE CAPM

330

The ModelsEx-Ante Expectations and Ex-Post Tests 3 3 0

Empirical Tests of the CAPM 3 3 1
Testing Some Alternative Forms of the CAPM Model 3 4 5
Testing the Post-Tax Form of the CAPM Model 3 4 5
Some Reservations about Traditional Tests of General Equilibrium
Relationships and Some New Research 3 4 9
Conclusion 3 5 1
Appendix: Random Errors in Beta and Bias in the Parameters
of the CAPM 3 5 2
Questions and Problems 3 5 3
Bibliography 3 5 4
Chapter 16

THE ARBITRAGE PRICING MODEL A N D - -ITS EMPIRICAL

RELEVANCE
APTWhat Is It?
358
Estimating and Testing APT 3 6 3
APT and CAPM 3 7 5
Recapitulation 3 7 6
Conclusion 3 8 5
Appendix A: A Simple Example of Factor Analysis 3 8 5
Appendix B: Specification of the APT with an Unobserved
Market Factor 3 8 6
Questions and Problems 3 8 7
Bibliography 3 8 8

358

CONTENTS

XVII

Part 4

SECURITY ANALYSIS A N D P O R T F O L I O T H E O R Y

395

Chapter 17

EFFICIENT MARKETS

396

Some Background 3 9 8
Tests of Return Predictability 4 0 0
Announcement and Price Return 4 1 6
Methodology of Event Studies 4 1 6
Strong-Form Efficiency 4 2 2
Market Rationality 4 2 5
Conclusion 4 2 7
Questions and Problems 4 2 7
Bibliography 4 2 7
Chapter 18

BEHAVIORAL FINANCE, INVESTOR DECISION

MAKING, AND ASSET PRICES

438

Prospect Theory and Decision Making Under Uncertainty

Biases From Laboratory Experiments 4 4 1
Summary of Investor Behavior 4 4 4
Behavioral Finance and Asset Pricing Theory 4 4 5
Bibliography 4 5 2
Chapter 19

438

VALUATION MODELS

455

Discounted Cash Flow Models 4 5 6

Cross-Sectional Regression Analysis 4 6 8
An Ongoing System 4 7 2
Conclusion 4 7 7
Questions and Problems 4 7 7
Bibliography 4 7 8
Chapter 2 0

482

EARNINGS ESTIMATION
The Elusive Number Called Earnings 4 8 2
The Importance of Earnings 4 8 5
Characteristics of Earnings and Earnings Forecasts
Conclusion 4 9 5
Questions and Problems 4 9 6
Bibliography 4 9 6

Chapter 21

488

INTEREST RATE THEORY AND THE PRICING OF BONDS

498

An Introduction to Debt Securities 4 9 9

The Many Definitions of Rates 5 0 1
Bond Prices and Spot Rates 5 0 8
Determining Spot Rates 5 1 0
The Determinants of Bond Prices 5 1 2
Conclusion 5 2 8
Appendix A: Special Considerations in Bond Pricing 5 2 8
Appendix B: Estimating Spot Rates 5 2 8
Appendix C: Calculating Bond Equivalent Yield and Effective
Annual Yield 5 3 1
Questions and Problems 5 3 1
Bibliography 5 3 2
Chapter 2 2

THE MANAGEMENT OF BOND PORTFOLIOS

Duration 5 3 6
Protecting Against Term Structure Shifts 5 4 4
Bond Portfolio Management of Yearly Returns
Swaps 5 5 7

536

548

XVIII

CONTENTS

Appendix A: Duration Measures 5 5 9

Appendix B: Exact Matching Programs 5 6 3
Appendix C: Bond-Swapping Techniques 5 6 5
Appendix D: Convexity 5 6 6
Questions and Problems 5 6 7
Bibliography 5 6 8
Chapter 23

VALUATION AND USES OF OPTIONS

571

Types of Options 571

Some Basic Characteristics of Option Values 5 7 7
Valuation Models 5 8 2
Artificial or Homemade Options 5 9 3
Uses of Options 5 9 4
Conclusion 5 9 7
Appendix A: Derivation of the Binomial Formula 5 9 7
Appendix B: Derivation of the Black-Scholes Formula 6 0 0
Questions and Problems 6 0 2
Bibliography 6 0 3
Chapter 2 4

THE VALUATION AND USES OF FINANCIAL FUTURES

Description of Financial Futures 6 0 9
Valuation of Financial Futures 6 1 3
The Uses of Financial Futures 6 1 9
Nonfinancial Futures and Commodity Funds
Questions and Problems 6 2 4
Bibliography 6 2 4

609

623

Part 5

E V A L U A T I N G T H E I N V E S T M E N T PROCESS

627

Chapter 2 5

EVALUATION OF PORTFOLIO PERFORMANCE

628

Evaluation Techniques 6 2 9
A Manipulation-Proof Performance Measure 6'44
Decomposition of Overall Evaluation 6 4 5
Multi-Index, APT, and Performance Evaluation 6 5 5
Mutual Fund Performance 6 6 1
Conclusion 6 7 4
Questions and Problems 6 7 4
Bibliography 6 7 5
Chapter 2 6

EVALUATION OF SECURITY ANALYSIS

680

Why the Emphasis on Earnings?

681
The Evaluation of Earnings Forecasts 6 8 2
Evaluating the Valuation Process 6 8 9
Conclusion 6 9 2
Questions and Problems 6 9 3
Bibliography 6 9 3
Chapter 27

PORTFOLIO MANAGEMENT REVISITED

Managing Stock Portfolios 6 9 6
Active Management 6 9 9
Passive Versus Active 7 0 0
International Diversification 7 0 1
Bond Management 701
Bond and Stock Investment with a Liability Stream
Bibliography 7 0 9

Index

695

704

711