INVESTMENT

SCIENCE
SECOND EDITION

DAVID G.LUENBERGER,
STANFORD UNIVERSITY

New York

Oxford

OXFORD UNIVERSITY PRESS

CONTENTS
PREFACE

xxi

Chapter 1 INTRODUCTION
_
1.1 Cash Flows
1.2 Investments and Markets
The Comparison Principle
Arbitrage
Dynamics
Risk Aversion
1.3 Typical Investment Problems
Pricing
Hedging
Risk Assessment and Management
Pure Investment
Other Problems
1.4 Organization of the Book
Deterministic Cash Flow Streams
Single-Period Random Cash Flow Streams
Derivative Assets
General Cash Flow Streams

1
2
3
4
4
5
5
6
6
7
8
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9
9
9
10
10
11

Part I: DETERMINISTIC CASH FLOW STREAMS

Chapter 2 THE BASIC THEORY OF INTEREST
2.1 Principal and Interest
Simple Interest
Compound Interest
Compounding at Various Intervals
Continuous Compounding
Debt
Money Markets
2.2 Present Value
'
2.3 Present and Future Values of Streams
The Ideal Bank
Future Value
Present Value

'

15
15
15
16
17
18
19
19
20
21
21
21
22

ix

CONTENTS

Frequent and Continuous Compounding

Present Value and an Ideal Bank
2.4 Internal Rate of Return
2.5 Evaluation Criteria
Net Present Value
Internal Rate of Return
Discussion of the Criteria
2.6 Applications and Extensions*
Net Flows
Cycle Problems
Taxes
~
Inflation
2.7 Summary
Exercises
References

23
23
24
26
27
28
28
30
30
31
33
34
36
37
41

Chapter 3 FIXED-INCOME SECURITIES

3.1 The Market for Future Cash
Savings Deposits
Money Market Instruments
U.S. Government Securities
Other Bonds
Mortgages
Annuities
3.2 Value Formulas
Perpetual Annuities
Finite-Life Streams
Running Amortization*
Annual Worth*
3.3 Bond Details
Quality Ratings
3.4 Yield
Qualitative Nature of Price-Yield Curves
Other Yield Measures
3.5 Duration
Interest Duration
Macaulay Duration
Explicit Formula*
Qualitative Properties of Duration*
Duration and Sensitivity Duration of a Portfolio
3.6 Immunization
3.7 Convexity*
3.8 Summary
Exercises
References

42
43
43
44
44
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46
46
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54
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58
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68
69
71
74

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CONTENTS
Chapter 4 THE TERM STRUCTURE OF INTEREST RATES
4.1 The Yield Curve
4.2 The Term Structure
Spot Rates
Discount Factors and Present Value
Determining the Spot Rate
4.3 Forward Rates
4.4 Term Structure Explanations
Expectations Theory
Liquidity Preference
Market Segmentation
Discussion
4.5 Expectations Dynamics
Spot Rate Forecasts
Discount Factors
Short Rates
Invariance Theorem
4.6 Running Present Value
4.7 Floating-Rate Bonds
4.8 Duration
Fisher-Weil Duration
Discrete-Time Compounding*
4.9 Immunization
4.10 Summary
Exercises
References

95
96
96
97
98
100
102
106

Chapter 5 APPLIED INTEREST RATE ANALYSIS

5.1 Capital Budgeting
Independent Projects
Interdependent Projects*
5.2 Optimal Portfolios
The Cash Matching Problem
5.3 Dynamic Cash Flow Processes
Representation of Dynamic Choice
Cash Flows in Graphs
5.4 Optimal Management
Running Dynamic Programming
Examples
5.5 The Harmony Theorem*
5.6 Valuation of a Firm*
Dividend Discount Models
Free Cash Flow*
5.7 Summary
Exercises
References

107
108
108
111
113
114
116
117
119
120
120
123
128
130
130
132
134
136
139

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92

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xii

CONTENTS

Part II: SINGLE-PERIOD RANDOM CASH FLOWS

Chapter 6 MEAN-VARIANCE PORTFOLIO THEORY
6.1 Asset Return
Short Sales
Portfolio Return
6.2 Random Variables
Expected Value
Variance
Several Random Variables
Covariance
Variance of a Sum
6.3 Random Returns
Mean-Standard Deviation Diagram
6.4 Portfolio Mean and Variance
Mean Return of a Portfolio
Variance of Portfolio Return
Diversification*
Diagram of a Portfolio
6.5 The Feasible Set
The Minimum-Variance Set and the Efficient Frontier
6.6 The Markowitz Model
Solution of the Markowitz Problem*
Nonnegativity Constraints*
6.7 The Two-Fund Theorem*
6.8 Inclusion of a Risk-Free Asset
6.9 The One-Fund Theorem
Solution Method*
Explicit Solution
6.10 Summary
Exercises
References
Chapter 7 THE CAPITAL ASSET PRICING MODEL
7.1 Market Equilibrium
7.2 The Capital Market Line
'
7.3 The Pricing Model
Betas of Common Stocks
Beta of a Portfolio
7.4 The Security Market Line
.
Systematic Risk
7.5 Investment Implications
7.6 Performance Evaluation
7.7 CAPM as a Pricing Formula
Linearity of Pricing and the Certainty Equivalent Form
7.8 Project Choice*

143
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147
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149
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152
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156
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162
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180
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184
187
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187
189
190
191
194
196
198

CONTENTS xiii

7.9

Projection Pricing

200

Minimum Norm Pricing*

202

7.10 Correlation Pricing

7.11 Summary
Exercises
References

203
206
207
211

Chapter 8 OTHER PRICING MODELS

8.1
8.2

213
213

Single-Factor Model
Portfolio Parameters
Multifactor Models
Selection of Factors

8.3
8.4

213

Introduction
Factor Models
-

214
215
219
219

The CAPM as a Factor Model

220

The Characteristic Line

221

Arbitrage Pricing Theory*

223

Simple Version of APT

Well-Diversified Portfolios
General APT
APT and CAPM

223
225
226
- 227

8.5 Projection Pricing with Factors

8.6 A Multiperiod Fallacy
8.7 Summary
Exercises
References

227
229
230
232
234

Chapter 9 DATA AND STATISTICS

9.1

235

Basic Estimation Methods

235

Period-Length Effects
Mean Blur

9.2

236
238

Estimation of Other Parameters

'

240

Estimation of cr
a Blur

9.3

240
241

The^Effect of Estimation Errors

Three Views
Maximum Tangent
Compounding Effect

9.4

242
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243
245
248

Conservative Approaches ,
Better Estimates*

9.5 Tilting Away From Equilibrium*

9.6 Summary
Exercises
References
Chapter 10 RISK MEASURES

10.1 Value at Risk

248
249

250
252
253
255
257

258

xiv

CONTENTS

Properties of VaR
Capital Requirement
10.2 Computation of Value at Risk
Model-Based Method
Other Models
Shortcut for Discrete Distributions
Empirical Approach for Market Risk*
10.3 Criticisms of VaR
Diversification Failure
Poor Assessment of Risk
Discontinuous Value
10.4 Coherent Risk Measures
10.5 Conditional Value at Risk
10.6 Coherent Characterization*
10.7 Convexity*
10.8 Summary
Exercises
References
Chapter 11 GENERAL PRINCIPLES

11.1 Introduction
11.2 Utility Functions
Equivalent Utility Functions
11.3 Risk Aversion
Derivatives
Risk Aversion Coefficients
Certainty Equivalent
11.4 Specification of Utility Functions*
Direct Measurement of Utility
Parameter Families
Questionnaire Method
11.5 Utility Functions and the Mean-Variance Criterion*
Quadratic Utility
Normal Returns
11.6 Linear Pricing
Type A Arbitrage
Portfolios
Type B Arbitrage
11.7 Portfolio Choice
11.8 Arbitrage Bounds
11.9 Zero-Level Pricing
11.10 Log-Optimal Pricing*
11.11 Finite State Models
Completeness
State Prices
Positive State Prices

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297
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301
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302

CONTENTS xv

11.12 Risk-Neutral Pricing

11.13 Summary
Exercises
References

304
306
308
311

Part III: DERIVATIVE SECURITIES

Chapter 12 FORWARDS, FUTURES, AND SWAPS

315

12.1 Pricing Principles

12.2 Forward Contracts,

316
318

Forward Interest Rates

319

12.3 Forward Prices

319

Costs of Carry
Tight Markets
Investment Assets

322
324
325

12.4 The Value of a Forward Contract

12.5 Swaps*

326
327

Value of a Commodity Swap

Value of an Interest Rate Swap

327
329

12.6 Basics of Futures Contracts

12.7 Futures Prices
12.8 Relation to Expected Spot Price*
12.9 The Perfect Hedge
12.10 The Minimum-Variance Hedge
12.11 Optimal Hedging*
12.12 Hedging Nonlinear Risk*
12.13 Summary
Exercises
References

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Chapter 13 MODELS OF ASSET DYNAMICS

350

13.1 Binomial Lattice Model

13.2 The Additive Model
i Normal Price Distribution
13.3 The Multiplicative Model
Lognormal Prices
Real Stock Distributions

329
332
335
336
336
340
341
345
346
349

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355
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13.4 Typical Parameter Values*

13.5 Lognormal Random Variables
13.6 Random Walks and Wiener Processes
Generalized Wiener Processes and Ito Processes

355
356

357
358
359
361

13.7 A Stock Price Process

362

Lognormal Prices
Standard Ito Form
Simulation

363
363
365

13.8 Ito's Lemma*

366

xvi

CONTENTS

13.9 Binomial Lattice Revisited

13.10 Summary
Exercises
References

368
370
370
373

Chapter 14 BASIC OPTIONS THEORY

374

14.1 Option Concepts

14.2 The Nature of Option Values

375
377

Time Value of Options

Other Factors Affecting the Value of Options

379
379

14.3 Option Combinations and'Put-Gall Parity

380

Put-Call Parity

381

14.4 Early Exercise

14.5 Single-Period Binomial Options Theory
14.6 Multiperiod Options

382
383
386

No Early Exercise*

389

14.7 More General Binomial Problems

389

Put Options
Dividend and Term Structure Problems*
Futures Options*

389
391
391

14.8 Evaluating Real Investment Opportunities

393

Real Options
Linear Pricing

.
>.

14.9 General Risk-Neutral Pricing*

14.10 Three-principle Power

401
402

Decomposition of the Pricing Principles

403

14.11 Summary
Exercises
References

403
404
408

Chapter 15 ADDITIONAL OPTIONS TOPICS

15.1 Introduction
15.2 The Black-Scholes Equation

410

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Proof of the Black-Scholes Equation*

Self-Financing Strategies*

15.3
15.4
15.5
15.6
15.7

Call Option Formula

'
Risk-Neutral Valuation*
Delta
Replication, Synthetic Options,and Portfolio Insurance*
Volatility Smiles
.
Equality of Implied Volatilities
Risk-Neutral Probability Density*

15.8 Computational Methods

Monte Carlo Simulation
Finite-Difference Methods
Binomial and Trinomial Lattices

397
399

410
410
412
414

414
416
417
419
422
423
424

425
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427
429

CONTENTS xvii

15.9 Exotic Options

431

Pricing*

433

15.10 Comparison of Methods

15.11 Storage Costs and Dividends*
Binomial Form
Brownian Motion Form*

434
435

435
436

15.12 Martingale Pricing*

15.13 Axioms and Black-Scholes

437
438

Market Price of Risk

15.14 Summary
Exercises
References

440

440
442
446

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Chapter 16 INTEREST RATE DERIVATIVES

448

16.1 Examples of Interest Rate Derivatives

16.2 The Need for a Theory
16.3 The Binomial Approach

448
450
451

Implied Term Structure

No Arbitrage Opportunities

452
454

16.4 Pricing Applications

455

Bond Derivatives
Forwards and Futures*
Futures*

455
455
457

,
.

16.5 Leveling and Adjustable-Rate Loans*

457

Adjustable-Rate Loans

458

16.6 The Forward Equation

16.7 Matching the Term Structure

461
464

The Ho-Lee Model

The Black-Derman-Toy Model
Matching Implied Volatilities

464
465
465

16.8 Immunization
16.9 Collateralized Mortgage Obligations*
16.10 Models of Interest Rate Dynamics*
16.11 Continuous-Time Solutions*
The Backward Equation
Affine Processes*
Risk-Neutral Pricing Formula

16.12 Extensions
16.13 Summary
Exercises
References

467
469
473
474
475
476
477

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Chapter 17 CREDIT RISK

17.1 The Classic Merton Model
Probability of Default
Credit Spread

477
478
479
482
483
484
486
486

xviii

CONTENTS

17.2 First Passage Times

487

Lattice Methods
Early Default*
Coupons*

488
490
491

17.3 Rating Methods

17.4 Intensity (Reduced-Form) Model

492
493

Poisson Processes
Inhomogeneous Process

493
495

17.5 Stochastic Intensity Model*

17.6 Intermediate Receipts
17.7 Analytically Tractable Cox Processes

495
496
497

Model Fitting

497

17.8 Simulation

498

Direct Simulation
A Better Way

498
499

17.9 Lattice Methods

17.10 Correlated Defaults
17.11 Credit Derivatives

500
503
505

Bonds and Loans

Credit Default Swaps (CDS's)
Forwards and Options on CDS's
Total Return Swaps (TRS's)
Collateralized Debt Obligations (CDO's)

506
506
508
508
509

17.12 Summary
Exercises
References

511
512
513

Part IV: GENERAL CASH FLOW STREAMS

Chapter 18 OPTIMAL PORTFOLIO GROWTH

517

18.1 The Investment Wheel

517

Analysis of the Wheel

519

18.2 The Log Utility Approach to Growth

519

Log Utility Form

Examples

18.3 Properties of the Log-Optimal Strategy*

18.4 Alternative Approaches*

521
521

<-

525
526

Other Utility

526

18.5 Continuous-Time Growth

528

Dynamics of Several Stocks

Portfolio Dynamics
'
Implications for Growth
The Portfolio of Maximum Growth Rate

18.6 The Feasible Region

528
529
530
530

531

CONTENTS xix

The Efficient Frontier

Inclusion of a Risk-Free Asset

531
532

18.7 The Log-Optimal Pricing Formula*

536

Market Data

539

18.8 Log-Optimal Pricing and the Black-Scholes

Equation*
18.9 Summary
Exercises
References

540
541
542
546

Chapter 19 GENERAL INVESTMENT EVALUATION

547

19.1 General Present Value

547

Projects and Opportunities

548

19.2 Multiperiod Securities*

548

Assets
Portfolio Strategies
Arbitrage
Short-Term Risk-Free Rates

549
549
550
550

19.3 Risk-Neutral Pricing

19.4 Optimal Pricing

550
552

The Single-Period Problem

Applications

552
553

19.5 The Double Lattice

19.6 Pricing in a Double Lattice
19.7 Investments with Private Uncertainty

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555
557
560

General Approach

562

19.8 Buying Price Analysis

566

Certainty Equivalent and Exponential Utility

Sequential Calculation of CE
Multiperiod Case
General Approach

19.9 Pricing Axioms for Continuous Time

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*

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572

Option Formula
Risk-Neutral Form
Alternative Forms

19.10 Summary
Exercises
'
References
AppendixA BASIC PROBABILITY THEORY

A.I General Concepts

A.2 Normal Random Variables
A.3 Lognormal Random Variables

567
568
569
570
575
575
575

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576
576
578
579

579
580
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xx

CONTENTS

Appendix B CALCULUS AND OPTIMIZATION

B.I Functions
B.2 Differential Calculus
B.3 Optimization

583
583
584
585

ANSWERS TO EXERCISES

588

INDEX

594