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BRIEF CONTENTS

PREFACE xxi
Chapter 1 INTRODUCTION 1
Part I: DETERMINISTIC CASH FLOW STREAMS
Chapter 2 THE BASIC THEORY OF INTEREST 15
Chapter 3 FIXED-INCOME SECURITIES 42
Chapter 4 THE TERM STRUCTURE OF INTEREST RATES 76
Chapter 5 APPLIED INTEREST RATE ANALYSIS 107
Part II: SINGLE-PERIOD RANDOM CASH FLOWS
Chapter 6 MEAN–VARIANCE PORTFOLIO THEORY 143
Chapter 7 THE CAPITAL ASSET PRICING MODEL 180
Chapter 8 OTHER PRICING MODELS 213
Chapter 9 DATA AND STATISTICS 235
Chapter 10 RISK MEASURES 257
Chapter 11 GENERAL PRINCIPLES 279
Part III: DERIVATIVE SECURITIES
Chapter 12 FORWARDS, FUTURES, AND SWAPS 315
Chapter 13 MODELS OF ASSET DYNAMICS 350
Chapter 14 BASIC OPTIONS THEORY 374
Chapter 15 ADDITIONAL OPTIONS TOPICS 410
Chapter 16 INTEREST RATE DERIVATIVES 448
Chapter 17 CREDIT RISK 483
Part IV: GENERAL CASH FLOW STREAMS
Chapter 18 OPTIMAL PORTFOLIO GROWTH 517
Chapter 19 GENERAL INVESTMENT EVALUATION 547

vii
viii · BRIEF CONTENTS ·

Appendix A BASIC PROBABILITY THEORY 579

Appendix B CALCULUS AND OPTIMIZATION 583
ANSWERS TO EXERCISES 588
INDEX 594
CONTENTS

PREFACE xxi

Chapter 1 INTRODUCTION 1
1.1 Cash Flows 2
1.2 Investments and Markets 3
The Comparison Principle 4
Arbitrage 4
Dynamics 5
Risk Aversion 5
1.3 Typical Investment Problems 6
Pricing 6
Hedging 7
Risk Assessment and Management 8
Pure Investment 8
Other Problems 9
1.4 Organization of the Book 9
Deterministic Cash Flow Streams 9
Single-Period Random Cash Flow Streams 10
Derivative Assets 10
General Cash Flow Streams 11

Part I: DETERMINISTIC CASH FLOW STREAMS

Chapter 2 THE BASIC THEORY OF INTEREST 15
2.1 Principal and Interest 15
Simple Interest 15
Compound Interest 16
Compounding at Various Intervals 17
Continuous Compounding 18
Debt 19
Money Markets 19
2.2 Present Value 20
2.3 Present and Future Values of Streams 21
The Ideal Bank 21
Future Value 21
Present Value 22

ix
x · CONTENTS ·

Frequent and Continuous Compounding 23

Present Value and an Ideal Bank 23
2.4 Internal Rate of Return 24
2.5 Evaluation Criteria 26
Net Present Value 27
Internal Rate of Return 28
Discussion of the Criteria 28
2.6 Applications and Extensions
30
Net Flows 30
Cycle Problems 31
Taxes 33
Inflation 34
2.7 Summary 36
Exercises 37
References 41

Chapter 3 FIXED-INCOME SECURITIES 42

3.1 The Market for Future Cash 43
Savings Deposits 43
Money Market Instruments 44
U.S. Government Securities 44
Other Bonds 45
Mortgages 46
Annuities 46
3.2 Value Formulas 46
Perpetual Annuities 47
Finite-Life Streams 48
Running Amortization
50
Annual Worth
51
3.3 Bond Details 52
Quality Ratings 53
3.4 Yield 54
Qualitative Nature of Price–Yield Curves 55
Other Yield Measures 58
3.5 Duration 59
Interest Duration 60
Macaulay Duration 60
Explicit Formula
61
Qualitative Properties of Duration
61
Duration and Sensitivity 62
Duration of a Portfolio 64
3.6 Immunization 65
3.7 Convexity
68
3.8 Summary 69
Exercises 71
References 74
 CONTENTS · xi

Chapter 4 THE TERM STRUCTURE OF INTEREST RATES 76

4.1 The Yield Curve 76
4.2 The Term Structure 78
Spot Rates 78
Discount Factors and Present Value 79
Determining the Spot Rate 81
4.3 Forward Rates 82
4.4 Term Structure Explanations 85
Expectations Theory 85
Liquidity Preference 86
Market Segmentation 87
Discussion 87
4.5 Expectations Dynamics 88
Spot Rate Forecasts 88
Discount Factors 89
Short Rates 90
Invariance Theorem 91
4.6 Running Present Value 92
4.7 Floating-Rate Bonds 95
4.8 Duration 96
Fisher-Weil Duration 96
Discrete-Time Compounding
97
4.9 Immunization 98
4.10 Summary 100
Exercises 102
References 106

Chapter 5 APPLIED INTEREST RATE ANALYSIS 107

5.1 Capital Budgeting 108
Independent Projects 108
Interdependent Projects
111
5.2 Optimal Portfolios 113
The Cash Matching Problem 114
5.3 Dynamic Cash Flow Processes 116
Representation of Dynamic Choice 117
Cash Flows in Graphs 119
5.4 Optimal Management 120
Running Dynamic Programming 120
Examples 123
5.5 The Harmony Theorem
128
5.6 Valuation of a Firm
130
Dividend Discount Models 130
Free Cash Flow
132
5.7 Summary 134
Exercises 136
References 139
xii · CONTENTS ·

Part II: SINGLE-PERIOD RANDOM CASH FLOWS

Chapter 6 MEAN–VARIANCE PORTFOLIO THEORY 143
6.1 Asset Return 144
Short Sales 144
Portfolio Return 146
6.2 Random Variables 147
Expected Value 148
Variance 149
Several Random Variables 150
Covariance 150
Variance of a Sum 152
6.3 Random Returns 152
Mean–Standard Deviation Diagram 155
6.4 Portfolio Mean and Variance 156
Mean Return of a Portfolio 156
Variance of Portfolio Return 156
Diversification
157
Diagram of a Portfolio 159
6.5 The Feasible Set 161
The Minimum-Variance Set and the Efficient Frontier 162
6.6 The Markowitz Model 164
Solution of the Markowitz Problem
165
Nonnegativity Constraints
168
6.7 The Two-Fund Theorem
168
6.8 Inclusion of a Risk-Free Asset 171
6.9 The One-Fund Theorem 173
Solution Method
173
Explicit Solution 175
6.10 Summary 175
Exercises 176
References 179

Chapter 7 THE CAPITAL ASSET PRICING MODEL 180

7.1 Market Equilibrium 180
7.2 The Capital Market Line 182
7.3 The Pricing Model 184
Betas of Common Stocks 187
Beta of a Portfolio 187
7.4 The Security Market Line 187
Systematic Risk 189
7.5 Investment Implications 190
7.6 Performance Evaluation 191
7.7 CAPM as a Pricing Formula 194
Linearity of Pricing and the Certainty Equivalent Form 196
7.8 Project Choice
198
 CONTENTS · xiii

7.9 Projection Pricing 200

Minimum Norm Pricing
202
7.10 Correlation Pricing 203
7.11 Summary 206
Exercises 207
References 211

Chapter 8 OTHER PRICING MODELS 213

8.1 Introduction 213
8.2 Factor Models 213
Single-Factor Model 214
Portfolio Parameters 215
Multifactor Models 219
Selection of Factors 219
8.3 The CAPM as a Factor Model 220
The Characteristic Line 221
8.4 Arbitrage Pricing Theory
223
Simple Version of APT 223
Well-Diversified Portfolios 225
General APT 226
APT and CAPM 227
8.5 Projection Pricing with Factors 227
8.6 A Multiperiod Fallacy 229
8.7 Summary 230
Exercises 232
References 234

Chapter 9 DATA AND STATISTICS 235

9.1 Basic Estimation Methods 235
Period-Length Effects 236
Mean Blur 238
9.2 Estimation of Other Parameters 240
Estimation of σ 240
a Blur 241
9.3 The Effect of Estimation Errors 242
Three Views 243
Maximum Tangent 245
Compounding Effect 248
9.4 Conservative Approaches 248
Better Estimates
249
9.5 Tilting Away From Equilibrium
250
9.6 Summary 252
Exercises 253
References 255

Chapter 10 RISK MEASURES 257

10.1 Value at Risk 258
xiv · CONTENTS ·

Properties of VaR 260

Capital Requirement 260
10.2 Computation of Value at Risk 261
Model-Based Method 261
Other Models 264
Shortcut for Discrete Distributions 264
Empirical Approach for Market Risk
265
10.3 Criticisms of VaR 266
Diversification Failure 266
Poor Assessment of Risk 267
Discontinuous Value 268
10.4 Coherent Risk Measures 269
10.5 Conditional Value at Risk 270
10.6 Coherent Characterization
272
10.7 Convexity
274
10.8 Summary 275
Exercises 275
References 277

Chapter 11 GENERAL PRINCIPLES 279

11.1 Introduction 279
11.2 Utility Functions 279
Equivalent Utility Functions 281
11.3 Risk Aversion 282
Derivatives 284
Risk Aversion Coefficients 284
Certainty Equivalent 284
11.4 Specification of Utility Functions
285
Direct Measurement of Utility 285
Parameter Families 287
Questionnaire Method 288
11.5 Utility Functions and the Mean–Variance Criterion
288
Quadratic Utility 288
Normal Returns 290
11.6 Linear Pricing 291
Type A Arbitrage 291
Portfolios 292
Type B Arbitrage 292
11.7 Portfolio Choice 293
11.8 Arbitrage Bounds 296
11.9 Zero-Level Pricing 297
11.10 Log-Optimal Pricing
299
11.11 Finite State Models 301
Completeness 302
State Prices 302
Positive State Prices 302
 CONTENTS · xv

11.12 Risk-Neutral Pricing 304

11.13 Summary 306
Exercises 308
References 311

Part III: DERIVATIVE SECURITIES

Chapter 12 FORWARDS, FUTURES, AND SWAPS 315
12.1 Pricing Principles 316
12.2 Forward Contracts 318
Forward Interest Rates 319
12.3 Forward Prices 319
Costs of Carry 322
Tight Markets 324
Investment Assets 325
12.4 The Value of a Forward Contract 326
12.5 Swaps
327
Value of a Commodity Swap 327
Value of an Interest Rate Swap 329
12.6 Basics of Futures Contracts 329
12.7 Futures Prices 332
12.8 Relation to Expected Spot Price
335
12.9 The Perfect Hedge 336
12.10 The Minimum-Variance Hedge 336
12.11 Optimal Hedging
340
12.12 Hedging Nonlinear Risk
341
12.13 Summary 345
Exercises 346
References 349

Chapter 13 MODELS OF ASSET DYNAMICS 350

13.1 Binomial Lattice Model 351
13.2 The Additive Model 353
Normal Price Distribution 354
13.3 The Multiplicative Model 355
Lognormal Prices 355
Real Stock Distributions 356
13.4 Typical Parameter Values
357
13.5 Lognormal Random Variables 358
13.6 Random Walks and Wiener Processes 359
Generalized Wiener Processes and Ito Processes 361
13.7 A Stock Price Process 362
Lognormal Prices 363
Standard Ito Form 363
Simulation 365
13.8 Ito’s Lemma
366
xvi · CONTENTS ·

13.9 Binomial Lattice Revisited 368

13.10 Summary 370
Exercises 370
References 373

Chapter 14 BASIC OPTIONS THEORY 374

14.1 Option Concepts 375
14.2 The Nature of Option Values 377
Time Value of Options 379
Other Factors Affecting the Value of Options 379
14.3 Option Combinations and Put–Call Parity 380
Put–Call Parity 381
14.4 Early Exercise 382
14.5 Single-Period Binomial Options Theory 383
14.6 Multiperiod Options 386
No Early Exercise
389
14.7 More General Binomial Problems 389
Put Options 389
Dividend and Term Structure Problems
391
Futures Options
391
14.8 Evaluating Real Investment Opportunities 393
Real Options 397
Linear Pricing 399
14.9 General Risk-Neutral Pricing
401
14.10 Three-principle Power 402
Decomposition of the Pricing Principles 403
14.11 Summary 403
Exercises 404
References 408

Chapter 15 ADDITIONAL OPTIONS TOPICS 410

15.1 Introduction 410
15.2 The Black–Scholes Equation 410
Proof of the Black–Scholes Equation
412
Self-Financing Strategies
414
15.3 Call Option Formula 414
15.4 Risk-Neutral Valuation
416
15.5 Delta 417
15.6 Replication, Synthetic Options, and Portfolio Insurance
419
15.7 Volatility Smiles 422
Equality of Implied Volatilities 423
Risk-Neutral Probability Density
424
15.8 Computational Methods 425
Monte Carlo Simulation 426
Finite-Difference Methods 427
Binomial and Trinomial Lattices 429
 CONTENTS · xvii

15.9 Exotic Options 431

Pricing
433
15.10 Comparison of Methods 434
15.11 Storage Costs and Dividends
435
Binomial Form 435
Brownian Motion Form
436
15.12 Martingale Pricing
437
15.13 Axioms and Black–Scholes 438
Market Price of Risk 440
15.14 Summary 440
Exercises 442
References 446

Chapter 16 INTEREST RATE DERIVATIVES 448

16.1 Examples of Interest Rate Derivatives 448
16.2 The Need for a Theory 450
16.3 The Binomial Approach 451
Implied Term Structure 452
No Arbitrage Opportunities 454
16.4 Pricing Applications 455
Bond Derivatives 455
Forwards and Futures
455
Futures
457
16.5 Leveling and Adjustable-Rate Loans
457
Adjustable-Rate Loans 458
16.6 The Forward Equation 461
16.7 Matching the Term Structure 464
The Ho–Lee Model 464
The Black–Derman–Toy Model 465
Matching Implied Volatilities 465
16.8 Immunization 467
16.9 Collateralized Mortgage Obligations
469
16.10 Models of Interest Rate Dynamics
473
16.11 Continuous-Time Solutions
474
The Backward Equation 475
Affine Processes
476
Risk-Neutral Pricing Formula 477
16.12 Extensions 477
16.13 Summary 478
Exercises 479
References 482

Chapter 17 CREDIT RISK 483

17.1 The Classic Merton Model 484
Probability of Default 486
Credit Spread 486
xviii · CONTENTS ·

17.2 First Passage Times 487

Lattice Methods 488
Early Default
490
Coupons
491
17.3 Rating Methods 492
17.4 Intensity (Reduced-Form) Model 493
Poisson Processes 493
Inhomogeneous Process 495
17.5 Stochastic Intensity Model
495
17.6 Intermediate Receipts 496
17.7 Analytically Tractable Cox Processes 497
Model Fitting 497
17.8 Simulation 498
Direct Simulation 498
A Better Way 499
17.9 Lattice Methods 500
17.10 Correlated Defaults 503
17.11 Credit Derivatives 505
Bonds and Loans 506
Credit Default Swaps (CDS’s) 506
Forwards and Options on CDS’s 508
Total Return Swaps (TRS’s) 508
Collateralized Debt Obligations (CDO’s) 509
17.12 Summary 511
Exercises 512
References 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 521
Examples 521
18.3 Properties of the Log-Optimal Strategy
525
18.4 Alternative Approaches
526
Other Utility 526
18.5 Continuous-Time Growth 528
Dynamics of Several Stocks 528
Portfolio Dynamics 529
Implications for Growth 530
The Portfolio of Maximum Growth Rate 530
18.6 The Feasible Region 531
 CONTENTS · xix

The Efficient Frontier 531

Inclusion of a Risk-Free Asset 532
18.7 The Log-Optimal Pricing Formula
536
Market Data 539
18.8 Log-Optimal Pricing and the Black–Scholes
Equation
540
18.9 Summary 541
Exercises 542
References 546

Chapter 19 GENERAL INVESTMENT EVALUATION 547

19.1 General Present Value 547
Projects and Opportunities 548
19.2 Multiperiod Securities
548
Assets 549
Portfolio Strategies 549
Arbitrage 550
Short-Term Risk-Free Rates 550
19.3 Risk-Neutral Pricing 550
19.4 Optimal Pricing 552
The Single-Period Problem 552
Applications 553
19.5 The Double Lattice 555
19.6 Pricing in a Double Lattice 557
19.7 Investments with Private Uncertainty 560
General Approach 562
19.8 Buying Price Analysis 566
Certainty Equivalent and Exponential Utility 567
Sequential Calculation of CE 568
Multiperiod Case 569
General Approach 570
19.9 Pricing Axioms for Continuous Time 572
Option Formula 575
Risk-Neutral Form 575
Alternative Forms 575
19.10 Summary 576
Exercises 576
References 578

Appendix A BASIC PROBABILITY THEORY 579

A.1 General Concepts 579
A.2 Normal Random Variables 580
A.3 Lognormal Random Variables 581
xx · CONTENTS ·

Appendix B CALCULUS AND OPTIMIZATION 583

B.1 Functions 583
B.2 Differential Calculus 584
B.3 Optimization 585

ANSWERS TO EXERCISES 588

INDEX 594
PREFACE

I
nvestment is a fundamental component of modern life, reflected in all manor
of economic activity. In practice, investment is generally carried out by processes
facilitated by banks, mutual funds, brokers, and markets and governed by rules and
protocols. These practicalities, together with the underlying investment motivation,
comprise the related subjects of finance and investment. This overall field has recently
expanded enormously, in terms of sheer volume but also in terms of the underlying
theoretical structure. Recent developments in investment theory are being infused into
university classrooms, into financial service organizations, into business ventures,
and into the awareness of many individual investors. This book is intended to be one
instrument in that dissemination process.
The book endeavors to emphasize fundamental principles and to illustrate how
these principles can be mastered and transformed into sound and practical solu-
tions of actual investment problems. The book’s organizational structure reflects this
approach: the material covered in the chapters progresses from the simplest in con-
cept to the more advanced. Particular financial products and investment problems are
treated, for the most part, in the order that they fall along this line of conceptual pro-
gression, their analyses serving to illustrate concepts as well as to describe particular
features of the investment environment.
The book is designed for individuals who have a technical background roughly
equivalent to a bachelor’s degree in engineering, mathematics, or science; or who
have some familiarity with basic mathematics. The language of investment science
is largely mathematical, and some aspects of the subject can be expressed only in
mathematical terms. The mathematics used in this book, however, is not complex—
for example, only elementary portions of calculus are required—but the reader should
be comfortable with the use of mathematics as a method of deduction and problem
solving. Such readers will be able to leverage their technical backgrounds to accelerate
and deepen their study.
Actually, the book can be read at several levels, requiring different degrees of
mathematical sophistication and having different scopes of study. A simple road map
to these different levels is coded into the typography of the text. Some section and
subsection titles are set with an ending star as, for example, “2.6 Applications and
Extensions.
” The star indicates that the section or subsection is special: the material
may be somewhat tangential or of higher mathematical level than elsewhere and can
be skipped at first reading. This coding scheme is only approximate; the text itself
often explains what is ahead in each section and gives guidelines on how the reader
may wish to proceed.

xxi
xxii · PREFACE ·

The end-of-chapter exercises are an important part of the text, and readers should
attempt several exercises in each chapter. The exercises are also coded: an exercise
marked
is mathematically more difficult than the average exercise; an exercise
marked ⊕ requires numerical computation (usually with a spreadsheet program).
Since publication of the first edition of this textbook, the subject of investment
as a practical field and as an academic specialty has been extremely vibrant and
innovative, with great interplay between theory and application, each motivating the
other. As appropriate, much of this work is based on the fundamental concepts of
CAPM and derivative theory, expanded and modified to address issues of portfolio
design and risk management.
The real world of finance greatly tested the scope of traditional foundations.
Issues of risk management, especially, became overwhelmingly important, as wit-
nessed by the failure of some large banks and the high volatility and heavy losses
in the stock market. Existing theory and its application methodologies, although
sound, were not comprehensive enough. An early approach developed to measure the
“riskiness” of institutions such as banks was value at risk, which by a single number
quantifies a portfolio’s risk of loss. This measure has been widely accepted and indeed
explicitly used for formal regulation of banks. The idea was studied by the academic
community where variations such as conditional value at risk were proposed which
have some theoretical and practical advantages over value at risk. Risk measures
comprise the subject of Chapter 10.
Beyond simply measuring risk, credit derivatives were established that, like an
insurance policy, protect the holder of a risky bond against default by the issuing
entity. New theory was developed to price these credit derivatives. Much remains do
be done in this area with regard to new products and theory. Credit risk is the subject
of Chapter 17.
Another topic new to this edition is projection pricing, which relates to the
common practice of applying the CAPM to price an asset that is not yet in the market.
It is shown that this price can be found in other ways, one of which is related to the
common everyday practice of pricing an asset by comparison with similar assets.
Other new topics include a more comprehensive study of the effect of parameter
estimation errors and how to minimize their negative impact, the “volatility smile”
associated with option prices, and a simple axiomatic approach to valuation that
unifies much of derivative pricing. The final chapter includes an extension of both
CAPM and the Black–Scholes equation that prices continuous-time assets that are
not derivatives. In addition, dozens of new end-of-chapter exercises (with answers
to half of them) are included. Throughout, emphasis remains on a combination of
clarity, intuition, and a modest level of mathematical rigor. Indeed some material has
been modified to include new intuition to important theory.
The preparation of this second edition was a major project, one in which many
people helped by their reading and critiquing of chapters. In this regard I wish to thank
Giles Auchmuty, B. Ross Barmish, Xuedong He, Robert Kohn, Siu-Tang Leung,
James Ligon and Frank Morgan. For special help with specific technical issues I wish
to thank Samuel Chiu, Darrell Duffie, Daniel Gabay, Kay Giesecke, Marius Holtan,
Daniel Kuhn, Robert Luenberger, Paul McEntire, James Primbs, and Stan Uryasev.
I am extremely grateful for students and graduates who helped in this endeavor by
 PREFACE · xxiii

reading chapters and helping devise new exercises. These include, Jose Blanchet,
Naveed Chehraz, Ioannis Giannakakis, Supakorn Mudchanatongsuk, Ali Nouri, Dan
Osborn, Wilfred Wong, and Li Xu. Finally, I (once again) thank my wife, Nancy, for
her support during the long hours of manuscript development.

DAVID G. LUENBERGER
March 2013
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 He was soon at the head of a large and powerful army. With this
he marched forward, defeated the English troops that advanced to
meet him, and, in three months after his arrival, he took Edinburgh,
the capital of Scotland.—​France now sent him aid, and, with a force
of 7000 men, he marched southward into England, and took the
town of Carlisle. At Preston Pans, he defeated an English army of
4000 strong; and such was his success, that the English
government, under King William, of Orange, trembled for their safety.
They therefore made great efforts, and in April, 1746, they sent a
large army against him, under the Duke of Cumberland. At Culloden,
the two armies met, and a terrible battle followed; Prince Edward
was defeated, and his army entirely dispersed. He was scarce able
to save his life by flight; and, indeed, he wandered about, from place
to place, among the wilds of Scotland, being every day in danger of
being seized and given up to the English government, who offered
$150,000 to anybody who would bring him to them. It seems strange
that so large a bribe could be resisted; but, such was the love that
the Scottish people bore him, and such their fidelity, that no one was
found to betray him, though many people were entrusted with the
secret of his being among them. Even the poor mountaineers
refused to give him up, though offered a sum of money that would
have made them very rich.
At last, a faithful Scottish nobleman, by the name of O’Neil, took
him in charge, and after wandering along the sea-shore in a skiff,
flying from island to island, and experiencing the greatest sufferings
and dangers, he was put on board a French frigate, that had been
sent for his rescue. He was now taken to France, and soon after,
giving up all hopes of seeing his family restored to the throne, he
settled in Italy, where he died in 1788, in the 68th year of his age. He
was the last of the Stuart line, and was called the Pretender, on
account of his pretending to set up claims to the throne of England.
 Winter.

December has come! Winter is here! These are common-place

words, but they mean more, perhaps, than we are apt to consider.
Winter, then, means that the myriad leaves of the forest are
shrivelled and torn from the trees, and scattered in the valley: it
means that the sap of the trees has ceased to flow, and that these
giants of the vegetable world have passed into a state of stupor, in
which they must remain till spring again returns.
Winter means that the myriad races of annual weeds and plants
are dead, to revive again no more; that myriads of blossoms have
faded forever from the view; that the verdure of the forest has
passed away; that the gemmed garment of the meadow is
exchanged for the thin, brown mantle of leanness and poverty; that
the velvet of the lawn has given place to the scanty covering of dried
and faded grass.
Winter means that the minstrelsy of the birds is gone, and that the
field and forest, so lately cheered by a thousand forms and sounds
of happy existence are now silent, or rendered more dreary and
desolate by the moaning winds. It means that the birds are gone to
their southern retreats; that the myriad races of insects are dead;
that the whole generation of butterflies has perished; that the
grasshoppers have sung their last song; that even the pensive
cricket has gone to his long home. It means that death has breathed
on our portion of the world, and that nature herself, as if weary of her
efforts, has fallen into a cold and fearful slumber.
Winter means all these melancholy things; but it also means
something more. It means that the granary of the farmer is full; that
his barn is supplied; that there is good and ample store for the
beasts that look to man for support, and for man himself. It means,
too, that the comfortable fire will be kindled, around which the family
will assemble, and where, secure from the bitter blast without, there
will still be peace, comfort, and content. It means, too, that there is
such a thing as poverty, shivering, without fire, without food—
perhaps, without sufficient shelter; and it means that charity should
seek and save those who are suffering in such a condition.
And winter means something more than all this: it means, by its
examples of decay and death, to teach us that we, too, must pass
away; and that it is well for us to make preparation for the great
event. Winter also brings us to the end of the year, and suggests a
serious self-inquiry, and self-examination. It would ask us if the last
year has been one of profit or loss? Are we better, and wiser, than
when it began? Are we more kind, more just, more patient, more
faithful, more fond of truth?—Summer is the season for the harvest
of the field; winter is the season for the moral harvest of the heart.
Let it not pass with any of us as a barren and unproductive season,
in which we neither sow nor reap the fruits of wisdom and peace.
 The Hand.

Every limb and member of the body is made for some good
purpose.
The eye is made to see with; the ear is made to hear with; the
nose is made to smell with; the mouth is made to eat and speak with.
The feet are made to run and walk with; the hands are made to
work with, to write with, and to do many other things.
But do you think children’s hands were ever made to strike their
brothers, or sisters, or playmates? Were your little hands ever made
to snatch away things from each other?
Who gave you hands? God gave them. Did he give you hands to
steal with? Did God give you hands that you might throw stones at
geese, or dogs, or hens, or cows, or any other innocent animals?
Did God give you hands to injure or wound any of the creatures
he has made?
Take care of your little hands, then, my children! Take care that
the hands God has given, do nothing that God disapproves.
 Nuts to Crack.

The Word “Fast.”—This is as great a contradiction as we have in

the language. The river is fast, because the ice is immoveable; and
then the ice disappears fast for the contrary reason—it is loose. A
clock is called fast when it goes quicker than time; but a man is told
to stand fast, when he is desired to remain stationary. People fast
when they have nothing to eat, and eat fast when opportunity offers.

Military Courtesy.—Gen. Meadows, equally renowned for his

wit and bravery, being on a reconnoitring party, in the Mysore
country, a twenty-four pound shot struck the ground at some
distance from the General, and was passing in such a direction as
would have exposed him to danger had he continued on his route;
quick as lightning he stopped his horse, and, pulling off his hat very
gracefully, as the shot rolled on, good-humoredly said: “I beg you to
proceed, sir; I never dispute precedence with any gentleman of your
family.”

A doctor, in Scotland, was employed by a poor man to attend

his wife, who was dangerously ill. The doctor gave a hint, amounting
to the suspicion that he would not be paid. “I have,” says the man,
“five pounds; and if you kill, or cure her, you shall have it.” The
woman died, under the hands of the doctor, and, after a reasonable
time, he called for his five pounds. The man then said: “Did you kill
my wife?—did you cure her?” “No.” “Then,” said the poor man, “you
have no legal demand,” and turned upon his heel.
 How to shake off Trouble.—Set about doing good to
somebody: put on your hat, and go and visit the sick and poor—
inquire into their wants, and minister to them; seek out the desolate
and oppressed, and tell them of the consolations of religion. I have
often tried this method, and have always found it the best medicine
for a heavy heart.

A Father’s Impulse.—When Lord Erskine made his debut at the

bar, his agitation almost overpowered him, and he was just going to
sit down: “At that moment,” said he, “I thought I felt my little children
tugging at my gown, and the idea roused me to an exertion, of which
I did not think myself capable.”

The Sublime.—Over the stall of a public writer, in Rue de Bac, at

Paris, is the following inscription: “M. Renard, public writer and
compiler—translates the tongues, explains the language of flowers,
and sells fried potatoes.”

Feeling for Another.—A Quaker, once hearing a person tell

how much he felt for a friend who needed his assistance, dryly
observed: “Friend, hast thou ever felt in thy pocket for him?”

“What are you writing such a thundering big hand for, Patrick?”
“Why, do you see, my grandmother is deaf, and I am writing a loud
lether to her.”

A Knotty Case.—Not many years ago, a man appeared in court,

whether as plaintiff, defendant, or witness, tradition does not inform
us. Be this as it may, the following dialogue ensued:—Court—“What
is your name, sir?” “My name is Knott Martin, your honor.” “Well,
what is it?” “It is Knott Martin.” “Not Martin, again! We do not ask you
what your name is not, but what it is. No contempt of court, sir.” “If
your honor will give me leave, I will spell my name.” “Well, spell it.”
“K-n-o-tt, Knott, M-a-r, Mar, t-i-n, tin—Knott Martin.” “O, well, Mr.
Martin, we see through it now; but it is one of the most knotty cases
we have had before us for some time.”

Good.—It was a judicious resolution of a father, as well as a most

pleasing compliment to his wife, when, on being asked by a friend
what he intended to do with his daughters, he replied: “I intend to
apprentice them to their mother, that they may become like her—
good wives, mothers, heads of families, and useful members of
society.”

A Learned Character.—“Give me ‘Venice Preserved,’” said a

gentleman, last week, on going to a celebrated bookseller’s at the
West-end. “We don’t sell preserves,” said an apprentice, newly-
imported from the country; “but you will get them next door, at Mr.
Brown’s, the confectioner.”

Ten To One.—Strict attention to office hours is a duty incumbent

upon every public officer. We heard of a case of an American consul,
in a foreign country, who was not remarkable for his attention to duty.
A gentleman, calling one day, found his office shut, and a label
sticking upon the door, with these words: “In from ten to one.” Having
called again several times within those hours, without finding him, he
wrote at the bottom of the label—“Ten to one he’s not in.”
 To the Black-ey’d and Blue-ey’d Friends of
Robert Merry.

It is now about a twelvemonth since our acquaintance

commenced; and I hope the feeling is such between us, that there is
a mutual desire to continue it. I know that the young, the happy, and
the gay-hearted, are apt to think that we old fellows are sour and sad
—disposed to look with an evil eye upon childhood and its sports;
and more ready to preach than practise charity.
I will not pretend to deny that, now and then, a person gets cross
and crabbed as he grows old, and like cider too long kept, turns to
vinegar: but this is not my case, or, if it be, my ill-humor never
displays itself toward the young. They are to me the buds and
blossoms of life, and their presence ever brings the welcome
feelings that belong to sunshine and summer.
Old age has been often compared to winter—the close of the
year; the season of desolation; the period of storms and tempests;
the funeral-time of the vegetable world; the time when the leaves,
the fruits, and the flowers are laid in their tomb, and covered over
with a winding-sheet of snow. This is a sad picture at first view; and I
believe many a child is led to avoid old people from the habit of
regarding them in this light—from the idea that they are shrivelled,
frost-bitten, bitter, and disagreeable.
Now, I will not deny that there is some resemblance between
winter and old age: an old man has not the warm blood of youth; his
pulses are, perhaps, like the river, chilled and obstructed by ice; his
temper is sometimes capricious and gusty, like the winds of
December; and his head, bald, or covered with a few silvery hairs, is
like the oak, stripped of its covering, and having its boughs
powdered with snow.
 All this may be true enough; but it is not good reason why the old
should be deserted by the young. I remember very well, that, when I
was a boy, there was a fine old walnut-tree, upon a hillside, not far
from where I lived. Now, I never thought or cared about this tree, till
the time when winter approached. Then, when the leaves were
scattered, the nuts were all ripe, then it was that the tree became an
object of interest to me. Then it was that I loved to visit it; to climb its
limbs and give it a shake, and hear the fruit rattle down like hail.
Never, in all my boyhood days, did I meet with anything more
delightful than this!
And let me tell you, my black-ey’d and blue-ey’d friends, that this
old walnut-tree was like many an old person you may meet with. You
will remark that, in this case, it was when winter had come, or was
near at hand, that the fruit was ripe, and ready for those who would
climb up for it and gather it. And let me tell you, that old people, like
this tree, have many a good nut to crack, many a good story to tell,
to those who will climb up in the lap and ask for it.
This is my view of the matter; and I hope that young people,
instead of running away from me, as a crusty, crabbed, one-legged
old chap, will treat me as I did the old walnut-tree—give it a shake,
and see if the nuts don’t rattle down!
I am not fond of making great promises; but, as I am anxious to
have my readers, who have set out on a journey with me, still keep
me company—at least for one year more—I am ready to engage to
do my best to please them. I shall, if I live, tell the rest of my own
story, and bring the history of Brusque to a close. The tale of the
Sable-Hunters, the travels of Thomas Trotter, the stories of the
Indians, will be continued and completed; and a variety of other
things are in store.
I can promise one thing more—and that is, some tales from the
pen of Peter Parley. That pleasant, kind-hearted old man is no more;
but I knew him better than anybody else, and all his papers are in my
hands. Among them are several tales, and I intend to publish them in
my magazine. My young readers, perhaps, do not know how
shabbily poor old Peter was treated. The fact was, that several
people in this country, as well as in others, wrote stories, and put his
name to them; thus pretending that they were actually his! Some of
these were very silly, and some were very improper. This cut Peter to
the heart, and it served greatly to shorten his days. I am sorry that,
even now, people are palming off trumpery works of their own as
Peter Parley’s.
But the tales that I propose to give, are genuine; there is no
mistake. They are by the same hand that wrote the tales about
Europe, Asia, Africa, and America; and I hope they may be as
acceptable as those were.
I return a thousand thanks to my many young friends, who have
written me letters, whether of criticism, advice, or commendation. I
am glad to know that so many of them like Bill Keeler: let them be
assured his whole story will come out in due time. I shall be very
glad to get the bear story, which L. S., of Vermont, offers to tell. The
Indiana legend of the Wolf and the Wild-cat, is received, and will
appear soon. Jane R—— will accept my thanks for—she knows
what! If she were not so many hundred miles off, I should ask her to
let me see whether she is a blue-eyed or black-eyed friend. The
basket of chestnuts were duly received from Alice D——, and were
very welcome. Ralph H—— will see that I have done as he
requested; I have given a portrait of the fine gray squirrel he sent
me, in this number. He is well, and as lively as ever.
Robert Merry.
 WINTER—A SONG.
the words and music composed for
merry’s museum.

“Tell me what does winter mean!”

’Tis a drea-ry change of scene—
When the meadow yields its bloom,
And the blo-soms seek their tomb.
Winter is the time of storms,
When the cloud in angry forms,
O’er the land in terror sweeps,
And the sighing forest weeps.
’Tis the funeral time of flowers,
Withered in their lovely bowers;
While the zephyr sings in grief,
O’er each shrivelled stem and leaf.
’Tis the dreary time of snow,
Falling chill on all below,
As a winding-sheet it weaves
O’er the graves of myriad leaves.

Winter is a time of tears,

For the poor, in youth or years,—
Where the storm drives keenly in,
And the blanket’s brief and thin.
Winter is the time of wreck,
When the billow cleaves the deck,
And the mariners go down
Where the battling surges frown.
 Transcriber’s Note:
This book was written in a period when many words had not
become standardized in their spelling. Words may have multiple
spelling variations or inconsistent hyphenation in the text. These
have been left unchanged unless indicated below. Obsolete and
alternative spellings were left unchanged. Misspelled words were not
corrected.
One Footnote was moved to the end of the chapter. Obvious
printing errors, such as backwards, upside down, or partially printed
letters and punctuation, were corrected. Final stops missing at the
end of sentences and abbreviations were added. Duplicate letters at
line endings or page breaks were removed. Quotation marks were
adjusted to common usage. Page numbers in the Table of Contents
were corrected to match book pages.
Links to audio files were added for music. The music files are the
music transcriber’s interpretation of the printed notation and are
placed in the public domain. At the time of this writing, music file
links will not work in mobile e-book formats like epub or Kindle/mobi.
Users who are reading the e-book in one of these formats can listen
to the music or download music files in the HTML version. Lyrics to
musical scores are presented as poetry following the illustration of
the music.
*** END OF THE PROJECT GUTENBERG EBOOK ROBERT
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