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HANDBOOKOF

FINANCE

VOLUME I

Financial Marketsand Instruments

Frank J. FabozziEditor

John Wiley & Sons, Inc.

iii


ii


HANDBOOKOF

FINANCE

VOLUME I

i


ii


HANDBOOKOF

FINANCE

VOLUME I

Financial Marketsand Instruments

Frank J. FabozziEditor

John Wiley & Sons, Inc.

iii


Copyright c© 2008 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, orauthorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com.Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons,Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online athttp://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Handbook of finance / Frank J. Fabozzi, editor.p. cm.

Includes index.ISBN 978-0-470-04256-4 (3 v. set : cloth) – ISBN 978-0-470-07814-3 (v. 1) –ISBN 978-0-470-07815-0 (v. 2) – ISBN 978-0-470-07816-7 (v. 3)

1. Finance–Handbooks, manuals, etc. I. Fabozzi, Frank J.HG173.H327 2008332–dc22 2008020129

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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www.wiley.com


About the Editor

Frank J. Fabozzi is Professor in the Practice of Financeand Becton Fellow in the Yale School of Management.Prior to joining the Yale faculty, he was a Visiting Pro-fessor of Finance in the Sloan School of Management atMassachusetts Institute of Technology. Professor Fabozziis a Fellow of the International Center for Finance at YaleUniversity and on the Advisory Council for the Depart-ment of Operations Research and Financial Engineeringat Princeton University. He is an affiliated professor at theInstitute of Statistics, Econometrics and Mathematical Fi-nance at the University of Karlsruhe (Germany). He is the

editor of the Journal of Portfolio Management and an asso-ciate editor of the Journal of Fixed Income, Journal of AssetManagement, Journal of Structured Finance, and the Review ofFutures Markets. He earned a doctorate in economics fromthe City University of New York in 1972. In 2002, Profes-sor Fabozzi was inducted into the Fixed Income AnalystsSociety’s Hall of Fame and is the 2007 recipient of theC. Stewart Sheppard Award given by the CFA Institute.He earned the designations of Chartered Financial Ana-lyst and Certified Public Accountant. He has authored andedited numerous books on various topics in finance.

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Contents

Contributors xvPreface xxiiiGuide to the Handbook of Finance xxvIndex 779

Volume I

PART 1 Market Players and Markets 1

1. Overview of Financial Instruments andFinancial Markets 3Frank J. Fabozzi

2. Fundamentals of Investing 9Frank J. Fabozzi

3. The American Banking System 17R. Philip Giles

4. Monetary Policy: How the Fed Sets,Implements, and Measures Policy Choices 29David M. Jones and Ellen J. Rachlin

5. Institutional Aspects of the Securities Markets 37James R. Thompson, Edward E. Williams, and M.Chapman Findlay, III

6. Investment Banking 51K. Thomas Liaw

7. Securities Innovation 61John D. Finnerty

8. An Arbitrage Perspective of the Purpose andStructure of Financial Markets 93Robert Dubil

9. Complete Markets 107Les Gulko

10. Introduction to Islamic Finance 115Mahmoud A. El-Gamal

PART 2 Common Stock 123

Cash Instruments

11. The U.S. Equity Markets 125Frank J. Jones and Frank J. Fabozzi

12. The Information Content of Short Sales 151Steven L. Jones and Glen Larsen

13. Emerging Stock Market Investment 163Larry Speidell and Jarrod W. Wilcox

Equity Derivatives

14. Listed Equity Options and Futures 175Bruce Collins and Frank J. Fabozzi

15. OTC Equity Derivatives 181Bruce Collins and Frank J. Fabozzi

16. Volatility Derivatives 191Robert Whaley

PART 3 Fixed Income Instruments 205

Basics

17. Bonds: Investment Features and Risks 207Frank J. Fabozzi

18. Residential Mortgages 221Frank J. Fabozzi, Anand K. Bhattacharya, andWilliam S. Berliner

19. Reverse Mortgages 231Laurie S. Goodman

Nonmortgage Related Fixed Income Securitiesand Money Market Instruments

20. U.S. Treasury Securities 237Frank J. Fabozzi

21. Federal Agency Securities 243Frank J. Fabozzi and George P. Kegler

22. Municipal Securities 249Frank J. Fabozzi

23. Corporate Fixed Income Securities 259Frank J. Fabozzi

24. The Eurobond Market 271Moorad Choudhry

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viii Contents

25. The Euro Government Bond Market 285Antonio Villarroya

26. The German Pfandbrief and EuropeanCovered Bonds Market 295Graham “Harry” Cross

27. Commercial Paper 305Moorad Choudhry, Frank J. Fabozzi, and StevenV. Mann

28. Money Market Calculations 313Steven V. Mann and Frank J. Fabozzi

29. Convertible Bonds 319Frank J. Fabozzi, Steven V. Mann, and FilippoStefanini

30. Syndicated Loans 325Steven Miller

31. Emerging Markets Debt 339Maria Mednikov Loucks, John A. Penicook, and UweSchillhorn

Structured Products

32. Introduction to Mortgage-Backed Securities 347Frank J. Fabozzi, Anand K. Bhattacharya, and WilliamS. Berliner

33. Structuring Collateralized MortgageObligations and Interest-Only/Principal-OnlySecurities 355Andrew Davidson, Anthony Sanders, Lan-Ling Wolff,and Anne Ching

34. Commercial Mortgage-Backed Securities 367James Manzi, Diana Berezina, and Mark Adelson

35. Nonmortgage Asset-Backed Securities 375Frank J. Fabozzi, Laurie S. Goodman, and Douglas J.Lucas

36. Synthetic Asset-Backed Securities 385Moorad Choudhry

37. Catastrophe Bonds 389William L. Messmore, Beth Starr, Sunita Ganapati,Mark Retik, and Paul Puleo

38. Collateralized Debt Obligations 395Douglas J. Lucas, Laurie S. Goodman, and FrankJ. Fabozzi

Fixed Income and Inflation Derivatives

39. Interest Rate Futures and Forward RateAgreements 411Frank J. Fabozzi and Steven V. Mann

40. Interest Rate Swaps 421Frank J. Fabozzi and Gerald W. Buetow

41. Interest Rate Options and Related Products 427Frank J. Fabozzi, Steven V. Mann, and MooradChoudhry

42. Introduction to Credit Derivatives 435Vinod Kothari

43. Fixed Income Total Return Swaps 447Mark J.P. Anson, Frank J. Fabozzi, Moorad Choudhry,and Ren-Raw Chen

Bond Market

44. Bond Market Transparency 455Daniel E. Gallegos and Chris Barr

45. Bond Spreads and Relative Value 463Moorad Choudhry

46. The Determinants of the Swap Spread andUnderstanding the LIBOR Term Premium 469Moorad Choudhry

PART 4 Real Estate 481

47. Real Estate Investment 483Susan Hudson-Wilson

48. Investing in Commercial Real Estate forIndividual Investors 495G. Timothy Haight and Daniel D. Singer

49. Types of Commercial Real Estate 505G. Timothy Haight and Daniel D. Singer

50. Commercial Real Estate Loans and Securities 515Rebecca J. Manning, Douglas J. Lucas, Laurie S.Goodman, and Frank J. Fabozzi

51. Commercial Real Estate Derivatives 525Jeffrey D. Fisher and David Geltner

PART 5 Alternative Investments 535

52. Alternative Asset Classes 537Mark J. P. Anson

53. Hedge Funds 543Mark J. P. Anson

54. Introduction to Venture Capital 561Mark J. P. Anson

55. Assessing Hedge Fund Investment Riskin Common Hedge Fund Strategies 575Ellen J. Rachlin

56. Diversify a Portfolio with TangibleCommodities 585Henry G. Jarecki and Terrence F. Martell

57. The Fundamentals of Commodity Investments 593Frank J. Fabozzi, Roland Fuss, and Dieter G. Kaiser

58. Art Finance 605Rachel A. J. Campbell

59. Investing in Life Settlements 611Anthony F. L. Pecore

PART 6 Investment Companies, ETFs,and Life Insurance Products 619

60. Investment Companies 621Frank J. Jones and Frank J. Fabozzi


CONTENTS ix

61. Exchange-Traded Funds 633Gary L. Gastineau

62. Investment-Oriented Life Insurance 643Frank J. Jones

63. Stable Value Investment Options for DefinedContribution Plans 657Brian K. Haendiges

PART 7 Foreign Exchange 675

64. An Introduction to Spot Foreign Exchange 677Shani Shamah

65. An Introduction to Foreign ExchangeDerivatives 687Shani Shamah

66. Introduction to Foreign Exchange Options 701Shani Shamah

PART 8 Inflation-Hedging Products 715

67. Inflation-Linked Bonds 717P. Brett Hammond

68. Introduction to Inflation Derivatives 729Jeroen Kerkhof

PART 9 Securities Finance 741

69. An Introduction to Securities Lending 743Mark C. Faulkner

70. Mechanics of the Equity Lending Market 757Jeff Cohen, David Haushalter, and Adam V. Reed

71. Securities Lending, Liquidity, and CapitalMarket-Based Finance 761

72. Repurchase Agreements and Dollar Rolls 769Frank J. Fabozzi and Steven V. Mann

Volume II

PART 1 Investment Management 1

Foundations

1. Portfolio Selection 3Frank J. Fabozzi, Harry M. Markowitz, and FrancisGupta

2. Asset Pricing Models 15Frank J. Fabozzi

3. Stochastic Growth and Discretionary Wealth 25Jarrod W. Wilcox

4. Why Quantitative Investment Management? 35Jarrod W. Wilcox

5. Quantitative Investment Management: Todayand Tomorrow 43Petter N. Kolm, Sergio M. Focardi, Frank J. Fabozzi,and Dessislava A. Pachamanova

6. Actuaries’ Evaluation of the Utility ofFinancial Economics 53Shane Whelan

7. Investment Beliefs 65Donald M. Raymond

8. Behavioral Finance 71Jarrod W. Wilcox

9. What Is Behavioral Finance? 79Meir Statman

10. The Psychology of Risk: The BehavioralFinance Perspective 85Victor Ricciardi

11. Investment Strategy for the Long Term 113William F. Sharpe

12. Implementing Investment Strategies: The Artand Science of Investing 117Wayne H. Wagner and Mark Edwards

13. Investment Management for TaxableInvestors 127David M. Stein and James P. Garland

14. Socially Responsible Investment 137Russell Sparkes

Asset Allocation

15. Employing Portfolio Selection Models inPractice 147Srichander Ramaswamy

16. Asset Allocation and PortfolioConstruction 159Noel Amenc, Felix Goltz, Lionel Martellini, andVeronique Le Sourd

17. Asset Allocation Barbells 165Kuntara Pukthuanthong-Le and Lee R. Thomas III

18. The Fallacy of Portable Alpha 171Mark P. Kritzman with the assistance of Paul A.Samuelson

19. Currency Overlay 177Bernd Scherer

Portfolio Construction

20. Risk Assessment and Portfolio Construction 187Jarrod W. Wilcox

21. Risk Budgeting 195Alexandre Schutel Da Silva, Wai Lee, and BobbyPornrojnangkool

Performance Analysis

22. Introduction to Performance Analysis 221Noel Amenc, Felix Goltz, Lionel Martellini, andVeronique Le Sourd

23. Evaluating Portfolio Performance:LPM-Based Risk Measures and theMean-Equivalence Approach 229Banikanta Mishra and Mahmud Rahman


x Contents

PART 2 Equity Portfolio Management 237

24. Overview of Active Common Stock PortfolioStrategies 239Frank J. Fabozzi, Sergio M. Focardi, Petter N. Kolm,and Robert R. Johnson

25. Investment Analysis: Profiting from aComplex Equity Market 249Bruce I. Jacobs and Kenneth N. Levy

26. Investment Management: An Architecture forthe Equity Market 259Bruce I. Jacobs and Kenneth N. Levy

27. Portfolio Construction with Active Managers:An Integrated Approach 271Vineet Budhraja, Rui J. P. de Figueiredo, Jr, JanghoonKim, and Ryan Meredith

28. Quantitative Modeling of Transaction andTrading Costs 283Petter N. Kolm, Frank J. Fabozzi, and Sergio M.Focardi

29. Quantitative Equity Portfolio Management 289Andrew Alford, Robert Jones, and Terrence Lim

30. Growth and Value Investing—Keepingin Style 299Eric H. Sorensen and Frank J. Fabozzi

31. Fundamental Multifactor Equity Risk Models 307Frank J. Fabozzi, Raman Vardharaj, and FrankJ. Jones

32. Tracking Error and Common Stock PortfolioManagement 319Raman Vardharaj, Frank J. Fabozzi, and Frank J. Jones

33. Long-Short Equity Portfolios 325Bruce I. Jacobs and Kenneth N. Levy

34. A Support Level for Technical Analysis 335Robert A. Schwartz, Reto Francioni, and Bruce W.Weber

35. Volatility and Structure: Building Blocks ofClassical Chart Pattern Analysis 347Daniel L. Chesler

36. Incorporating Trading Strategies in theBlack-Litterman Framework 359Petter N. Kolm, Sergio M. Focardi, and Frank J.Fabozzi

37. The Blindness of Hindsight in Finance 369Peter L. Bernstein

38. Are Stock Prices Predictable? 373Peter L. Bernstein

39. Dynamic Factor Approaches to EquityPortfolio Management 381Dorsey D. Farr

40. Statistical Arbitrage 393Brian J. Jacobsen

41. The Use of Derivatives in Managing EquityPortfolios 399Roger G. Clarke, Harindra De Silva, and Greg M.McMurran

42. A Valuation Framework for Selecting OptionStrategies 413Roger G. Clarke, Harindra De Silva, and Greg M.Mcmurran

PART 3 Fixed Income PortfolioManagement 419

43. Bond Portfolio Strategies for Outperforminga Benchmark 421Bulent Baygun and Robert Tzucker

44. Fixed Income Portfolio Investing: The Art ofDecision Making 431Chris P. Dialynas and Ellen Rachlin

45. Analysis and Evaluation of CorporateBonds 447Christoph Klein

46. Analyzing and Interpreting the Yield Curve 455Moorad Choudhry

47. Creating an Optimal Portfolio to FundPension Liabilities 463Paul Ross, Dan Bernstein, Niall Ferguson, and RayDalio

48. Convertible Bond Arbitrage 485Filippo Stefanini

49. Maturity, Capital Structure, and Credit Risk:Important Relationships for PortfolioManagers 493Steven I. Dym

50. A Unified Approach to Interest Rate Riskand Credit Risk of Cash and DerivativeInstruments 499Steven I. Dym

51. Swaps for the Modern Investment Manager 507Steven I. Dym

52. Overview of ABS Portfolio Management 513Karen Weaver and Eugene Xu

PART 4 Alternative Investments 521

53. Integrating Alternative Investments into theAsset Allocation Process 523Vineet Budhraja, Rui J. P. de Figueiredo, JanghoonKim, and Ryan Meredith

54. Some Considerations in the Use of Currencies 531Bruce Collins and Ozgur Kan

PART 5 Corporate Finance 539

Basics

55. Introduction to Financial Management andAnalysis 541Frank J. Fabozzi and Pamela P. Drake

56. Introduction to International CorporateFinancial Management 551Frank J. Fabozzi and Pamela P. Drake


CONTENTS xi

57. Corporate Strategy and Financial Planning 563Frank J. Fabozzi and Pamela P. Drake

58. Corporate Governance 583Mark J. P. Anson and Frank J. Fabozzi

59. Measuring the Performance of CorporateManagers 591Harold Bierman, Jr.

Capital Structure and Dividend Policy

60. Capital Structure Decisions in CorporateFinance 601Frank J. Fabozzi and Pamela P. Drake

61. Capital Structure: Lessons from Modiglianiand Miller 617Frank J. Fabozzi and Pamela P. Drake

62. Bondholder Value versus ShareholderValue 623Claus Huber

63. Recapitalization of Troubled Companies 631Enrique R. Arzac

64. Dividend and Dividend Policies 645Frank J. Fabozzi and Pamela P. Drake

Capital Budgeting

65. The Investment Problem and CapitalBudgeting 653Frank J. Fabozzi and Pamela P. Drake

66. Estimating Cash Flows of Capital BudgetingProjects 659Frank J. Fabozzi and Pamela P. Drake

67. Capital Budgeting Techniques 671Frank J. Fabozzi and Pamela P. Drake

68. Capital Budgeting and Risk 685Pamela P. Drake and Frank J. Fabozzi

69. Real Options 697John D. Finnerty

70. Real Options and Modern Capital InvestmentDecisions 715William T. Moore

71. Hurdle Rates for Overseas Projects 727Thomas J. O’Brien

Structured Finance

72. Structured Finance 737Frank J. Fabozzi, Henry A. Davis, and MooradChoudhry

73. Introduction to Securitization 745Anand K. Bhattacharya, Frank J. Fabozzi, andW. Alexander Roever

74. Issuer Prospective in StructuringAsset-Backed Securities Transactions 757Frank J. Fabozzi and Vinod Kothari

75. Structuring Efficient Asset-BackedTransactions 765Len Blum and Chris DiAngelo

76. Funding through the Use of Trade ReceivableSecuritizations 779Adrian Katz and Jeremy Blatt

77. Operational Issues in Securitization 789Vinod Kothari

78. Project Financing 799Henry A. Davis and Frank J. Fabozzi

79. The Fundamentals of Equipment Leasing 815Frank J. Fabozzi

80. Leveraged Leasing 825Frank J. Fabozzi

81. Lease versus Borrow-to-Buy Analysis 837Frank J. Fabozzi

Working Capital Management

82. Basic Treasury Management Concepts 851James Sagner and Michele Allman-Ward

83. Advanced Treasury Management Concepts 861James Sagner and Michele Allman-Ward

84. Management of Accounts Receivable 871Pamela P. Drake and Frank J. Fabozzi

85. Inventory Management 877Pamela P. Drake and Frank J. Fabozzi

Mergers and Acquisitions

86. Acquisitions and Takeovers 883Aswath Damodaran

87. Taking Control of a Company 903Pascal Quiry, Maurizio Dallocchio, Yann Le Fur,and Antonio Salvi

88. Mergers and Demergers 915Pascal Quiry, Maurizio Dallocchio, Yann Le Fur,and Antonio Salvi

89. Leveraged Buyouts 925Pascal Quiry, Maurizio Dallocchio, Yann Le Fur,and Antonio Salvi

Volume III

PART 1 Risk Management 1

General Principles

1. Risk and the French Connection 3Peter L. Bernstein

2. Risk: Traditional Finance versus BehavioralFinance 11Victor Ricciardi

3. Overview of Risk Management andAlternative Risk Transfer 39Erik Banks


xii Contents

4. Risk and Risk Management 53Christopher L. Culp

5. Risk Management for Asset ManagementFirms 63Noel Amenc, Jean-Rene Giraud, Lionel Martellini,and Veronique Le Sourd

6. Catastrophe and Risk 71Erik Banks

7. Overview of Enterprise Risk Management 81James Lam

Risk Models

8. Model Risk 87Kevin Dowd

9. Back-Testing Market Risk Models 93Kevin Dowd

10. Risk Measures and Portfolio Selection 101Svetlozar T. Rachev, Christian Menn, and Frank J.Fabozzi

11. Statistical Models of Operational Loss 109Carol Alexander

12. Risk Management in Freight Markets withForwards and Options Contracts 129Juby George and Radu Tunaru

Fixed Income Risk Management

13. Fixed Income Risk Modeling 137Ludovic Breger and Oren Cheyette

14. Effective Duration and Convexity 153Gerald W. Buetow, Jr. and Robert R. Johnson

15. Duration Estimation for Bonds and BondPortfolios 159Frank J. Fabozzi

16. Yield Curve Risk Measures 165Frank J. Fabozzi and Steven V. Mann

17. Improving Guidelines for Interest Rateand Credit Derivatives 175Steven K. Kreider, Scott F. Richard, and Frank J.Fabozzi

18. Modeling Portfolio Credit Risk 183Srichander Ramaswamy

19. The Basics of Cash-Market Hedging 193Shrikant Ramamurthy

20. Hedging Fixed Income Securities withInterest Rate Swaps 207Shrikant Ramamurthy

21. Yield Curve Risk Management 215Robert R. Reitano

PART 2 Interest Rate Modeling 233

22. The Concept and Measures of Interest RateVolatility 235Alexander Levin

23. Short-Rate Term Structure Models 243Alexander Levin

PART 3 Credit Risk Modeling andAnalysis 255

24. Credit Risk 257Frank J. Fabozzi

25. Credit Risk Modeling Using StructuralModels 267Mark J.P. Anson, Frank J. Fabozzi, Ren-Raw Chen,and Moorad Choudhry

26. Credit Risk Modeling Using Reduced-FormModels 277Mark J.P. Anson, Frank J. Fabozzi, Ren-Raw Chen,and Moorad Choudhry

27. The Credit Analysis of Municipal Bonds 287Sylvan G. Feldstein and Frank Fabozzi

PART 4 Valuation 301

Equity Valuation

28. Introduction to Valuation 303Aswath Damodaran

29. Applied Equity Valuation: Discounted CashFlow Method 309Glen A. Larsen, Jr.

30. Applied Equity Valuation: RelativeValuation Method 321Glen A. Larsen, Jr.

31. Dividend Discount Models 329Pamela P. Drake and Frank J. Fabozzi

32. Equity Analysis Using Traditional andValue-Based Metrics 339Frank J. Fabozzi and James L. Grant

33. The Franchise Factor Approach to FirmValuation 359Martin L. Leibowitz and Stanley Kogelman

34. IPO Valuation 375Kuntara Pukthuanthong-Le

35. The Valuation of Private Firms 383Stanley Jay Feldman

Valuing Fixed Income Securities

36. General Principles of Bond Valuation 399Frank J. Fabozzi and Steven V. Mann

37. Yield Curves and Valuation Lattices 411Frank J. Fabozzi, Andrew Kalotay, and MichaelDorigan

38. Using the Lattice Model to Value Bondswith Embedded Options, Floaters, Options,and Caps/Floors 417Frank J. Fabozzi, Andrew Kalotay, and MichaelDorigan

39. Valuing Mortgage-Backed and Asset-BackedSecurities 429Frank J. Fabozzi


CONTENTS xiii

40. A Framework for Valuing TreasuryInflation-Protected Securities 439Priya Misra, Kodjo Apedjinou, and Anshul Pradhan

41. Quantitative Models to Value ConvertibleBonds 445Filippo Stefanini

Derivatives Valuation

42. Introduction to the Pricing ofFutures/Forwards and Options 451Frank J. Fabozzi

43. Black-Scholes Option Pricing Model 459Svetlozar T. Rachev, Christian Menn, and FrankJ. Fabozzi

44. Valuing a Plain Vanilla Swap 467Gerald W. Buetow and Frank J. Fabozzi

45. Valuing Swaptions 477Frank J. Fabozzi and Gerald W. Buetow

46. Pricing Options on Interest Rate Instruments 495Radu Tunaru and Brian Eales

47. Credit Default Swaps Valuation 507Ren-Raw Chen, Frank J. Fabozzi, and DominicO’Kane

48. The Valuation of Fixed Income Total ReturnSwaps 519Ren-Raw Chen and Frank J. Fabozzi

49. Valuing Inflation Derivatives 523Jeroen Kerkhof

Valuing Commodity, Foreign Exchange,and Real Estate Products

50. The Pricing and Economics of CommodityFutures 535Mark J. P. Anson

51. Introduction to Currency Option PricingModels 545Shani Shamah

52. Pricing Commercial Real Estate Derivatives 557David Geltner and Jeffrey D. Fisher

PART 5 Mathematical Tools andTechniques for Financial Modelingand Analysis 567

Basic Tools and Analysis

53. Cash-Flow Analysis 569Pamela P. Drake and Frank J. Fabozzi

54. Financial Ratio Analysis 581Pamela P. Drake and Frank J. Fabozzi

55. Mathematics of Finance 597Pamela P. Drake and Frank J. Fabozzi

56. Calculating Investment Returns 617Bruce J. Feibel

Statistical Tools

57. Basic Data Description for FinancialModeling and Analysis 633Markus Hoechstoetter, Svetlozar T. Rachev, andFrank J. Fabozzi

58. Elementary Statistics 645Robert Whaley

59. Regression Analysis 669Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi,Sergio Focardi, and Teo Jasic

60. ARCH/GARCH Models in Applied FinancialEconometrics 689Robert F. Engle, Sergio M. Focardi, and Frank J.Fabozzi

61. Cointegration and Its Application inFinance 701Bala Arshanapalli and William Nelson

62. Moving Average Models for Volatility andCorrelation, and Covariance Matrices 711Carol Alexander

63. Introduction to Stochastic Processes 725Svetlozar T. Rachev, Christian Menn, and FrankJ. Fabozzi

64. Bayesian Probability for Investors 739Jarrod W. Wilcox

Optimization and Simulation Tools

65. Monte Carlo Simulation in Finance 751Dessislava A. Pachamanova

66. Principles of Optimization for PortfolioSelection 763Stoyan V. Stoyanov, Svetlozar T. Rachev, and FrankJ. Fabozzi

67. Introduction to Stochastic Programming andIts Applications to Finance 775Koray D. Simsek

68. Robust Portfolio Optimization 785Dessislava A. Pachamanova, Petter N. Kolm, FrankJ. Fabozzi, and Sergio M. Focardi


xiv


Contributors

Mark AdelsonPrincipal, Adelson & Jacob Consulting, LLC

Carol Alexander, PhDChair of Risk Management and Director of Research,ICMA Centre, Business School, The University ofReading

Roever W. Alexander, CFAManaging Director, U.S. Fixed Income Strategy,JPMorgan Securities, Inc.

Andrew Alford, PhDManaging Director, Quantitative Investment Strategies,Goldman Sachs Asset Management

Michele Allman-WardManaging Partner, Allman-Ward Associates

Noel Amenc, PhDProfessor of Finance, Edhec Graduate School ofBusiness, Director, Edhec Risk and Asset ManagementResearch Centre

Mark J. P. Anson, PhD, JD, CPA, CFA, CAIAPresident and Executive Director of Nuveen InvestmentServices

Kodjo ApedjinouVice President, Lehman Brothers Inc.

Bala Arshanapalli, PhDProfessor of Finance, Indiana University Northwest

Enrique R. Arzac, PhDProfessor of Finance and Economics, Graduate Schoolof Business, Columbia University

Erik BanksManaging Director, Risk Advisory, Unicredit GroupEurope

Chris Barr, CFAPrincipal, Barclays Global Investors

Bulent Baygun, PhDHead of Global Quantitative Strategy, Barclays Capital

Diana BerezinaAssociate Director, Fitch Ratings

William S. BerlinerExecutive Vice President, Countrywide SecuritiesCorporation

Dan BernsteinDirector, Research, Bridgewater Associates

Peter L. BernsteinPresident, Peter L. Bernstein Inc.

Anand K. Bhattacharya, PhDManaging Director, Countrywide SecuritiesCorporation

Harold Bierman Jr., PhDThe Nicholas H. Noyes Professor of BusinessAdministration, Johnson Graduate School ofManagement, Cornell University

Jeremy BlattManaging Director, Deal Structuring and Execution,Finacity Corporation

Len BlumManaging Partner, Westwood Capital, LLC

Ludovic Breger, PhDPrincipal, Barclays Global Investors

Vineet BudhrajaSenior Research Analyst, Citi Alternative Investments

Gerald W. Buetow, Jr., PhD, CFAPresident and Founder, BFRC Services, LLC

Rachel A. J. Campbell, PhDAssistant Professor of Finance, Rotterdam Schoolof Management, Erasmus University & MaastrichtUniversity, The Netherlands

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xvi Contributors

Findlay M. Chapman, IIIPrincipal, Findlay, Phillips and Associates

Ren-Raw Chen, PhDAssociate Professor of Finance, Rutgers University

Daniel L. Chesler, CMT, CTAPresident, Chesler Analytics

Oren Cheyette, PhDPrincipal, Barclays Global Investors

Anne ChingSenior Consultant, Andrew Davidson & Co., Inc.

Moorad Choudhry, PhDHead of Treasury, KBC Financial Products, London

Roger G. Clarke, PhDChairman, Analytic Investors, Inc.

Jeff CohenSecurities Lending Manager, Susquehanna Intl Group,LLLP

Bruce Collins, PhDProfessor of Finance, Western Connecticut StateUniversity

Graham “Harry” CrossFinancial Tutor, 7City Learning

Christopher L. CulpSenior Advisor, Lexecon Senior Fellow in FinancialRegulation, Competitive Enterprise Institute AdjunctProfessor of Finance, Graduate School of Business,University of Chicago

Alexandre Schutel Da SilvaVice President, Quantitative Investments Group,Lehman Brothers Asset Management

Ray DalioPresident and Chief Investment Officer, BridgewaterAssociates

Maurizio DallocchioLehman Brothers Professor of Corporate Finance,Bocconi University

Aswath Damodaran, PhDProfessor of Finance and David Margolis TeachingFellow, Stern School of Business, New YorkUniversity

Andrew DavidsonPresident and Founder, Andrew Davidson & Co., Inc.

Henry A. DavisEditor, Journal of Structured Finance

Rui J. P. de Figueiredo, Jr., PhDAssociate Professor, Haas School of Business,University of California at Berkeley

Harindra De Silva, PhD, CFAManaging Director, Analytic Investors, Inc.

Chris P. DialynasManaging Director–Portfolio Management, PacificInvestment Management Company

Chris DiAngeloPartner, Dewey Ballantine

Michael Dorigan, PhDSenior Quantitative Analyst, PNC Capital Advisors

Kevin Dowd, PhDProfessor of Financial Risk Management, Centre forRisk and Insurance Studies, Nottingham UniversityBusiness School

Pamela P. Drake, PhD, CFAJ. Gray Ferguson Professor of Finance and DepartmentHead of Finance and Business Law, James MadisonUniversity

Robert Dubil, PhDAssociate Professor, Lecturer of Finance, David EcclesSchool of Business, University of Utah

Steven I. Dym, PhDPresident, Mariner Capital Partners

Brian Eales, BA, MSc (Econ)Academic Leader, London Metropolitan University

Mark EdwardsVice President, ITG Solutions Network, Inc.

Mahmoud A. El-Gamal, PhDProfessor of Economics and Statistics, and Chair ofIslamic Economics, Finance, and Management at RiceUniversity

Robert F. Engle, PhDMichael Armellino Professorship in the Management ofFinancial Services, Leonard N. Stern School of Business,New York University

Frank J. Fabozzi, PhD, CFA, CPAProfessor in the Practice of Finance, Yale School ofManagement

Dorsey D. Farr, PhD, CFAPrincipal, French Wolf & Farr

Mark C. FaulknerManaging Director, Spitalfields Advisors


CONTRIBUTORS xvii

Bruce J. Feibel, CFAGlobal Director of Products, Eagle InvestmentSystems

Stanley Jay Feldman, PhDChairman, Axiom Valuation Solutions and AssociateProfessor of Finance, Bentley University

Sylvan G. Feldstein, PhDDirector, Investment Department, Guardian LifeInsurance Company of America

Niall FergusonManager of Client Service Analytics, BridgewaterAssociates

John D. Finnerty, PhDProfessor of Finance and Director of the MS inQuantitative Finance Program, Fordham UniversityGraduate School of Business Managing Principal,Finnerty Economic Consulting, LLC

Jeffrey D. Fisher, PhDDunn Professor of Real Estate, Indiana University

Sergio M. FocardiPartner, Intertek Group

Reto Francioni, PhDChief Executive Officer, Deutsche Borse

Roland Fuss, PhDProfessor of Finance, Union Investment Endowed Chairof Asset Management, European Business School (EBS),International University-Schloss Reichartshausen

Daniel E. GallegosPrincipal, Barclays Global Investors

Sunita Ganapati

James P. Garland, CFAPresident, The Jeffrey Company

Gary L. GastineauManaging Director, ETF Consultants, LLC

David Geltner, PhDGeorge Macomber Professor of Real Estate Finance,MIT

Juby GeorgeValuation Risk Group, Credit Suisse, London

R. Philip Giles, PhDAdjunct Professor of Finance and Economics, ColumbiaUniversity Graduate School of Business and President,CBT Worldwide, Inc.

Jean-Rene GiraudDirector of Business Development, Edhec Risk andAsset Management Research Centre

Felix GoltzSenior Research Engineer, Edhec Risk and AssetManagement Research Centre

Laurie S. Goodman, PhDCo-head of Global Fixed Income Research Managerof U.S. Securitized Products Research, UBS

James L. Grant, PhDJLG Research and Professor of Finance, Universityof Massachusetts (Boston)

Les Gulko, PhDPrincipal, Cove Island Ventures

Francis Gupta, PhDDirector, Research, Dow Jones Indexes

Brian K. Haendiges, FSA, CRC, CRAHead, Institutional Defined Contribution Plans, INGRetirement Services

G. Timothy Haight, DBAPresident, Menlo College and Chair of the Board, Boardof Commonwealth Business Bank (Los Angeles)

Brett P. Hammond, PhDManaging Director and Chief Investment Strategist,TIAA-CREF Asset Management

David Haushalter, PhDCorporate Research and Educational Associate,Susquehanna Intl Group, LLLP

Markus Hoechstoetter, Dr. rer. pol.Lecturer, School of Economics and BusinessEngineering, University of Karlsruhe

Susan Hudson-Wilson, CFAMember, Boards of Hawkeye Partners, LLC, Property &Portfolio Research, Inc. and University of VermontEndowment

Claus Huber, CFA, FRM, PhDChief Risk Officer, Credaris Portolio Management

Bruce I. Jacobs, PhDPrincipal, Jacobs Levy Equity Management

Brian J. Jacobsen, PhD, CFA, CFPAssociate Professor of Business Administration,Wisconsin Lutheran College Chief Economist Partner,Capital Market Consultants, LLC

Henry G. Jarecki, MDChairman, The Falconwood Corporation

Teo Jasic, Dr. rer. pol.Postdoctoral Research Fellow at the Chair of Statistics,Econometrics and Mathematical Finance at theUniversity of Karlsruhe in the School of Economics andBusiness Engineering and a Partner of an InternationalManagement Consultancy Firm in Frankfurt, Germany


xviii Contributors

Robert Johnson, PhD, CFADeputy Chief Executive Officer, CFA Institute

David M. Jones, PhDPresident, DMJ Advisors, LLC

Frank J. Jones, PhDProfessor, Accounting and Finance Department, SanJose State University

Robert Jones, CFAManaging Director, and Chief Investment Officer forQuantitative Equity, Quantitative InvestmentStrategies, Goldman Sachs Asset Management

Steven L. Jones, PhDAssociate Professor of Finance, Indiana University,Kelley School of Business–Indianapolis

Dieter G. Kaiser, PhDDirector Alternative Investments, InstitutionalAdvisors GmbH Research Fellow, Centre for PracticalQuantitative Finance, Frankfurt School of FinanceManagement

Andrew Kalotay, PhDPresident, Andrew Kalotay Associates

Ozgur Kan, PhD, CFA, FRMProduct Specialist, Moody’s Investors Service

Adrian KatzCEO, Finacity Corporation

George P. KeglerPresident, Cassian Consultants

Jeroen Kerkhof, PhDVice President, Morgan Stanley

Janghoon Kim, CFAResearch Analyst, Citi Alternative Investments

Christoph Klein, CFADirector, Portfolio Management, Deutsche AssetManagement

Stanley KogelmanChief Investment Officer, Summer Hill Inc. & Partner,Advanced Portfolio Management

Petter N. Kolm, PhDClinical Associate Professor and Deputy Director of theMathematics in Finance M.S. Program, CourantInstitute, New York University

Vinod KothariIndependent financial consultant and trainer onsecuritization, visiting Faculty, Indian Institute ofManagement, Kolkata, India

Steven K. Kreider, PhDManaging Director, Morgan Stanley InvestmentManagement

Mark P. Kritzman, CFAPresident and CEO, Windham Capital Management,LLC

James LamPresident, James Lam & Associates Senior ResearchFellow, Beijing University

Glen A. Larsen, Jr., PhD, CFAProfessor of Finance, Indiana University, Kelley Schoolof Business–Indianapolis

Yann Le FurProfessor of Corporate Finance, HEC Paris

Veronique Le SourdSenior Research Engineer, Edhec Risk and AssetManagement Research Centre

Wai Lee, PhDManaging Director, Head of Quantitative InvestmentsGroup, Lehman Brothers Asset Management

Yann LeFurProfessor of Corporate Finance, HEC, Paris

Martin L. Leibowitz, PhDManaging Director, Morgan Stanley & Co. Inc.

Alexander Levin, PhDDirector of Valuation Modeling, Andrew Davidson andCo., Inc.

Kenneth N. Levy, CFAPrincipal, Jacobs Levy Equity Management

Thomas K. Liaw, PhDProfessor of Finance and Chair, St. John’s University

Terrence Lim, PhD, CFAManaging Director, Quantitative Investment Strategies,Goldman Sachs Asset Management

Maria Mednikov Loucks, CFASenior Managing Director, Black River AssetManagement

Douglas J. LucasExecutive Director and Head of CDO Research, UBS

Steven V. Mann, PhDProfessor of Finance, Moore School of Business,University of South Carolina

Rebecca J. ManningVice President, Harbor Asset Management


CONTRIBUTORS xix

James Manzi, CFAConsultant

Harry M. Markowitz, PhDConsultant

Terrence F. Martell, PhDSaxe Distinguished Professor of Finance, Zicklin Schoolof Business, Baruch College/CUNY

Lionel Martellini, PhDProfessor of Finance, Edhec Graduate School ofBusiness, Scientific Director, Edhec Risk and AssetManagement Research Centre

Greg M. McMurranChief Investment Officer, Analytic Investors, Inc.

Christian Menn, Dr. rer. pol.Associate, Sal. Oppenheim Jr. & Cie, Frankfurt,Germany

Ryan Meredith, CFA, FFASenior Research Analyst, Citi Alternative Investments

William L. MessmoreVice President, Lehman Brothers

Steven MillerManaging Director, Standard & Poor’s LCD

Banikanta Mishra, PhDVisiting Professor of Finance, University of Michiganand Professor of Finance XIM-Bhubaneswar, India

Priya MisraSenior Vice President, Lehman Brothers Inc.

Stefan Mittnik, PhDProfessor of Financial Econometrics at the University ofMunich, Germany, and Research Director at the IfoInstitute for Economic Research in Munich

William T. Moore, PhDDavid & Esther Berlinberg Professor, Vice Provost forAcademic Affairs, University of South Carolina

William Nelson, PhDProfessor of Finance, Indiana University Northwest

Thomas J. O’Brien, PhDProfessor, University of Connecticut

Dominic O’Kane, PhDAffiliated Professor of Finance, EDHEC BusinessSchool, Nice, France

Dessislava A. Pachamanova, PhDAssistant Professor of Operations Research, BabsonCollege

Anthony F. L. PecoreResearch Analyst, Franklin Templeton Investments

John A. Penicook, CFAManaging Director, UBS Global AssetManagement

Bobby Pornrojnangkool, PhDVice President, Quantitative Investments Group,Lehman Brothers Asset Management

Anshul PradhanAssociate, Lehman Brothers Inc.

Kuntara Pukthuanthong-Le, PhDAssistant Professor, San Diego State University

Paul Puleo

Pascal QuiryProfessor of Corporate Finance, HEC Paris

Svetlozar T. Rachev, PhD, DrSciChair-Professor, Chair of Econometrics, Statistics andMathematical Finance, School of Economics andBusiness Engineering, University of Karlsruhe andDepartment of Statistics and Applied Probability,University of California, Santa Barbara

Ellen J. RachlinManaging Director–Portfolio & Risk Manager, MarinerInvestment Group, Inc.

Mahmud Rahman, PhDProfessor of Finance, Eastern Michigan University

Shrikant RamamurthyManaging Director, RBS Greenwich Capital

Srichander Ramaswamy, PhDSenior Economist, Bank for International Settlements,Basel, Switzerland

Donald M. Raymond, PhD, CFASenior Vice President, Public Market Investments,Canada Pension Plan Investment Board

Adam V. Reed, PhDAssistant Professor of Finance, University of NorthCarolina at Chapel Hill

Robert R. Reitano, PhD, FSAProfessor of the Practice in Finance, BrandeisUniversity, International Business School

Mark Retik


xx Contributors

Victor RicciardiAssistant Professor of Finance, Kentucky StateUniversity, and Editor, Social Science ResearchNetwork Behavioral & Experimental Finance,eJournal

Scott F. Richard, PhDManaging Director, Morgan Stanley InvestmentManagement

W. Alexander Roever, CFAManaging Director, U.S. Fixed Income Strategy,JPMorgan Securities, Inc.

Paul RossInvestment Associate, Bridgewater Associates

James SagnerManaging Principal, Sagner/Marks and AssociateProfessor in the School of Business of MetropolitanCollege of New York

Antonio Salvi, PhDProfessor of Corporate Finance, EM Lyon and BocconiUniversity

Paul A. Samuelson, PhDInstitute Professor Emeritus, Massachusetts Institute ofTechnology

Anthony Sanders, PhDJohn W. Galbraith Chair and Professor of Finance, OhioState University

Bernd Scherer, PhDManaging Director and Global Head of QuantitativeStructured Products, Morgan Stanley InvestmentManagement

Uwe Schillhorn, CFAExecutive Director, UBS Global Asset Management

Robert A. Schwartz, PhDMarvin M. Speiser Professor of Finance and UniversityDistinguished Professor, Zicklin School of Business,Baruch College, CUNY

Shani ShamahConsultant, E J Consultants

William F. Sharpe, PhDSTANCO 25 Professor of Finance, Emeritus at StanfordUniversity’s Graduate School of Business

Koray D. Simsek, PhDAssistant Professor, Faculty of Management, SabanciUniversity

Daniel D. Singer, PhDProfessor of Finance, Towson University

Eric H. Sorensen, PhDPresident and CEO, PanAgora Asset Management

Russell SparkesChief Investment Officer, Central Finance Board of theMethodist Church (UK)

Larry Speidell, CFAGeneral Partner, Ondine Asset Management, LLC

Beth StarrManaging Director, Lehman Brothers

State Street Corporation

Meir Statman, PhDGlenn Klimek Professor of Finance, Santa ClaraUniversity

Filippo StefaniniDeputy Chief Investment Officer, Aletti GestielleAlternative SGR Professor of Risk Management,Faculty of Engineering at Bergamo Universityin Italy

David M. Stein, PhDManaging Director, Parametric Portfolio Associates

Stoyan V. Stoyanov, PhDChief Financial Researcher, FinAnalytica Inc.

Lee R. Thomas III, PhDManaging Partner and CEO, Flint Rock CapitalManagement

James R. Thompson, PhDNoah Harding Professor of Statistics, Rice University

Radu Tunaru, PhDSenior Lecturer in Financial Mathematics,City University, CASS Business School

Robert TzuckerInflation Trading, Barclays Capital

Raman Vardharaj, CFASenior Quantitative Analyst, RS Investments

Antonio Villarroya, MDGlobal Head of Rates Derivatives Strategy, MerrillLynch

Wayne H. WagnerSenior Advisor, ITG Inc., Principal OM/NI, A TradingConsultancy

Karen Weaver, CFAManaging Director, Global Head of SecuritizationResearch and Regional Research Head—the Americas,Deutsche Bank Securities, Inc.

Bruce W. Weber, PhDProfessor of Information Management, LondonBusiness School


CONTRIBUTORS xxi

Robert Whaley, PhDValere Blair Potter Professor of Management, TheOwen Graduate School of Management, VanderbiltUniversity

Shane Whelan, FSAI, FSA, FFA, PhDLecturer in Actuarial Science, School of MathematicalSciences, University College Dublin, Ireland

Jarrod W. Wilcox, PhD, CFAPresident, Wilcox Investment Inc.

Edward E. Williams, PhDHenry Gardiner Symonds Professor of Management,Rice University

Lan-Ling WolffFredell & Co. Structured Finance Ltd.

Eugene Xu, PhDDirector, Global Securitization Research, Deutsche BankSecurities, Inc.


xxii


Preface

Over the past two decades, financial profession-als have had available to them excellent refer-ence books on specialty areas in finance. There are

handbooks on corporate financial management, financialinstruments, portfolio strategies, structured finance, capi-tal budgeting, derivatives, and the list goes on. But to trulyunderstand financial markets throughout the world, it isnecessary to understand how financial decision makers—such as corporate treasurers, chief financial officers, port-folio managers, traders, and security analysts—make deci-sions and the tools that they employ in doing so. From thatperspective, the idea for this handbook was conceived.

Finance is the application of economic principles andconcepts to business decision making and problem solv-ing. The field of finance can be considered to comprisethree broad categories: financial markets and instruments,financial management, and investment management.

The field of financial markets and instruments deals withthe role of financial markets in an economy, the structureand organization of financial markets, the efficiency ofmarkets, the role of the various players in financial mar-kets (i.e., governments, regulators, financial institutions,investment banks and securities firms, and institutionaland retail investors), and the determinants of asset pric-ing and interest rates.

Financial management, sometimes referred to as businessfinance, is the specialized field in finance that is concernedprimarily with financial decision-making within a busi-ness entity and encompasses many different types of deci-sions. (While financial management is sometimes referredto as corporate finance, the principles are applied to themanagement of municipalities and nonprofit profit enti-ties.) We can classify financial management decisions intotwo groups: investment decisions and financing decisions.Investment decisions are concerned with the use of funds—the buying, holding, or selling of all types of assets. Basi-cally, the types of assets acquired are either working capi-tal, such as inventory and receivables, or long-term assets.Decisions involving the former are called working capi-tal decisions and those involving the latter are called capi-tal budgeting decisions. Financing decisions are concernedwith the acquisition of funds to be used for investing andfinancing day-to-day operations. Basically, this involvesthe selection of the firm’s capital structure—that is, the

combination of equity and debt used to finance the firm—and is referred to as the capital structure decision. The fi-nancing decision also involves the determination of howmuch of the company’s earnings to retain and how muchto distribute to shareholders in the form of dividends. Thisdecision is referred to as the dividend decision. Whether afinancial decision involves investing or financing, the coreof the decision will rest on two specific factors: expectedreturn and risk. Expected return is the difference betweenpotential benefits and potential costs. Risk is the degree ofuncertainty associated with the expected returns.

Investment management is the area of finance that focuseson the management of portfolios of assets for institu-tional investors and individuals. The activities involvedin investment management, also referred to as asset man-agement, include working with clients to set investmentobjectives and an investment policy to accomplish thoseobjectives, the selection a portfolio strategy consistentwith the investment objectives and investment policy, andthe construction of the specific assets to include in a port-folio based on the portfolio strategy. Investment manage-ment begins with the decision as to how to allocate fundsacross the major asset classes (e.g., stocks, bonds, real es-tate, alternative investments). This decision, referred toas the asset allocation decision, requires a thorough under-standing of the expected returns and risks associated withinvesting in a specific asset class. Again, we see the im-portance of understanding expected return and risk. Theinvestment strategy employed can be classified as eitheractive or passive and the decision as to which type to fol-low depends on the client’s view of the efficiency (i.e., thedifficulty of obtaining superior returns) of the market forthe asset class. The portfolio construction phase involvesassembling the best portfolio given the client’s investmentobjectives, given the investment constraints set forth in theinvestment policy, and the estimated expected return andrisk of the individual assets that are potential candidatesfor inclusion in the portfolio.

These three general areas use theories and analyticaltools developed in other disciplines. For example, theo-ries about the pricing of assets and the determination ofinterest rates draw from theories in economics. In fact,many academics refer to finance as financial economics.There are investment management strategies that utilize

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xxiv Preface

theories and concepts that draw from the field of psychol-ogy, giving rise to the specialized field in finance known asbehavioral finance. The complex nature of financial marketsrequires a finance professional to draw from the fieldsof statistics and econometrics in order to describe themovement in asset prices and returns, as well as to ob-tain meaningful measures of risk. The field of financialrisk management, used both in financial management andinvestment management, employ these tools. These sametools are used by investment managers in formulating andtesting potential strategies and in the valuation (pricing)of complex financial instruments known as derivatives.Investment managers and financial managers utilize so-phisticated mathematical models developed in the area ofoperations research/management science to aid in mak-ing optimal allocation decisions such as in portfolio con-struction and the selection of capital projects. Managersalso use simulation models, a tool of operations research,in a variety of activities that involve corporate and invest-ment decisions. Financial engineering, sometimes referredto as mathematical finance, is the relatively new special-ized field in finance that uses statistical and mathematicaltools to deal with problems in all areas of finance and riskmanagement.

This multivolume reference provides a bird’s-eye viewof finance that will help the reader appreciate the widerange of topics that the discipline of “finance” encom-passes. While there are handbooks that address special-ized areas within finance, the purpose of this three-volumehandbook is to cover all of the areas mentioned above andis intended for professionals involved in finance, as wellas the student of finance.

This three-volume handbook offers coverage of both es-tablished and cutting-edge theories and developments infinance. It contains chapters from global experts in in-dustry and academia, and offers the following uniquefeatures:

� The handbook was written by more than 190 expertsfrom around the world. This diverse collection of exper-tise has created the most definitive coverage of estab-lished and cutting-edge financial theories, applications,and tools in this ever-evolving field.

� The series emphasizes both technical and managerialissues. This approach provides researchers, educators,students, and practitioners with a balanced understand-ing of the topics and the necessary background to dealwith issues related to finance.

� Each chapter follows a format that includes the author,chapter abstract, keywords, introduction, body, sum-mary, and references. This enables readers to pick andchoose among various sections of a chapter and createsconsistency throughout the entire handbook.

� Each chapter provides extensive references for addi-tional readings, enabling readers to further enrich theirunderstanding of a given topic.

� Numerous illustrations and tables throughout the workhighlight complex topics and assist further understand-ing.

� Each chapter provides cross-references within the bodyof the chapter. This helps readers identify other chapterswithin the handbook related to a particular topic, whichprovides a one-stop knowledge base for a given topic.

� Each volume includes a complete table of contents andindex for easy access to various parts of the handbook.

TOPIC CATEGORIESThe allocation of the topics among the three volumes ofthe handbook required a good deal of time, with morethan two dozen restructurings of the table of contents foreach volume before reaching what I believe to be the mostuseful allocation for readers. There was no simple for-mula. The decision involved feedback from practitioners,academics, and graduate students. The final allocation tothe three volumes was as follows.

Volume I (Financial Markets and Instruments) covers thegeneral characteristics of the different asset classes, deriva-tive instruments, the markets in which financial instru-ment trade, and the players in the market. Topics include:� Market Players and Markets� Common Stock� Fixed Income Instruments� Real Estate� Alternative Investments� Investment Companies, Exchange-Traded Funds, and

Life Insurance Products� Foreign Exchange� Inflation-Hedging Products� Securities Finance

Volume II (Investment Management and Financial Man-agement) covers the theories, issues, decisions, and imple-mentation for both investment management and financialmanagement. Topics include:� Investment Management� Equity Portfolio Management� Fixed Income Portfolio Management� Alternative Investments� Corporate Finance

The analytical tools, the measurement of risk, and thetechniques for valuation are the subject of Volume III (Val-uation, Financial Modeling, and Quantitative Tools). Topicsinclude:� Risk Management� Interest Rate Modeling� Credit Risk Modeling and Analysis� Valuation� Mathematical Tools and Techniques for Financial Mod-

eling and Analysis

The chapters can serve as material for a wide spectrumof courses, such as the following:� Financial markets� Principles of finance� Investment and portfolio management� Corporate finance� Derivative instruments and their applications� Financial mathematics� Financial engineering

Frank J. FabozziEditor, Handbook of Finance


Guide to the Handbook of Finance

The Handbook of Finance is a comprehensive overviewof the field of finance. This reference work consistsof three separate volumes and 229 chapters. Each

chapter provides a comprehensive overview of the se-lected topic intended to inform a broad spectrum of read-ers ranging from finance professionals to academicians tostudents to the general business community.

To derive the greatest possible benefit from the Handbookof Finance, we have provided this guide. It explains howthe information within the handbook can be located.

ORGANIZATIONThe Handbook of Finance is organized to provide maximumease of use for its readers. The material is broken downinto three distinct volumes:� Volume I (Financial Markets and Instruments) covers the

general characteristics of the different asset classes,derivative instruments, the markets in which financialinstrument trade, and the players in the market.

� Volume II (Investment Management and Financial Manage-ment) covers the theories, issues, decisions, and imple-mentation for both investment management and finan-cial management.

� Volume III (Valuation, Financial Modeling, and Quantita-tive Tools) tackles the analytical tools, the measurementof risk, and the techniques for valuation.

TABLE OF CONTENTSA complete table of contents for the entire handbook ap-pears in the front of each volume. This list of titles rep-resents topics that have been carefully selected by theeditor, Frank J. Fabozzi. The Preface includes a more de-tailed description of the volumes and parts the chaptersare grouped under.

INDEXA Subject Index for the entire handbook is located at theend of each volume. The subjects in the index are listed

alphabetically and indicate the volume and page numberwhere information on this topic can be found.

CHAPTERSEach chapter in the Handbook of Finance begins on a newpage, so that the reader may quickly locate it. The author’sname and affiliation are displayed at the beginning of thechapter.

All chapters in the handbook are organized accordingto a standard format, as follows:� Title and author� Outline� Abstract� Keywords� Introduction� Body� Summary� References

OutlineEach chapter begins with an outline indicating the contentto come. The outline is intended as an overview and thuslists only the major headings of the chapter. Lower-levelheadings also may be found within the chapter.

AbstractThe abstract for each chapter gives an overview of thetopic, but not necessarily the content of the chapter. Thisis designed to put the topic in the context of the entirehandbook, rather than give an overview of the specificchapter content.

KeywordsThe keywords section contains terms that are importantto an understanding of the chapter.

IntroductionThe text of each chapter begins with an introductory sec-tion that defines the topic under discussion and summa-rizes the content. By reading this section, the reader gets ageneral idea about the content of a specific chapter.

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xxvi Guide to the Handbook of Finance

BodyThe body of each chapter discusses the items that werelisted in the outline section.

SummaryThe summary section provides a review of the materialsdiscussed in each chapter. It imparts to the reader the mostimportant issues and concepts discussed.

ReferencesThe references section lists both publications cited in thechapter and secondary sources to aid the reader in lo-cating more detailed or technical information. Reviewarticles and research papers that are important to anunderstanding of the topic are also listed. The refer-ences provide direction for further research on the giventopic.


HANDBOOKOF

FINANCE

VOLUME I

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