What are the types of inflation?

Businesses base pricing decisions in part on what consumers are buying and not buying. Changes in prices may show different patterns overtime. These patterns result in varying types of infl ation.<br /><br />DISINFLATION<br /> Disinfl ation occurs when prices are rising, but the rate of increase is slowing down. Some products and services do not increase in price as fast as others. Often, this happens when demand for a product is not thesame throughout the year. For example, in spring and summer, the price of swimsuits may be high and rising. In fall and winter, however, if the price is rising, it is doing so at a much slower rate.<br /><br />REFLATION<br />Reflation occurs when high prices are lowered due to decreased demand, but then are restored to the previous high level. Perhaps you have heard a news reporter use this term to describe crude oil prices.  Refl ation can happen when the available supply of a product, such as oil, goes up and down. Refl ation can also happenwhen consumers  temporarily stop buying a product or service and then, for some reason, start buying it again. For example, when gas prices surge, people may not buy as many big cars and trucks that use more gas. They wait to see what will happen with gas prices. When gas prices fall, they begin buying large vehicles again.<br /><br />DEFLATION<br />Defl ation is a decrease in the general level of prices for goods and services. It is the opposite ofinfl ation. In other words, prices are going down. Defl ation occurs when producers are willing and able to provide goods and services at lower prices, but due to certain events, consumers are buying less. Some products go down in price over time even when the market as a whole is not experiencing a period of defl ation. For example, a computer that uses a new, faster processor may sell at a high price when it fi rst comes on the market. A year later, the same computer may sell for hundreds of dollars less. The price is lower because it is no longer the newest, fastest computer available. Other, newer models have been released.<br /><br />

Businesses base pricing decisions in part on what consumers are buying and not buying. Changes in prices may show different patterns overtim...

What Is Infl ation?

<div style="text-align: justify;"> The price is the amount a buyer pays for a good or service. Infl ation is an increase in the general level of prices for goods and services. Infl ation refl ects how much prices are rising. When prices are rising faster than income, buyers lose purchasing power. In other words, the money workers earn will buy less as prices rise. Changing prices affect the purchasing power of both producers and consumers. The economy changes over time based on events and on habits and attitudes of producers and consumers. For example, an event such as a fl ood or hurricane that wipes out crops may affect prices. The supply of crops becomes small compared to demand, driving up price. As new digital devices, such as cell phones and video games, are invented, we are eager to buy them. Because demand for these devices is high, prices are also high.<br /><br />Habits and attitudes explain how people react to changes in the supply of goods, world events, and their individual situations. We buy things without thinking about it to support our habits. As our habits change, so does our spending. Attitudes refl ect how people think about their future and about the product being sold. We ask ourselves questions such as: Will this product help me stay healthy? Is it worth the price? As consumers make choices and spend money, they affect prices and infl ation.<br /><br />MEASURING INFLATION<br />Infl ation is measured by the U.S. government. The measurement toolused is called the Consumer Price Index (CPI). The CPI uses a list of goods and services that are commonly bought by consumers. The index measures changes in price from a base or starting point in time to the current time (or time of measurement). For example, if the price of an item was $1.00 in the base year and it is now $1.12, that is a 12 percent increase in the price. If the increase happened in just one year and it happened to all the goods on the list, the infl ation rate for that year would also be 12 percent.<br /><br />INFLATION VS. PURCHASING POWER<br />As infl ation rises, the true purchasing power of each dollar falls. That means you must earn more to maintain the same standard of living. If you do not earn more, your standard of living will drop. Many people receive annual cost-of-living adjustments (COLAs) or pay increases from their employers to keep pace with infl ation. The COLA does not provide more purchasing power but keeps purchasing power equal to rising costs. On top of the COLA, workers are often given merit raises and or bonuses. These increases in income provide more purchasing power.<br /><br /><br /></div>

The price is the amount a buyer pays for a good or service. Infl ation is an increase in the general level of prices for goods and services...

What is self-employment?

<div style="text-align: justify;"> Working for yourself is called self-employment. A person who takes the risks of being self-employed and owning a business is called an entrepreneur. Small businesses contribute billions of dollars to the U.S. economy and employ more workers than all of the country’s large corporations combined. Owning a business can be challenging, but it can be very rewarding as well.<br /><br />ADVANTAGES OF OWNING A BUSINESS<br />A major advantage of being the owner is that you get to make the decisions about how the business will be run. The owner can say what the business will and will not do. This includes the choice of products and services that will be offered. It also includes hours of operation, the types of customers the business will target, and the prices it will charge. As a small business owner, you have the freedom to set your own hours, deciding when you will work and how long you will work. Small business owners also keep all the profi ts of the business. Profi t is the amount left after all expenses are deducted from the revenues or sales of the business.<br /><br />DISADVANTAGES OF OWNING A BUSINESS<br />If the business fails, the money invested in the business is lost. Most money invested in a small business comes from the owner and/or theowner’s family and friends. Owning a small business is often risky because it is hard to get credit. In many cases, the owner uses his or her personal credit, including credit cards, home equity, and loan debt in order to get and keep the business running. With most small businesses, and especially during its fi rst years, the owner works long hours and does many different tasks to keep the business running. Because money is often tight, owners cannot always hire others to do the work for them.<br /><br />TYPES OF SMALL BUSINESSES<br />There are two main types of small businesses: lifestyle businesses and venture businesses. A lifestyle business is one where the owner intends to keep the business small. The business provides a good income for the owner and his or her family. These businesses exist for the lifetime of the owner and often have no resale value. For example, a dentist may elect to be a one-dentist offi ce and provide services to his or her patients. When the dentist retires, the business closes. Some entrepreneurs have their businesses “on the side.” This means they work a full-time job for someone else and pursue their avocation—a secondary occupation they enjoy—in their spare time. Their avocation  may also bring them a nice “side income.” Other business owners want their businesses to grow into large companies with unlimited growth and many workers. This type of business is called a venture business.<br /><br />As it continues to grow, it will eventually become a corporation. For example, Phil Knight started a business designing tennis shoes in his garage in Eugene, Oregon. When the company grew, it eventually became the publicly held corporation known as Nike. A venture business owner has an “exit plan” so that others can continue operation of the business when the owner decides to leave. The business owner simply may become one of the  many stockholders and will no longer have total control of the business.<br /><br />GETTING STARTED IN BUSINESS<br />How can you decide if being an entrepreneur is the right career for you? Your answers to the questions that follow will give you a better idea of whether or not you should consider owning your own business.</div> <ol style="text-align: justify;"> <li> Are you self-motivated? If you can get going and do what you need to do without being told or reminded, you will make a good entrepreneur.</li> <li> Do you like people? If you like people and can get along with your customers, you have a good chance of success</li> <li> Are you a leader? Entrepreneurs are able to get others to follow their lead. They are confi dent and persuasive.</li> <li>Do you take responsibility? Entrepreneurs take charge and follow through.</li> <li> Are you organized? Business owners must have a good plan before they get started. They line up their resources, fi ll in the gaps, and charge forward.</li> <li>Do you work hard? To be a successful owner, you must set the pace by example. Business owners work many long, hard hours. They don’t expect others to do what they themselves are unwilling to do.</li> <li>Do you make decisions easily and quickly? Owners must take risks and be willing to accept the consequences. Decisions sometimes have to be made without complete information.</li> <li>Are you trustworthy? Others must trust you and accept that you know what you are talking about. This means building trust and long-term relationships.</li> <li> Are you persistent? Business owners stick with it, even when the going gets tough. They fi nish projects and forget about excuses.</li> <li> Do you keep good records? Entrepreneurs must account for their costs and their revenues. They must pay taxes and understand about profi tability and cost analysis. These things require complete and accurate records.</li> </ol> <div style="text-align: justify;"> If you have a good business idea, you should start the process early. Get your thoughts and plans onto paper, get advice from those you trust, and work toward your dream of owning your own business. In putting your idea into writing, you will be starting your business plan. A business plan is a document that describes the steps that will be taken to open and operate a business. It should show that you are worthy of funding (loans) from government and private sources, such as banks and venture capitalists. Sample business plans can be found at the SBA website or at various other websites by conducting an online search using the keywords business plans.</div> <div style="text-align: justify;"> <br /></div>

Working for yourself is called self-employment. A person who takes the risks of being self-employed and owning a business is called an entr...

What are sources of earned income?

<div style="text-align: justify;"> Many people work for hourly wages. Some people work for an annual salary. Others have additional income from tips or commissions. Some people work for themselves, and the money they earn is called self-employment income. All these types of earned income are subject to income taxes and social security taxes. A tax is a required payment for the support of a government.<br /><br />WAGES<br />Employees who work for wages are paid for each hour worked. Minimum wage is the lowest pay rate allowed by law for eachregular hour of work. The federal minimum wage is set by the  U.S. Congress. In 2010, that rate was $7.25 per hour. Manystates have minimum wage laws that set a rate higher than the federal rate. <br /><br />An 8-hour day and 40-hour workweek has become the standard in the American workplace. Hours worked in addition to the standard are called overtime hours. When employees must work overtime hours, they are entitled to extra pay called overtime pay. By law, overtime pay must be at least 1½ times the regular rate. For example, a worker who earns $8 per hour for regular pay would earn $12 per hour ($8 x 1½) for overtime pay. People who work on holidays may be entitled to even higher pay rates for their hours. Both federal and state laws control when extra pay is required for additional time worked.<br /><br />SALARIES<br />Some people work for a set salary, such as $3,000 a month or $36,000 a year. Salaried workers usually do not keep time cards or count hours worked. They may have more fl exibility in the times they work than do hourly workers. They often work more than 40 hours a week but do not receive overtime pay. People who work for a salary are usually selfdirected. Managers and supervisors are typically paid a salary.<br /><br />TIPS AND COMMISSIONS<br />Some workers receive tips in addition to wages. A tip is a gift of money, often a percentage of the total bill, to a person for performing a service. The amount of the tip may be based on the quality of service provided. For example, a waiter may receive tips in the form of money from customers. A caddy at a golf course might receive free tickets to a show as a tip. Some workers make most of their earnings from tips rather than hourly pay. Tips are subject to federal income taxes. Tips may be subject to state taxes as well. The law requires some employers (such as restaurants and hair salons) to withhold taxes based on tips, even though tips may have been received in cash directly from customers.<br /><br />Some workers are paid a commission. A commission is a set fee or a percentage of a sale paid to an employee instead of or in addition to salary or wages. Sales commissions are earned only when a sale is made. If no sale is made, no commission is received. In some types of jobs, such as real estate sales, the worker’s entire earnings may be based on commission. For example, a real estate agent who sells a home for $200,000 might receive a $12,000 commission. In other types of jobs, workers may be paid a base salary plus commissions. For example, a person who sells cars might receive a salary of $10,500 a year plus 25 percent of the profi t on each car sold.</div>

Many people work for hourly wages. Some people work for an annual salary. Others have additional income from tips or commissions. Some peop...

How do you make yourself stand out?

<div style="text-align: justify;"> After you have found out about job openings, you must begin the process of selling yourself as the most desirable job applicant. You must show the employer that your unique skill set is just what is needed. The job application and interview can separate you from your competition.<br /><br />THE JOB APPLICATION<br />To apply for a job, you will most likely have to fi ll out a job application (also called an employment application). A job application is a form (either electronic or on paper) that asks you basic questions about your background, such as your work history (names, dates, places), education, skills, and references.<br /><br />When completing a job application by hand, write neatly using a blue or black ink pen that does not skip or blot. Stay within the space provided. Fill in all the blanks. When you cannot answer a question or it isn’t applicable, use the abbreviation N/A or a line (-----) to show that you have not ignored the question. Be truthful and give complete answers. Have all the needed information with you, including the names of references with their job titles, addresses, phone numbers, and e-mail addresses.<br /><br />When possible, take the job application form home with you and fi ll it out carefully at your leisure. Proofread very carefully, checking every word. Keep a copy of the form you submit. When completing a job application online, follow the same rules. Select a standardfont and proofread. You cannot rely on spell checking tools to catch all spelling and grammar errors. Be sure to print a  copy for your own records.<br /><br />THE JOB INTERVIEW<br />The next step is the job interview, a face-to-face meeting with a potential employer to discuss a job opening.<br /><br />During your interview, the employer will likely have a copy of your resume, cover letter, job application, and reference letters. The interviewer may ask you about information on any of these documents or about any other job-related matters. Prepare for the job interview so you will impress the interviewer. Here are some general guidelines</div> <ul style="text-align: justify;"> <li>Review your resume so you are familiar with everything you have stated about yourself</li> <li>Rehearse open-ended questions where you talk about yourself. Be ready for questions such as, “Tell me about yourself,” or “Why do you want to work for us?” Talk about your skill set and how it relates to the job opening. Practice your interviewing skills with a friend or family member.</li> <li>Lean forward, listen carefully, and show the interviewer you are interested and enthusiastic about the job opening</li> <li> Arrive on time, or about ten minutes early. Dress appropriately, asyou would if you were already on the job (or one notch better).</li> <li>Always go alone. Do not take a friend or relative.</li> <li>Appear self-confi dent and relaxed. Do not show tension or stress. Avoid eating or drinking, except water if it helps keep you calm.</li> <li>Be courteous, using “please” and “thank you.”</li> <li>Think before you speak. Speak slowly and clearly. Use good grammar and avoid slang.</li> <li>Look directly at your interviewer(s), making eye contact frequently. Smile often and show confi dence.</li> <li>Watch for clues that you should talk more or less.</li> <li>Do company research so you can speak intelligently about the company and ask meaningful questions. It is common for the interviewer to ask you what questions you might have about thecompany make them impressive!</li> </ul> <div style="text-align: justify;"> <br />After the interview, you may wish to do some type of follow-up. Follow-up is contact with the prospective employer after the interview but before a person is actually hired for the opening. When it could be days or even weeks before a decision is made or announced, it could be in your best interest to remind the employer of your interest and enthusiasm.<br /><br />A thank-you letter is one form of follow-up. The thank-you letter shows appreciation for the time taken to interview you. It also reminds the employer of your interest. When writing a thank-you letter, keep it short and direct. You might enclose a letter of reference or remind the interviewer of a special skill or aptitude that you have. Make sure it is error-free, friendly, and appreciative. Other forms of follow-up include a phone call or a drop-in visit where you would inquire about the status of the job opening. Be sure to dress like you already have the job. Be courteous and friendly.</div>

After you have found out about job openings, you must begin the process of selling yourself as the most desirable job applicant. You must s...

Employment agencies help you find job

<div style="text-align: justify;"> EMPLOYMENT AGENCIES<br />All major cities have public and private employment agencies. Employment agencies help job seekers fi nd a job for which they are qualifi ed. They also help employers locate the best job applicants for their openings. Private employment agencies may or may not charge a fee for their services. Some agencies charge a fee to the employer. Others divide the fee between the employer and the new employee. Fees vary from agency to agency, so you should compare prices. A headhunter is a type of employment specialist who seeks out highly qualifi ed people to fi ll upper-level positions for an employer. For example, if a company needs a new manager or vice president, it may use a headhunter to recruit an executive with the skills and experience needed rather than advertise the job opening and go through an open interview process.<br /><br />State Employment Offices<br />The state employment offi ce also helps people fi nd jobs. It does not charge fees because it is a government agency. There you can also fi nd information about job-training and assistance programs, such as YES (Youth Employment Services), Youth Corps, Civil Service (both state and federal), and other government-sponsored programs. You may  qualify for one or more of these types of work programs.<br /><br />Temp Agencies<br />If you initially have trouble fi nding a full-time or permanent job, you might consider starting at a temp agency. A temporary agency, commonly called a temp agency, provides part-time and full-time jobs on a temporary basis. Working in a temporary job gives you a chance to make a good impression on an employer and to expand your network. It also gives you good work experience that could be applied to other jobs. When the company sees that you are a good fi t, you may be offered a permanent job. In such a case, the company will buy out your contract with the temp agency. Or, you may be hired after the contract with the temp agency is completed.</div>

EMPLOYMENT AGENCIES All major cities have public and private employment agencies. Employment agencies help job seekers fi nd a job for whic...

How can you find job openings?

<div style="text-align: justify;"> There are many ways to fi nd out about job openings in the Internet age. In the past, many people found jobs by reading about them in  the newspaper and mailing in their applications. Today, many applicantsfi nd out about job openings through contacts, networking sites, company websites, and online career and employment sites. A contact is a person you know, such as a relative or friend. You may have met this person just recently, or you may have known him or her all of your life. Many job openings are never advertised. They are fi lled from within the company or with people who are privately told about the job opening.<br /><br />GETTING STARTED<br />While you are in school, you can start building your social network. A social network is a group of friends and acquaintances who keep in contact and share information. Many people today belong to online social networking sites, such as FaceBook, MySpace, LinkedIn, Twitter, and personal blogs. At these sites, you are able to exchange information with others, post messages, and keep in contact over time. you are seeking a job in a fi eld where you have no contacts, try to get to know people who can tell you about openings. Ask if they have a web page or blog and stay in touch. Start by letting others know about your skill set that makes you a unique and desirable employee.<br /> If you are working, even on a part-time or volunteer basis, keepothers informed and talk to them often. This includes coworkers, you are seeking a job in a fi eld where you have no contacts, try to get to know people who can tell you about openings. Ask if they have a web page or blog and stay in touch. Start by letting others know about your skill set that makes you a unique and desirable employee. If you are working, even on a part-time or volunteer basis, keep others informed and talk to them often. This includes coworkers,<br /><br /><b>Job Shadowing</b><br />If you would like to get to know people in a particular type of job, but you have no contacts, you might consider job shadowing. Job shadowing is spending time observing a worker in a type of job that interests you. Many employers will let you come and visit in this manner, as long as you do not disrupt the work being done. You can see how activitiesare performed in a typical day. The contacts you make while job shadowing can give you the inside track on fi nding out about future job openings.<br /><br /><b>Cooperative Work Experience</b><br />Many schools have programs to assist students in preparing for careers, making career choices, and securing part-time or full-time work. One such program is called cooperative work experience, where students attend classes part of the day and then go to a job that provides supervised work. Students receive credit for the on-the-job skills they learn.<br /><br /><b>School Counselors, Teachers, and Placement Centers</b><br />School counselors and teachers are often good sources of job opportunity information. They are often asked by employers to recommend students for specifi c job openings. Placement centers also help students fi nd jobs. Their services are usually offered free of charge. Placement centers post job openings at the school and provide information to qualifi ed students so they can apply. Be sure to check at your school to see what kind of assistance may be available.</div>

There are many ways to fi nd out about job openings in the Internet age. In the past, many people found jobs by reading about them in  the ...

The major fiancial statement

<div style="text-align: justify;"> The Income Statement<br />The income statement is a summary of the profitability of the firm over a period of time, such as a year. It presents revenues generated during the operating period, the expenses incurred during that same period, and the company’s net earnings or profits, which are simply the difference between revenues and expenses. It is useful to distinguish among four broad classes of expenses: cost of goods sold, which is the direct cost attributable to producing the product sold by the firm; general and administrative expenses, which correspond to overhead expenses, salaries, advertising, and other costs of operating the firm that are not directly attributable to production; interest expense on the firm’s debt; and taxes on earnings owed to federal and local governments.<br /><br />Table 14.1 presents an income statement for Home Depot (HD). At the top are the company’s revenues. Next come operating expenses, the costs incurred in the course of generatingthese revenues, including a depreciation allowance. The difference between operating revenues and operating costs is called operating income. Income (or expenses) from other, primarily nonrecurring, sources is then added to obtain earnings before interest and taxes (EBIT), which is what the firm would have earned if not for obligations to its creditors and the tax authorities. EBIT is a measure of the profitability of the firm’s operations abstracting from any interest burden attributable to debt financing. The income statement then goes on to subtract net interest expense from EBIT to arrive at taxable income. Finally, the income tax  due the government is subtracted to arrive at net income, the “bottom line” of the income statement.<br /><br />Analysts also commonly prepare a common-size income statement, in which all items on the income statement are expressed as a fraction of total revenue. This makes it easier to compare  firms of different sizes. The right-hand column of Table 14.1 is HD’s common-size income statement.</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUnIP2GRosmbqg0yRW2rhYBSc6Blr5biit_61IWqL5fxt5pdD8GshzIghCtc-UMqSmrQRULaxDoYfgZvEKXFsYo-YS2aNBaUml0llVRri0L_jKQtjTzJOavDoO80gDGtPmNWozyx7wGjAA/s1600/k.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUnIP2GRosmbqg0yRW2rhYBSc6Blr5biit_61IWqL5fxt5pdD8GshzIghCtc-UMqSmrQRULaxDoYfgZvEKXFsYo-YS2aNBaUml0llVRri0L_jKQtjTzJOavDoO80gDGtPmNWozyx7wGjAA/s1600/k.png" /></a></div> <div style="text-align: justify;"> the productive capacity of the firm. In contrast, accounting earnings are affected by several conventions regarding the valuation of assets such as inventories (e.g., LIFO versus FIFO treatment) and by the way some expenditures such as capital investments are recognized over time (as depreciation expenses). We will discuss problems with some of these accounting conventions in greater detail later in the chapter. In addition to these accounting issues, as the firm makes its way through the business cycle, its earnings will rise above or fall below the trend line that might more accurately reflect sustainable economic earnings. This introduces an added complication in interpreting net income figures. One might wonder how closely accounting earnings approximate economic earnings and, correspondingly, how useful accounting data might be to investors attempting to value the firm. In fact, the net income figure on the firm’s income statement does convey considerable information concerning a firm’s products. We see this in the fact that stock prices tend to increase when firms announce earnings greater than market analysts or investors had anticipated.</div>

The Income Statement The income statement is a summary of the profitability of the firm over a period of time, such as a year. It presents ...

Active bond management sources of potential profit

<div style="text-align: justify;"> Sources of Potential Profit<br /> Broadly speaking, there are two sources of potential value in active bond management. The first is interest rate forecasting, that is, anticipating movements across the entire spectrum of the fixed-income market. If interest rate declines are forecast, managers will increase portfolio duration; if increases seem likely, they will shorten duration. The second source of potential profit is identification of relative mispricing within the fixed-income market. An analyst might believe, for example, that the default premium on one bond is unnecessarily large and the bond is underpriced.<br /> <br /> These techniques will generate abnormal returns only if the analyst’s information or insight is superior to that of the market. You can’t profit from knowledge that rates are about to fall if everyone else in the market is onto this. In that case, the anticipated lower future rates will be built into bond prices in the sense that long-duration bonds already sell at higher prices, reflecting the anticipated fall in future short rates. If you do not have information before the  market does, you will be too late to act prices will have already responded to the news. You know this from our discussion of market efficiency.</div> <div style="text-align: justify;"> For now we simply repeat that valuable information is differential information. And it is worth noting that interest rate forecasters have a notoriously poor track record. Homer and Leibowitz (1972) have developed a popular taxonomy of active bond portfolio strategies. They characterize portfolio rebalancing activities as one of four types of bond swaps. In the first two swaps, the investor typically believes the yield relationship between bonds or sectors is only temporarily out of alignment. Until the aberration is eliminated, gains can be realized on the underpriced bond during a period of realignment called the workout period.<br /> <br /> 1. The substitution swap is an exchange of one bond for a nearly identical substitute. The substituted bonds should be of essentially equal coupon, maturity, quality, call features, sinking fund provisions, and so on. A substitution swap would be motivated by a belief that the market has temporarily mispriced the two bonds, with a discrepancy representinga profit opportunity.</div> <div style="text-align: justify;"> An example of a substitution swap would be a sale of a 20-year maturity, 8% coupon Toyota bond that is priced to provide a yield to maturity of 8.05% coupled with a purchase of an 8% coupon Honda bond with the same time to maturity that yields 8.15%. If the bonds have about the same credit risk, there is no apparent reason for the Honda bonds to provide a higher yield. Therefore, the higher yield actually available in the market makes the Honda bond seem relatively attractive. Of course, the equality of credit risk is an important condition. If the Honda bond is in fact riskier, then its higher promised yield does not represent a bargain.<br /> <br /> 2. The intermarket spread swap is an exchange of two bonds from different sectors of the bond market. It is pursued when an investor believes the yield spread between two sectors of the bond market is temporarily out of line. For example, if the yield spread between 10-year Treasury bonds and 10-year Baarated corporate bonds is now 3%, and the historical spread has been only 2%, an investor might consider selling holdings of Treasury bonds and replacing them with corporates. If the yield spread eventually narrows, the Baa-rated corporate bonds will outperform the Treasury bonds.   Of course, the investor must consider carefully whether there is a good reason that the yield spread seems out of alignment. For example, the default premium on corporate bonds might have increased because the market is expecting a severe recession. In this case, the wider spread would not represent attractive pricing of corporates relative to Treasuries but would simply be an adjustment for a perceived increase in credit risk.<br /> <br /> 3. The rate anticipation swap is an exchange of bonds with different maturities. It is pegged to interest rate forecasting. Investors who believe rates will fall will swap into bonds of longer duration. For example, the investor might sell a five-year maturity Treasury bond, replacing it with a 25-year maturity Treasury bond. The new bond has the same lack ofcredit risk as the old one, but it has longer duration.<br /> <br /> 4. The pure yield pickup swap is an exchange of a shorter-duration bond for a longerduration bond. This swap is pursued not in response to perceived mispricing but as a means of increasing return by holding higher-yielding, longer-maturity bonds. Theinvestor is willing to bear the interest rate risk this strategy entails.</div>

Sources of Potential Profit Broadly speaking, there are two sources of potential value in active bond management. The first is interest ra...

Credit default swaps

<div style="text-align: justify;"> A credit default swap (CDS) is in effect an insurance policy on the default risk of a corporate bond or loan. To illustrate, the annual premium in July 2011 on a five-year Citigroup CDS was about 1.3%, meaning that the CDS buyer would pay the seller an annual premium of $1.30 for each $100 of bond principal. The seller collects these annual payments for the term of the contract, but must compensate the buyer for loss of bond value in the event of a default.</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgfrEGPcc1D4iOAV0QjB5Bne6jl1vZ3I9ZD0aqTwQ-LI-OFHzaWTVZINXazJLWvx7Rq5NvEido2ETkUqIVnWcD3vHvICWyWnpXTnI7mXG-QeYouYlIuCPJTxAKQ6aq7RVMZVYJH5F335B-5/s1600/ak.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgfrEGPcc1D4iOAV0QjB5Bne6jl1vZ3I9ZD0aqTwQ-LI-OFHzaWTVZINXazJLWvx7Rq5NvEido2ETkUqIVnWcD3vHvICWyWnpXTnI7mXG-QeYouYlIuCPJTxAKQ6aq7RVMZVYJH5F335B-5/s1600/ak.png" /></a></div> <div style="text-align: justify;"> As originally envisioned, credit default swaps were designed to allow lenders to buy protection against losses on sizable loans. The natural buyers of CDSs would then be large bondholders or banks that had made large loans and wished to enhance the creditworthiness of those loans. Even if the borrowing firm had shaky credit standing, the “insured” debt would be as safe as the issuer of the CDS. An investor holding a bond with a BB rating could, in principle, raise the effective quality of the debt to AAA by buying a CDS on the issuer. This insight suggests how CDS contracts should be priced. If a BB-rated bond bundled with insurance via a CDS is effectively equivalent to a AAA-rated bond, then the fair price of</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5Adcq3xgTl3sy-piJCEfLMNtQSaWpzTlF8ZZIkzwsiw0GOe4MVjXxIR2qdNu_p5USTyRPlL3tA49VwghhAVpPCedrM-kxMbydma_4ypE0coM5NQxTVW00d3eBFQRB4E2CSJixRx_FIK7K/s1600/ak+2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5Adcq3xgTl3sy-piJCEfLMNtQSaWpzTlF8ZZIkzwsiw0GOe4MVjXxIR2qdNu_p5USTyRPlL3tA49VwghhAVpPCedrM-kxMbydma_4ypE0coM5NQxTVW00d3eBFQRB4E2CSJixRx_FIK7K/s1600/ak+2.png" /></a></div> <div class="separator" style="clear: both; text-align: center;"> </div> <div style="text-align: justify;"> the swap ought to approximate the yield spread between AAA-rated and BB-rated bonds. The risk structure of interest rates and CDS prices ought to be tightly aligned. Figure 10.11 , Panel A, shows the average prices of five-year CDSs on U.S. banks between mid-2007 and 2011. Notice the sharp run-up in prices in September 2008 as Lehman Brothers entered bankruptcy and the financial crisis peaked. CDS prices fell back, but then they increased again in 2009 in the depths of the recession. As perceived credit risk increased, so did the price of insuring that debt.<br /></div> <div style="text-align: justify;"> CDS contracts also trade on the sovereign debt of a wide range of countries. Panel B of Figure 10.11 shows the prices of five-year CDS contracts on German debt. Even with Germany being the strongest economy in the euro zone, German CDS prices nevertheless reflect financial strain, first in the great recession of 2009 and then again in 2011 as the prospects of default (and a German-led bailout) of Greece and other euro zone countries worsened. Still, even in late 2011, German CDS prices were only about one-third of those on U.S. banks.<br /><br />While CDSs were conceived as a form of bond insurance, it wasn’t long before investors realized that they could be used to speculate on the financial health of particular companies. As Figure 10.11 makes clear, someone in August 2008 wishing to bet against the financial sector might have purchased CDS contracts on those firms and would have profited as CDS prices spiked in September. In fact, hedge fund manager John Paulson famously did just this. His bearish bets in 2007–2008 on commercial banks and Wall Street firms as well as on some riskier mortgage-backed securities made his funds more than $15 billion, bringing him a personal payoff of more than $3.7 billion.</div>

A credit default swap (CDS) is in effect an insurance policy on the default risk of a corporate bond or loan. To illustrate, the annual pre...

Bond Indentures

<div style="text-align: justify;"> In addition to specifying a payment schedule, the bond indenture, which is the contract between the issuer and the bondholder, also specifies a set of restrictions that protect the rights of the bondholders. Such restrictions include provisions relating to collateral, sinking funds, dividend policy, and further borrowing. The issuing firm agrees to these so-called protective covenants in order to market its bonds to investors concerned about the safety of the bond issue.<br /><br /><b>Sinking funds</b> Bonds call for the payment of par value at the end of the bond’s life. This payment constitutes a large cash commitment for the issuer. To help ensure that the commitment does not create a cash flow crisis, the firm may agree to establish a sinking fundto spread the payment burden over several years. The fund may operate in one of two ways:<br /><br />1. The firm may repurchase a fraction of the outstanding bonds in the open market each year.<br />2. The firm may purchase a fraction of outstanding bonds at a special call price associated<br /> </div> <div style="text-align: justify;"> with the sinking fund provision. The firm has an option to purchase the bonds at either<br />the market price or the sinking fund price, whichever is lower. To allocate the burden of<br />the sinking fund call fairly among bondholders, the bonds chosen for the call are selectedat random based on serial number.<br /> </div> <div style="text-align: justify;"> The sinking fund call differs from a conventional call provision in two important ways. First, the firm can repurchase only a limited fraction of the bond issue at the sinking fund call price. At best, some indentures allow firms to use a doubling option, which allows repurchase ofdouble the required number of bonds at the sinking fund call price. Second, while callable</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh0S-OIDpZQEJOUm2F4czhI2WsQUW78K5YzoA6bulZqkSu6ouj_8JSgrlmGOQCeaUibomBkNLr2kmHgF9q0b5UhXnl019Jp52mIZeXTJaCqRglQYwr7YfpqsDrd1_ie7OqTStH4uphTDF4_/s1600/e.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh0S-OIDpZQEJOUm2F4czhI2WsQUW78K5YzoA6bulZqkSu6ouj_8JSgrlmGOQCeaUibomBkNLr2kmHgF9q0b5UhXnl019Jp52mIZeXTJaCqRglQYwr7YfpqsDrd1_ie7OqTStH4uphTDF4_/s1600/e.png" /></a></div> <div style="text-align: justify;"> bonds generally have call prices above par value, the sinking fund call price usually is set at the bond’s par value.<br /> </div> <div style="text-align: justify;"> Although sinking funds ostensibly protect bondholders by making principal repayment more likely, they can hurt the investor. The firm will choose to buy back discount bonds (selling below par) at their market price, while exercising its option to buy back premium bonds (selling above par) at par. Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that enables it to repurchase its bonds at belowmarket prices. In these circumstances, the firm’s gain is the bondholder’s loss.<br /><br />One bond issue that does not require a sinking fund is a serial bond issue in which the firm sells bonds with staggered maturity dates. As bonds mature sequentially, the principal repayment burden for the firm is spread over time just as it is with a sinking fund. Serial bonds do not include call provisions. Unlike sinking fund bonds, serial bonds do not confront security holders with the risk that a particular bond may be called for the sinking fund. The disadvantage of serial bonds, however, is that the bonds of each maturity date are different bonds, which reduces the liquidity of the issue. Trading these bonds, therefore, is more expensive.<br /><br />Subordination of further debt One of the factors determining bond safety is the total outstanding debt of the issuer. If you bought a bond today, you would be understandably distressed to see the firm tripling its outstanding debt tomorrow. Your bond would be riskier than it appeared when you bought it. To prevent firms from harming bondholders in this manner, subordination clauses restrict the amount of their additional borrowing. Additional debt might be required to be subordinated in priority to existing debt; that is, in the event of bankruptcy, subordinated or junior debtholders will not be paid unless and until the prior senior debt is fully paid off.<br /><br />Dividend restrictions Covenants also limit the dividends firms may pay. These limitations protect the bondholders because they force the firm to retain assets rather than pay them out to stockholders. A typical restriction disallows payments of dividends if cumulative dividends paid since the firm’s inception exceed cumulative retained earnings plus proceeds from sales of stock.<br /><br />Collateral Some bonds are issued with specific collateral behind them. Collateral is a particular asset that the bondholders receive if the firm defaults. If the collateral is property, the bond is called a mortgage bond. If the collateral takes the form of other securities held by the firm, the bond is a collateral trust bond. In the case of equipment, the bond is known as an equipment obligation bond. This last form of collateral is used most commonly by firms such as railroads, where the equipment is fairly standard and can be easily sold to another firm should the firm default.</div>

In addition to specifying a payment schedule, the bond indenture, which is the contract between the issuer and the bondholder, also specifi...

Determinants of bond safety

<div style="text-align: justify;"> DEFAULT RISK AND BOND PRICING<br />Although bonds generally promise a fixed flow of income, that income stream is not riskless unless the investor can be sure the issuer will not default on the obligation. While U.S. government bonds may be treated as free of default risk, this is not true of corporate bonds. If the company goes bankrupt, the bondholders will not receive all the payments they have been promised. Therefore, the actual payments on these bonds are uncertain, for they depend to some degree on the ultimate financial status of the firm. Bond default risk is measured by Moody’s Investor Services, Standard & Poor’s Corporation, and Fitch Investors Service, all of which provide financial information on firms as well as the credit risk of large corporate and municipal bond issues. International sovereign bonds, which also entail default risk, especially in emerging markets, also are commonly rated for default risk. Each rating firm assigns letter grades to reflect its assessment of bond safety. The top rating is AAA or Aaa. Moody’s modifies each rating class with a 1, 2, or 3 suffix (e.g., Aaa1, Aaa2, Aaa3) to provide a finer gradation of ratings. The other agencies use a 1 or 2 modification.<br /><br />Determinants of Bond Safety<br />Bond rating agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer’s financial ratios. The key ratios used to evaluate safety are:</div> <div style="text-align: justify;"> <br /></div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhVLd8HSlyKAKLf1cEarZ4KaYD7DkXrjpZ88ZFnTdnI92ZeN3kmFVp35Z_mF9zeIVpK3aafw17oguICgNwBm_egjYodIu9UjoLsvzOYiaEmxwTuJ1DJqAuqUlh4o2M5pSrbBMUXZ38_A6kt/s1600/d.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhVLd8HSlyKAKLf1cEarZ4KaYD7DkXrjpZ88ZFnTdnI92ZeN3kmFVp35Z_mF9zeIVpK3aafw17oguICgNwBm_egjYodIu9UjoLsvzOYiaEmxwTuJ1DJqAuqUlh4o2M5pSrbBMUXZ38_A6kt/s1600/d.png" /></a></div> <div style="text-align: justify;"> <br /></div> <ol> <li> Coverage ratios. Ratios of company earnings to fixed costs. For example, the times-interestearned ratio is the ratio of earnings before interest payments and taxes to interest obligations. The f ixed-charge coverage ratio includes lease payments and sinking fund paymentswith interest obligations to arrive at the ratio of earnings to all fixed cash obligations. Low or falling coverage ratios signal possible cash flow difficulties.</li> <li> Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy the obligations on its bonds</li> <li> Liquidity ratios. The two common liquidity ratios are the current ratio (current assets/current liabilities) and the quick ratio (current assets excluding inventories/current liabilities). These ratios measure the firm’s ability to pay bills coming due with its most liquid assets.\</li> <li> Prof itability ratios. Measures of rates of return on assets or equity. Profitability ratios are indicators of a firm’s overall performance. The return on assets (earnings before interest and taxes divided by total assets) or return on equity (net income/equity) are the most popular of these measures. Firms with higher return on assets or equity should be better able to raise money in security markets because they offer prospects for better returns on the firm’s investments.</li> </ol>

DEFAULT RISK AND BOND PRICING Although bonds generally promise a fixed flow of income, that income stream is not riskless unless the invest...

Fundamental analysis uses earnings and dividend

<div style="text-align: justify;"> Fundamental Analysis<br /> Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. Ultimately, it represents an attempt to determine the present discounted value of all the payments a stockholder will receive from each share of stock. If that value exceeds the stock price, the fundamental analyst would recommend purchasing the stock. Fundamental analysts usually start with a study of past earnings and an examination of company financial statements. They supplement this analysis with further detailed economic analysis, ordinarily including an evaluation of the quality of the firm’s management, the firm’s standing within its industry, and the prospects for the industry as a whole. <br /> <br /> Once again, the efficient market hypothesis predicts that most fundamental analysis also is doomed to failure. If the analyst relies on publicly available earnings and industry information, his or her evaluation of the firm’s prospects is not likely to be significantly more accurate than those of rival analysts. There are many well-informed, well-financed firms conducting such market research, and in the face of such competition it will be difficult to uncover data not also available to other analysts. Only analysts with a unique insight will be rewarded. Fundamental analysis is much more difficult than merely identifying well-run firms withgood prospects. </div> <div style="text-align: justify;"> <br /></div> <div style="text-align: justify;"> Discovery of good firms does an investor no good in and of itself if the rest of the market also knows those firms are good. If the knowledge is already public, the investor will be forced to pay a high price for those firms and will not realize a superior rate of return. The trick is not to identify firms that are good but to find firms that are better than everyone else’s estimate. Similarly, poorly run firms can be great bargains if they are not quite as bad as their stock prices suggest. This is why fundamental analysis is difficult. It is not enough to do a good analysis of a firm; you can make money only if your analysis is better than that of your competitors because the market price will already reflect all commonly available information.<br /> <br /></div>

Fundamental Analysis Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and ris...

Implications of the EHM technical analysis

<div style="text-align: justify;"> Technical Analysis<br /> Technical analysis is essentially the search for recurrent and predictable patterns in stock prices. Although technicians recognize the value of information regarding future economic prospects of the firm, they believe that such information is not necessary for a successful trading strategy. This is because whatever the fundamental reason for a change in stock price, if the stock price responds slowly enough, the analyst will be able to identify a trend that can be exploited during the adjustment period. The key to successful technical analysis is a sluggish response of stock prices to fundamental supply-and-demand factors. This prerequisite, of course, is diametrically opposed to the notion of an efficient market.<br /> <br /> Technical analysts are sometimes called chartists because they study records or charts of past stock prices, hoping to find patterns they can exploit to make a profit. As an example of technical analysis, consider the relative strength approach. The chartist compares stock performance over a recent period to performance of the market or other stocks in the same industry. A simple version of relative strength takes the ratio of the stock price to a market indicator such as the S&P 500 Index. If the ratio increases over time, the stock is said to exhibit relative strength because its price performance is better than that of the broad market. Such strength presumably may continue for a long enough period of time to offer profit opportunities.<br /> One of the most commonly heard components of technical analysis is the notion of resistance levels or support levels. These values are said to be price levels above which it is difficult for stock prices to rise or below which it is unlikely for them to fall, and they are believed to be levels determined by market psychology.<br /> <br /> The efficient market hypothesis implies that technical analysis is without merit. The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analyzing past prices has already been reflected in stock prices. As investors compete to exploit their common knowledge of a stock’s price history, they necessarily drive stock prices to levels where expected rates of return are exactly commensurate with risk. At those levels one cannot expect abnormal returns.<br /> <br /> As an example of how this process works, consider what would happen if the market believed that a level of $72 truly were a resistance level for stock XYZ in Example 8.2 . No one would be willing to purchase the stock at a price of $71.50, because it would have almost no room to increase in price but ample room to fall. However, if no one would buy it at $71.50, then $71.50 would become a resistance level. But then, using a similar analysis, no one would buy it at $71, or $70, and so on. The notion of a resistance level is a logical conundrum. Its simple resolution is the recognition that if the stock is ever to sell at $71.50, investors must believe that the price can as easily increase as fall. The fact that investors are willing to purchase (or even hold) the stock at $71.50 is evidence of their belief that they can earn a fair expected rate of return at that price.</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJIUhxECBbhwNli23noTY-_fpEoTC53Dpfh752_eJPdnMZgvULuLNzh-d-oBNDzP_ndXoal7vlgUltWxSMuPfPyC_O40n47pSejmxzwXcJ4w0Q1BM-cYwVoDBoDhuHqKae1jKR-uOU_Oi5/s1600/chek.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJIUhxECBbhwNli23noTY-_fpEoTC53Dpfh752_eJPdnMZgvULuLNzh-d-oBNDzP_ndXoal7vlgUltWxSMuPfPyC_O40n47pSejmxzwXcJ4w0Q1BM-cYwVoDBoDhuHqKae1jKR-uOU_Oi5/s1600/chek.png" /></a></div> <div style="text-align: justify;"> An interesting question is whether a technical rule that seems to work will continue to work in the future once it becomes widely recognized. A clever analyst may occasionally uncover a profitable trading rule, but the real test of efficient markets is whether the rule itself becomes reflected in stock prices once its value is discovered. Once a useful technical rule (or price pattern) is discovered, it ought to be invalidated when the mass of traders attempts to exploit it. In this sense, price patterns ought to be self-destructing.  Thus the market dynamic is one of a continual search for profitable trading rules, followed by destruction by overuse of those rules found to be successful, followed by more search for yet-undiscovered rules.Also read <a href="http://www.siteeconomics.net/2016/12/fundamental-analysis-uses-earnings-and-dividend.html" target="_blank">fundamental analysis uses earnings and dividend</a></div>

Technical Analysis Technical analysis is essentially the search for recurrent and predictable patterns in stock prices. Although technicia...

Scenario analysis and probability distributions

<div style="text-align: justify;"> When we attempt to quantify risk, we begin with the question: What HPRs are possible, and how likely are they? A good way to approach this question is to devise a list of possible economic outcomes, or scenarios, and specify both the likelihood (probability) of each scenario and the HPR the asset will realize in that scenario. Therefore, this approach is called scenario analysis. The list of possible HPRs with associated probabilities is the probability distribution of HPRs. Consider an investment in a broad portfolio of stocks, say, an index fund, which we will refer to as the “stock market.” A very simple scenario analysis for the stock market (assuming only four possible scenarios) is illustrated in Spreadsheet 5.1 . The probability distribution lets us derive measurements for both the reward and the risk of the investment. The reward from the investment is its expected return, which you can think of as the average HPR you would earn if you were to repeat an investment in the asset many times. The expected return also is called the mean of the distribution of HPRs and often is referred to as the mean return. To compute the expected return from the data provided, we label scenarios by s and denote the HPR in each scenario as r ( s ), with probability p ( s ). The expected return, denoted E ( r ), is then the weighted average of returns in all possible scenarios, s 5 1, . . . , S, with weights equal to the probability of that particular scenario.</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgK3prVy0yJhEsft5Y8JOW6kS6TXI1zwe8ofgj61aNkPa5aU6yqf_J4iXcX-m1o6nBadZGsPwLMVx9zeKfZzHcr28Q6nzLxEgVoTTp1b8YNoMSmHmP5jXm7jCddzmlhsgVLLfo-7xCk9FD-/s1600/scen+1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgK3prVy0yJhEsft5Y8JOW6kS6TXI1zwe8ofgj61aNkPa5aU6yqf_J4iXcX-m1o6nBadZGsPwLMVx9zeKfZzHcr28Q6nzLxEgVoTTp1b8YNoMSmHmP5jXm7jCddzmlhsgVLLfo-7xCk9FD-/s1600/scen+1.png" /></a></div> <div style="text-align: justify;"> Each entry in column D of Spreadsheet 5.1 corresponds to one of the products in the summation in Equation 5.6 . The value in cell D7, which is the sum of these products, is therefore the expected return. Therefore, E ( r ) = 10%. Because there is risk to the investment, the actual return may be (a lot) more or less than 10%. If a “boom” materializes, the return will be better, 30%, but in a severe recession the return will be a disappointing - 37%. How can we quantify this uncertainty?<br /><br />The “surprise” return in any scenario is the difference between the actual return and the expected return. For example, in a boom (scenario 4) the surprise is r (4) - E ( r ) 5=30% -10% 5 20%. In a severe recession (scenario 1), the surprise is r (1) - E ( r ) =  - 37% - 10% = - 47%.</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcb7-iNZ1Fc8bDtbTVQj_a-FAjfWE8H4USmyotqZXfPk-HU0Iw90IspYH-_Y8csb9OprJdiQHLDoprKpyqGCLUf-4yW8qLqjZtSLPjPbZLAmysz-M0sQ8fVgX9saWwhMAPszwiepzfmEcb/s1600/scen+2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcb7-iNZ1Fc8bDtbTVQj_a-FAjfWE8H4USmyotqZXfPk-HU0Iw90IspYH-_Y8csb9OprJdiQHLDoprKpyqGCLUf-4yW8qLqjZtSLPjPbZLAmysz-M0sQ8fVgX9saWwhMAPszwiepzfmEcb/s1600/scen+2.png" /></a></div> <div style="text-align: justify;"> Uncertainty surrounding the investment is a function of both the magnitudes and the  probabilities of the possible surprises. To summarize risk with a single number, we define the variance as the expected value of the squared deviation from the mean (the expected squared “surprise” across scenarios).</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJ_-KHA-PedFWsemPdUx9jhoIq2Nb4ofIb0za33imDMudi-bfzGAwZNZiG5CWdeGL7gbBeMJVbkmdeRgZ_dzyIppYgWAJfQl1zRVMMZeHKaXTbIp_K9zQH_mycPPC-qu_a1zIhuJINCeP-/s1600/scen+3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJ_-KHA-PedFWsemPdUx9jhoIq2Nb4ofIb0za33imDMudi-bfzGAwZNZiG5CWdeGL7gbBeMJVbkmdeRgZ_dzyIppYgWAJfQl1zRVMMZeHKaXTbIp_K9zQH_mycPPC-qu_a1zIhuJINCeP-/s1600/scen+3.png" /></a></div> <div style="text-align: justify;"> We square the deviations because negative deviations would offset positive deviations otherwise, with the result that the expected deviation from the mean return would necessarily be zero. Squared deviations are necessarily positive. Squaring (a nonlinear -transformation) exaggerates large (positive or negative) deviations and deemphasizes small deviations. Another result of squaring deviations is that the variance has a dimension of percent squared. To give the measure of risk the same dimension as expected return (%), we use the standard deviation, defined as the square root of the variance:</div> <div style="text-align: justify;"> </div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcRZGjw4coAG69gqlss9_kE-Ewb-f-I6W-HPqQ7uhe9LRoJOrRHLnYW2FEGsJGMK-3wFaYto5gPMLsL-dlGRmLSo2aVgECIoBAHJLzQVUjvopN011fsGKncVeriGhsZzfhRFeXuLWgwcpA/s1600/scen+4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="45" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcRZGjw4coAG69gqlss9_kE-Ewb-f-I6W-HPqQ7uhe9LRoJOrRHLnYW2FEGsJGMK-3wFaYto5gPMLsL-dlGRmLSo2aVgECIoBAHJLzQVUjvopN011fsGKncVeriGhsZzfhRFeXuLWgwcpA/s320/scen+4.png" width="320" /></a></div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjrNsoqq7cLKr23H72864IgV5bYM70Kl2SsfFQBLQEuodGViRYvi5U6DBHZRiTAacGEh_ulPe2EnwlSnFX4XItr0VDMVHdvWI55dgTH_f6HUVqyfjUiGcAY8QlXQaVA63EB6aBnTexXcf28/s1600/d.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjrNsoqq7cLKr23H72864IgV5bYM70Kl2SsfFQBLQEuodGViRYvi5U6DBHZRiTAacGEh_ulPe2EnwlSnFX4XItr0VDMVHdvWI55dgTH_f6HUVqyfjUiGcAY8QlXQaVA63EB6aBnTexXcf28/s1600/d.png" /></a></div> <div style="text-align: justify;"> <br /></div> <div style="text-align: justify;"> Column F of Spreadsheet 5.1 replicates these calculations. Each entry in that column is the squared<br />deviation from the mean multiplied by the probability of that scenario. The sum of the probabilityweighted squared deviations that appears in cell F7 is the variance, and the square root of that value is the standard deviation (in cell F8).</div>

When we attempt to quantify risk, we begin with the question: What HPRs are possible, and how likely are they? A good way to approach this ...

Measuring investment returns over multiple periods

<div class="separator" style="clear: both; text-align: center;"> </div> <div style="text-align: justify;"> The holding-period return is a simple and unambiguous measure of investment return over a single period. But often you will be interested in average returns over longer periods of time. For example, you might want to measure how well a mutual fund has performed over the preceding five-year period. In this case, return measurement is more ambiguous. Consider a fund that starts with $1 million under management. It receives additional funds from new and existing shareholders and also redeems shares of existing shareholders so that net cash inflow can be positive or negative. The fund’s quarterly results are as given in Table 5.1 , with negative numbers in parentheses. The numbers indicate that when the firm does well (i.e., achieves a high HPR), it attracts new funds; otherwise it may suffer a net outflow. For example, the 10% return in the first quarter by itself increased assets under management by .10 3 $1 million 5 $100,000; it also elicited new investments of $100,000, thus bringing assets under management to $1.2 million</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUH947zCE-T58a4mm4-Y-HGg5m2pQbngkLVhYuj6HDnKqgpVFg48B5511nhi-x1iFE3lucmPx3h9us2nvym9e0dkS4P0GMWn_xdoKDcVcvalwudMnD9YYgI3WQn-Sz4hkVKZPOg82llj7i/s1600/geo.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUH947zCE-T58a4mm4-Y-HGg5m2pQbngkLVhYuj6HDnKqgpVFg48B5511nhi-x1iFE3lucmPx3h9us2nvym9e0dkS4P0GMWn_xdoKDcVcvalwudMnD9YYgI3WQn-Sz4hkVKZPOg82llj7i/s1600/geo.png" /></a></div> <div style="text-align: justify;"> by the end of the quarter. An even better HPR in the second quarter elicited a larger net inflow, and the second quarter ended with $2 million under management. However, HPR in the third quarter was negative, and net inflows were negative. How would we characterize fund performance over the year, given that the fund experienced both cash inflows and outflows? There are several candidate measures of performance, each with its own advantages and shortcomings. These are the arithmetic average, the geometric average, and the dollar-weighted return. These measures may vary considerably, so it is important to  understand their differences.<br /><br />Arithmetic average The arithmetic average of the quarterly returns is just the sum of the quarterly returns divided by the number of quarters; in the above example: (10 + 25 - 20 + 20)/4 5 8.75%. Since this statistic ignores compounding, it does not represent an equivalent, single quarterly rate for the year. However, without information beyond the historical sample, the arithmetic average is the best forecast of performance for the next quarter.<br /><br />Geometric average The geometric average of the quarterly returns is equal to the single per-period return that would give the same cumulative performance as the sequence of actual returns. We calculate the geometric average by compounding the actual period-byperiod returns and then finding the per-period rate that will compound to the same final  value. In our example, the geometric average quarterly return, r G , is defined by</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWfkz8BhAl_DX9gFjcGbD8ebfkHAYaKMqX0d9SartcFSKFZaTKoTa_kKXBfRValjjK7rxy_qmVeRLQh7sW301id9zXIIy5uFbyMsDz_dSXjMEZXzl_cA_Z_HIu63kmbaGGBmm76VcurH56/s1600/ge0+2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWfkz8BhAl_DX9gFjcGbD8ebfkHAYaKMqX0d9SartcFSKFZaTKoTa_kKXBfRValjjK7rxy_qmVeRLQh7sW301id9zXIIy5uFbyMsDz_dSXjMEZXzl_cA_Z_HIu63kmbaGGBmm76VcurH56/s1600/ge0+2.png" /></a></div> <div style="text-align: justify;"> The left-hand side of this equation is the compounded year-end value of a $1 investment earning the four quarterly returns. The right-hand side is the compounded value of a $1 investment earning r G each quarter. We solve for r G :</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj_v9v5zGJYmu-0jE276pr59tgXmFw2S-QcA0kgGadNHuD-x8mpWVoOm7VLF-6-BBHK-Hc6uAbQ5OD3QbOyJFyIRwCbkfrVbdYcmdKPnwy0TfBIMMLo6MSUAOaP80AfBFBJn9Bi8U3fxO-d/s1600/geo+3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj_v9v5zGJYmu-0jE276pr59tgXmFw2S-QcA0kgGadNHuD-x8mpWVoOm7VLF-6-BBHK-Hc6uAbQ5OD3QbOyJFyIRwCbkfrVbdYcmdKPnwy0TfBIMMLo6MSUAOaP80AfBFBJn9Bi8U3fxO-d/s1600/geo+3.png" /></a></div> <div style="text-align: justify;"> The geometric return is also called a time-weighted average return because it ignores the quarter-to-quarter variation in funds under management. In fact, an investor will obtain a larger cumulative return when high returns are earned in periods when larger sums have been invested and low returns are earned when less money is at risk. In Table 5.1 , the higher returns (25% and 20%) were achieved in quarters 2 and 4, when the fund managed $1,200,000 and $800,000, respectively. The lower returns ( 2 20% and 10%) occurred when the fund managed $2,000,000 and $1,000,000, respectively. In this case, better returns were earned when less money was under management an unfavorable combination. Published data on past returns earned by mutual funds actually are required to be timeweighted returns. The rationale for this practice is that since the fund manager does not have full control over the amount of assets under management, we should not weight returns in one  period more heavily than those in other periods when assessing “typical” past performance.<br /><br />Dollar-weighted return To account for varying amounts under management, we treat the fund cash flows as we would a capital budgeting problem in corporate finance and compute the portfolio manager’s internal rate of return (IRR). The initial value of $1 million and the net cash inflows are treated as the cash flows associated with an investment “project.” The year-end “liquidation value” of the portfolio is the final cash flow of the project. In our example, the investor’s net cash flows are as follows:</div> <div class="separator" style="clear: both; text-align: center;">   </div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgnaDrDZji7r1SjExU0Q3XG9I6mnHdZLaWxytWLvHG9qVmSbSD-1xdoAKCvrAhR1-Tq43CzXPtE9CTP98-NrYrQTkQKe23mzcqLPNTHTu_UHIvHqPSq-dSAVKM0eb56D54Uincx3-KzfSmF/s1600/b.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgnaDrDZji7r1SjExU0Q3XG9I6mnHdZLaWxytWLvHG9qVmSbSD-1xdoAKCvrAhR1-Tq43CzXPtE9CTP98-NrYrQTkQKe23mzcqLPNTHTu_UHIvHqPSq-dSAVKM0eb56D54Uincx3-KzfSmF/s1600/b.png" /></a></div> <div class="separator" style="clear: both; text-align: center;"> <br /></div> <div style="text-align: justify;"> The entry for time 0 reflects the starting contribution of $1 million; the negative entries for times 1 and 2 are additional net inflows in those quarters, while the positive value for quarter 3 signifies a withdrawal of funds. Finally, the entry for time 4 represents the sum of the final (negative) cash inflow plus the value of the portfolio at the end of the fourth quarter. The latter is the value for which the portfolio could have been liquidated at year-end. The dollar-weighted average return is the internal rate of return of the project, which is 3.38%. The IRR is the interest rate that sets the present value of the cash flows realized on the portfolio (including the $1.56 million for which the portfolio can be liquidated at the end of the year) equal to the initial cost of establishing the portfolio. It therefore is the interest rate that satisfies the following equation </div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5ZD6EyS0raDWmUHz5LVmL3f2yCej4WqNk1Mtg0uKoFTlYih9s1_dy6SFnY_BphFKi1GlMqTWM_etxFBF1wbUnVY8divQt3HwZ0ZWClC_tfF-z-7nYlprYTGQwekQUFDsgwPumb0AHGcgi/s1600/geo+5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi5ZD6EyS0raDWmUHz5LVmL3f2yCej4WqNk1Mtg0uKoFTlYih9s1_dy6SFnY_BphFKi1GlMqTWM_etxFBF1wbUnVY8divQt3HwZ0ZWClC_tfF-z-7nYlprYTGQwekQUFDsgwPumb0AHGcgi/s1600/geo+5.png" /></a></div> <div style="text-align: justify;"> The dollar-weighted return in this example is less than the time-weighted return of 7.19% because, as we noted, the portfolio returns were higher when less money was under management. The difference between the dollar- and time-weighted average return in this case is quite large.</div>

The holding-period return is a simple and unambiguous measure of investment return over a single period. But often you will be interested...

Information on mutual funds

<div style="text-align: justify;"> The first place to find information on a mutual fund is in its prospectus. The Securities and Exchange Commission requires that the prospectus describe the fund’s investment objectives and policies in a concise “Statement of Investment Objectives” as well as in lengthy discussions of investment policies and risks. The fund’s investment adviser and its portfolio manager also are described. The prospectus also presents the costs associated with purchasing shares in the fund in a fee table. Sales charges such as front-end and back-end loads as well as annual operating expenses such as management fees and 12b-1 fees are detailed in the fee table.<br /><br />Funds provide information about themselves in two other sources. The Statement of Additional Information, or SAI, also known as Part B of the prospectus, includes a list of the securities in the portfolio at the end of the fiscal year, audited financial statements, a list of the directors and officers of the fund as well as their personal investments in the fund, and data on brokerage commissions paid by the fund. Unlike the fund prospectus, however, investors do not receive the SAI unless they specifically request it; one industry joke is that SAI stands for  “something always ignored.” The fund’s annual report also includes portfolio composition andfinancial statements, as well as a discussion of the factors that influenced fund performance over the last reporting period.<br /><br />With more than 8,000 mutual funds to choose from, it can be difficult to find and select the fund that is best suited for a particular need. Several publications now offer “encyclopedias” of mutual fund information to help in the search process. One prominent source is Morningstar’s Mutual Fund Sourcebook. Morningstar’s website, www.morningstar.com , is another excellent source of information, as is Yahoo!’s site, finance.yahoo.com/funds . The Investment Company Institute the national association of mutual funds, closed-end funds, and unit investment trusts publishes an annual Directory of Mutual Funds that includes information on fees as well as phone numbers to contact funds. To illustrate the range of information available about funds, we consider a sample report from Morningstar, reproduced in Figure 4.5 .</div> <div style="text-align: justify;"> <br /></div> <div style="text-align: justify;">  Some of Morningstar’s analysis is qualitative. The top box on the left-hand side of the report reproduced in the figure provides a short description of fund strategy, in particular the types of securities in which the fund manager tends to invest. The bottom box on the left (“Morningstar’s Take”) is a more detailed discussion of the fund’s income strategy. The short statement of the fund’s investment policy is in the top right-hand corner: Laudus is a “large</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTZQGFvkLV2SNlRP3s18dfuDtG-da7yoD5sQyZthsJUFE8SUai-_CWOe40STt2aXgRP-tg5C9jQ1FESsSKfck76hGAI-LhtW8aP5YDKY5OZL8LzWYoDcDCkeHepKpiVMIfP8MDCKTIOD_D/s1600/n.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTZQGFvkLV2SNlRP3s18dfuDtG-da7yoD5sQyZthsJUFE8SUai-_CWOe40STt2aXgRP-tg5C9jQ1FESsSKfck76hGAI-LhtW8aP5YDKY5OZL8LzWYoDcDCkeHepKpiVMIfP8MDCKTIOD_D/s1600/n.png" /></a></div> <div style="text-align: justify;"> growth” fund, meaning that it tends to invest in large firms, with an emphasis on growth over value stocks. The table on the left in the figure, labeled “Performance,” reports on the fund’s quarterly returns over the last few years and then over longer periods up to 15 years. Comparisons of returns to relevant indexes, in this case, the S&P 500 and the Russell 1000 indexes, are provided to serve as benchmarks in evaluating the performance of the fund. The values under these columns give the performance of the fund relative to the index. The returns reported for the fund are calculated net of expenses, 12b-1 fees, and any other fees automatically deducted from fund assets, but they do not account for any sales charges such as<br /><br />front-end loads or back-end charges. Next appear the percentile ranks of the fund compared to all other funds with the same investment objective (see column headed “%Rank Cat”). A rank of 1 means the fund is a top performer. A rank of 80 would mean that it was beaten by 80% of funds in the comparison group. Finally, growth of $10,000 invested in the fund over various periods ranging from the past three months to the past 15 years is given in the last column.<br /><br />More data on the performance of the fund are provided in the graph near the top of the figure. The line graph compares the growth of $10,000 invested in the fund and the S&P 500 over the last 10 years. Below the graph are boxes for each year that depict the relative performance of the fund for that year. The shaded area on the box shows the quartile in which the fund’s performance falls relative to other funds with the same objective. If the shaded band is at the top of the box, the firm was a top quartile performer in that period, and so on. The table below the bar charts presents historical data on characteristics of the fund such as return data and expense ratios.<br /><br />The table on the right entitled “Portfolio Analysis” presents the 20 largest holdings of the portfolio, showing the price–earnings ratio and year-to-date return of each of those securities. Investors can thus get a quick look at the manager’s biggest bets. Below the portfolio analysis table is a box labeled “Current Investment Style.” In this box, Morningstar evaluates style along two dimensions: One dimension is the size of the firms held in the portfolio as measured by the market value of outstanding equity; the other dimension is a value/growth measure. Morningstar defines value stocks as those with low ratios of market price per share to various measures of value. It puts stocks on a growth-value continuum based on the ratios of stock price to the firm’s earnings, book value, sales, cash flow, and dividends. Value stocks are those with a low price relative to these measures of value. In contrast, growth stocks have high ratios, suggesting that investors in these firms must believe that the firm will experience rapid growth to justify the prices at which the stocks sell. The shaded box for Laudus shows that the portfolio tends to hold larger firms (top row) and growth stocks (right column). A year-by-year history of Laudus’s investment style is presented in thesequence of such boxes at the top of Figure 4.5 .<br /><br />The center of the figure, labeled “Rating and Risk,” is one of the more complicated but interesting facets of Morningstar’s analysis. The column labeled “Load-Adj Return” rates a fund’s return compared to other funds with the same investment policy. Returns for periods ranging from 1 to 10 years are calculated with all loads and back-end fees applicable to that investment period subtracted from total income. The return is then compared to the average return for the comparison group of funds to obtain the Morningstar Return vs. Category. Similarly, risk measures compared to category are computed and reported in the next column. The last column presents Morningstar’s risk-adjusted rating, ranging from one to five stars. The rating is based on the fund’s return score minus risk score compared to other funds with similar investment styles. To allow funds to be compared to other funds with similar investment styles, Morningstar employs a large number of categories; there are now 48 separate stock and bond fund categories. Of course, we are accustomed to the disclaimer that “past performance is not a reliable measure of future results,” and this is true as well of the coveted Morningstar five-star rating.<br /><br />The “Tax Analysis” box shown on the left in Figure 4.5 provides some evidence on the tax efficiency of the fund. The after-tax return, given in the first column, is computed based on the dividends paid to the portfolio as well as realized capital gains, assuming the investor is in the maximum federal tax bracket at the time of the distribution. State and local taxes are ignored. The tax efficiency of the fund is measured by the “Tax-Cost Ratio,” which is an estimate of the impact of taxes on the investor’s after-tax return. Morningstar ranks each fund compared to its category for both tax-adjusted return and tax-cost ratio. The bottom of the page in Figure 4.5 provides information on the expenses and loads associated with investments in the fund, as well as information on the fund’s investment adviser. Thus, Morningstar provides a considerable amount of the information you would need to decide among several competing funds.</div>

The first place to find information on a mutual fund is in its prospectus. The Securities and Exchange Commission requires that the prospec...

Fees and Mutual Fund Returns

The rate of return on an investment in a mutual fund is measured as the increase or decrease in net asset value plus income distributions such as dividends or distributions of capital gains expressed as a fraction of net asset value at the beginning of the investment period. If we denote the net asset value at the start and end of the period as NAV 0 and NAV 1 , respectively, then<br /> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjcZzQNIV2BHEFmayuZtfSHxSzUGMdv7I9VkM8mk25dXu0-i-1lz4OmUOQPPbZ1SxNj6taNt-UghCFA7wGuFw3gE1ztQOsPsMrgWvx1rAqB-Vkop75g2qPodKHq9sp4TUAoiz223e1yDkDJ/s1600/1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjcZzQNIV2BHEFmayuZtfSHxSzUGMdv7I9VkM8mk25dXu0-i-1lz4OmUOQPPbZ1SxNj6taNt-UghCFA7wGuFw3gE1ztQOsPsMrgWvx1rAqB-Vkop75g2qPodKHq9sp4TUAoiz223e1yDkDJ/s1600/1.png" /></a></div> For example, if a fund has an initial NAV of $20 at the start of the month, makes income distributions of $.15 and capital gain distributions of $.05, and ends the month with NAV of $20.10, the monthly rate of return is computed as<br /><br /> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYA3R4NCb7oxnCGzPSSfAMksGx9RQxKizJg-cDDAjATLJQ4lMqaVIRKZNFS-MFeAeWh7HraabLpElU6L_wP5bxX6aQKpN13VjGo7fR98OgQlo34hPP_gWnr-dr1QLX0Ribmn2qIx9PRTio/s1600/2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYA3R4NCb7oxnCGzPSSfAMksGx9RQxKizJg-cDDAjATLJQ4lMqaVIRKZNFS-MFeAeWh7HraabLpElU6L_wP5bxX6aQKpN13VjGo7fR98OgQlo34hPP_gWnr-dr1QLX0Ribmn2qIx9PRTio/s1600/2.png" /></a></div> Notice that this measure of the rate of return ignores any commissions such as front-end loads paid to purchase the fund. On the other hand, the rate of return is affected by the fund’s expenses and 12b-1 fees. This is because such charges are periodically deducted from the portfolio, which reduces net asset value. Thus the rate of return on the fund equals the gross return on the underlying portfolio minus the total expense ratio.<br /> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqVMIBDkHnZgcG8lOqou67KvlLfcQIDLznk2BZErEE8FDb6iR0-cpRLq_va0jLHrAwUS6CrydXvftolOAJjcrGXsiu0NsweUeyDJWmkH3-cL_frMgMzTsFZvoffYRRD3Gl5TzLzoMuphlh/s1600/3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqVMIBDkHnZgcG8lOqou67KvlLfcQIDLznk2BZErEE8FDb6iR0-cpRLq_va0jLHrAwUS6CrydXvftolOAJjcrGXsiu0NsweUeyDJWmkH3-cL_frMgMzTsFZvoffYRRD3Gl5TzLzoMuphlh/s1600/3.png" /></a></div> Fees can have a big effect on performance. Table 4.2 considers an investor who starts with $10,000 and can choose between three funds that all earn an annual 12% return on investment before fees but have different fee structures. The table shows the cumulative amount in each fund after several investment horizons. Fund A has total operating expenses of .5%, no  load, and no 12b-1 charges. This might represent a low-cost producer like Vanguard. Fund B has no load but has 1% management expenses and .5% in 12b-1 fees. This level of charges<br /><br />is fairly typical of actively managed equity funds. Finally, Fund C has 1% in management expenses, has no 12b-1 charges, but assesses an 8% front-end load on purchases. Note the substantial return advantage of low-cost Fund A. Moreover, that differential is greater for longer investment horizons.<br /><br />Although expenses can have a big impact on net investment performance, it is sometimes difficult for the investor in a mutual fund to measure true expenses accurately. This is because of the common practice of paying for some expenses in soft dollars. A portfolio manager earns soft-dollar credits with a brokerage firm by directing the fund’s trades to that broker. Based on those credits, the broker will pay for some of the mutual fund’s expenses, such as databases, computer hardware, or stock-quotation systems. The soft-dollar arrangement means that the stockbroker effectively returns part of the trading commission to the fund. Purchases made with soft dollars are not included in the fund’s expenses, so funds with extensive soft-dollar arrangements may report artificially low expense ratios to the public. However, the fund will have paid its brokers needlessly high commissions to obtain its soft-dollar “rebates.” The impact of the higher trading commissions shows up in net investment performance rather than the reported expense ratio. The SEC allows soft-dollar arrangements as long as the proceeds are used for research that may ultimately benefit the mutual fund shareholder. About half of such funds have been used to purchase stock research reports. There have certainly been cases in which soft dollars were used for purposes other than the welfare of shareholders, however, and consumer advocates periodically propose that their use be curtailed.<br /><br />

The rate of return on an investment in a mutual fund is measured as the increase or decrease in net asset value plus income distributions su...

Costs of investing in mutual funds

<div style="text-align: justify;"> <b>Fee Structure</b><br />An individual investor choosing a mutual fund should consider not only the fund’s stated investment policy and past performance, but also its management fees and other expenses. Comparative data on virtually all important aspects of mutual funds are available in the annual reports prepared by CDA/Wiesenberger or in Morningstar’s Mutual Fund Sourcebook, which can be found in many academic and public libraries. You should be aware of four general classes of fees.<br /><br /><b>Operating expenses</b> </div> <div style="text-align: justify;">  Operating expenses are the costs incurred by the mutual fund in operating the portfolio, including administrative expenses and advisory fees paid to the investment manager. These expenses, usually expressed as a percentage of total assets under management, may range from 0.2% to 2%. Shareholders do not receive an explicit bill for these operating expenses; however, the expenses periodically are deducted from the assets of the fund. Shareholders pay for these expenses through the reduced value of the portfolio. The simple average of the expense ratio of equity funds in the U.S. was 1.43% in 2011. But larger funds tend to have lower expense ratios (and investors place more of their assets in lower-cost funds), so the average expense ratio weighted by assets under management is considerably smaller, .79%. In addition to operating expenses, most funds assess fees to pay for marketing and distribution costs. These charges are used primarily to pay the brokers or financial advisers who sell the funds to the public. Investors can avoid these expenses by buying shares directly from the fund sponsor, but many investors are willing to incur these distribution fees in return for the advice they may receive from their broker.<br /><br /><b>Front-end load</b> </div> <div style="text-align: justify;">  A front-end load is a commission or sales charge paid when you purchase the shares. These charges, which are used primarily to pay the brokers who sell the funds, may not exceed 8.5%, but in practice they are rarely higher than 6%. Low-load funds have loads that range up to 3% of invested funds. No-load funds have no front-end sales charges. About half of all funds today (measured by assets) are no load. Loads effectively reduce the amount of money invested. For example, each $1,000 paid for a fund with a 6% load results in a sales charge of $60 and fund investment of only $940. You need cumulativereturns of 6.4% of your net investment (60/940 5 .064) just to break even.<br /><br /><b>Back-end load</b> </div> <div style="text-align: justify;"> A back-end load is a redemption, or “exit,” fee incurred when you sell your shares. Typically, funds that impose back-end loads start them at 5% or 6% and reduce them by one percentage point for every year the funds are left invested. Thus, an exit fee that starts at 6% would fall to 4% by the start of your third year. These charges are known more formally as “contingent deferred sales charges.”<br /><br /><b>12b-1 charges</b> </div> <div style="text-align: justify;"> The Securities and Exchange Commission allows the managers of socalled 12b-1 funds to use fund assets to pay for distribution costs such as advertising, promotional literature including annual reports and prospectuses, and, most important, commissions paid to brokers who sell the fund to investors. These 12b-1 fees are named after the SEC rule that permits use of these plans. Funds may use annual 12b-1 charges instead of, or in addition to, front-end loads to generate the fees with which to pay brokers. As with operating expenses, investors are not explicitly billed for 12b-1 charges. Instead, the fees are deducted from the assets of the fund. Therefore, 12b-1 fees (if any) must be added to operating expenses to obtain the true annual expense ratio of the fund. The SEC now requires that all funds include in the prospectus a consolidated expense table that summarizes all relevant fees. The 12b-1 fees are limited to 1% of a fund’s average net assets per year.<br /> </div> <div style="text-align: justify;"> Many funds offer “classes” which represent ownership in the same portfolio of securities, but with different combinations of fees. Typical Class A shares have front-end loads and a small 12b-1 fee, often around .25%. Class B shares rely on larger 12b-1 fees, commonly 1%, and often charge a modest back-end load. If an investor holds Class B shares for a long enough duration, typically 6–8 years, the shares often will convert into Class A shares which have lower 12b-1 fees. Class C shares generally rely on 12b-1 fees and back-end loads. These shares usually will not convert to Class A shares.</div> <div class="separator" style="clear: both; text-align: justify;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiT2xBa7znifT3P5tIfy2yLMacRBsRolgk6d1kSphI_vlHYbZa82ix-jTpnqNB6x32GSZdF1LsD3n4Jquvwpbz11icb34UFcGnpJwyB5DVajAkQqhscXv3vqKeAK0_JbcmwEbZzZRR6f4Sg/s1600/fo.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiT2xBa7znifT3P5tIfy2yLMacRBsRolgk6d1kSphI_vlHYbZa82ix-jTpnqNB6x32GSZdF1LsD3n4Jquvwpbz11icb34UFcGnpJwyB5DVajAkQqhscXv3vqKeAK0_JbcmwEbZzZRR6f4Sg/s1600/fo.png" /></a></div> <div style="text-align: justify;"> Each investor must choose the best combination of fees. Obviously, pure no-load no-fee funds distributed directly by the mutual fund group are the cheapest alternative, and these will often make the most sense for knowledgeable investors. But as we noted earlier, many investors are willing to pay for financial advice, and the commissions paid to advisers who sell these funds are the most common form of payment. Alternatively, investors may choose to hire a fee-only financial manager who charges directly for services instead of collecting commissions. These advisers can help investors select portfolios of low- or no-load funds (as well as provide other financial advice). Independent financial planners have become increasingly  important distribution channels for funds in recent years.<br /><br />If you do buy a fund through a broker, the choice between paying a load and paying 12b-1 fees will depend primarily on your expected time horizon. Loads are paid only once for each purchase, whereas 12b-1 fees are paid annually. Thus, if you plan to hold your fund for a long time, a one-time load may be preferable to recurring 12b-1 charges.</div>

Fee Structure An individual investor choosing a mutual fund should consider not only the fund’s stated investment policy and past performan...

Mutual funds Investment policies

<div style="text-align: justify;"> Investment Policies<br />Each mutual fund has a specified investment policy, which is described in the fund’s prospectus. For example, money market mutual funds hold the short-term, low-risk instruments of the money market , while bond funds hold fixed-income securities. Some funds have even more narrowly defined mandates. For example, some bond funds will hold primarily Treasury bonds, others primarily mortgage-backed securities. Management companies manage a family, or “complex,” of mutual funds. They organize an entire collection of funds and then collect a management fee for operating them. By managing a collection of funds under one umbrella, these companies make it easy for investors to allocate assets across market sectors and to switch assets across funds while still benefiting from centralized record keeping. Some of the most well-known management companies are Fidelity, Vanguard, Putnam, and Dreyfus. Each offers an array of open-end mutual funds with different investment policies. In early 2011, there were over 8,000 mutual funds in the United States, which were offered by 669 fund complexes. Some of the more important fund types, classified by investment policy, are discussed next.<br /><br /><b>Money market funds</b> These funds invest in money market securities such as commercial paper, repurchase agreements, or certificates of deposit. The average maturity of these assets tends to be a bit more than one month. They usually offer check-writing features, and net asset value is fixed at $1 per share, 1 so that there are no tax implications such as capital gains or losses associated with redemption of shares.<br /><br /><b>Equity funds</b> Equity funds invest primarily in stock, although they may, at the portfolio manager’s discretion, also hold fixed-income or other types of securities. Equity funds commonly will hold about 5% of total assets in money market securities to provide the liquidity necessary to meet potential redemption of shares. Stock funds are traditionally classified by their emphasis on capital appreciation versus current income. Thus income funds tend to hold shares of firms with high dividend yields that provide high current income. Growth funds are willing to forgo current income, focusing instead on prospects for capital gains. While the classification of these funds is couched in terms of income versus capital gains, it is worth noting that in practice the more relevant distinction concerns the level of risk these funds assume. Growth stocks—and therefore growth funds—are typically riskier and respond more dramatically to changes in economic conditions than do income funds.<br /><br /><b>Specialized sector funds</b> Some equity funds, called sector funds, concentrate on a particular industry. For example, Fidelity markets dozens of “select funds,” each of which invests in a specific industry such as biotechnology, utilities, precious metals, or telecommunications. Other funds specialize in securities of particular countries.<br /><br /><b>Bond funds</b> As the name suggests, these funds specialize in the fixed-income sector. Within that sector, however, there is considerable room for further specialization. For example, various funds will concentrate on corporate bonds, Treasury bonds, mortgage-backed securities, or municipal (tax-free) bonds. Indeed, some municipal bond funds invest only in bonds of a particular state (or even city!) in order to satisfy the investment desires of residents of that state who wish to avoid local as well as federal taxes on interest income. Many funds also specialize by maturity, ranging from short-term to intermediate to long-term, or by the credit risk of the issuer, ranging from very safe to high-yield or “junk” bonds. </div> <div style="text-align: justify;"> <br /></div> <div style="text-align: justify;"> <b>International funds</b> Many funds have international focus. Global funds invest in securities worldwide, including the United States. In contrast, international funds invest in securities of firms located outside the U.S. Regional funds concentrate on a particular part of the world, and emerging market funds invest in companies of developing nations.<br /><br /><b>Balanced funds</b> Some funds are designed to be candidates for an individual’s entire investment portfolio. These balanced funds hold both equities and fixed-income securities in relatively stable proportions. Life-cycle funds are balanced funds in which the asset mix can range from aggressive (primarily marketed to younger investors) to conservative (directed at older investors). Static allocation life-cycle funds maintain a stable mix across stocks and bonds, while targeted-maturity funds gradually become more conservative as the investor ages. Many balanced funds are in fact funds of funds. These are mutual funds that primarily invest in shares of other mutual funds. Balanced funds of funds invest in equity and bond funds in proportions suited to their investment goals.<br /><br /><br /><b>Asset allocation and flexible funds </b>These funds are similar to balanced funds in that they hold both stocks and bonds. However, asset allocation funds may dramatically vary the proportions allocated to each market in accord with the portfolio manager’s forecast of the relative performance of each sector. Hence, these funds are engaged in market timing and are not designed to be low-risk investment vehicles.<br /><br /><b>Index funds</b> An index fund tries to match the performance of a broad market index. The fund buys shares in securities included in a particular index in proportion to the security’s representation in that index. For example, the Vanguard 500 Index Fund is a mutual fund that replicates the composition of the Standard & Poor’s 500 stock price index. Because the S&P 500 is a value-weighted index, the fund buys shares in each S & P 500 company in proportion to the market value of that company’s outstanding equity. Investment in an index fund is a low-cost way for small investors to pursue a passive investment strategy—that is, to invest without engaging in security analysis. Nearly 25% of assets invested in equity funds in 2012 were in index funds. Of course, index funds can be tied to nonequity indexes as well. For example, Vanguard  offers a bond index fund and a real estate index fund.<br /><br />Table 4.1 breaks down the number of mutual funds by investment orientation. Sometimes the fund name describes its investment policy. For example, Vanguard’s GNMA Fund invests in mortgage-backed securities, the Municipal Intermediate Fund invests in intermediateterm municipal bonds, and the High-Yield Corporate Bond Fund invests in large part in</div> <div class="separator" style="clear: both; text-align: center;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTvmzQvlLYiBkjUMZlWlQPUaSxLStmPmP5S0zwxJaTbXTNt9qE7iVYSDSEjG5KXDm1G6CUbMKXoXhVV8JxDiIVA5kfqwIIW9wNl665tHk3qAq5nus2BCbbBcTmZEkv8ph__aeq3p9XCpxN/s1600/fund.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTvmzQvlLYiBkjUMZlWlQPUaSxLStmPmP5S0zwxJaTbXTNt9qE7iVYSDSEjG5KXDm1G6CUbMKXoXhVV8JxDiIVA5kfqwIIW9wNl665tHk3qAq5nus2BCbbBcTmZEkv8ph__aeq3p9XCpxN/s1600/fund.png" /></a></div> <div style="text-align: justify;">  speculative grade, or “junk,” bonds with high yields. However, names of common stock funds often reflect little or nothing about their investment policies. Examples are Vanguard’s Windsor and Wellington funds.</div>

Investment Policies Each mutual fund has a specified investment policy, which is described in the fund’s prospectus. For example, money mar...