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 Mc TM
Graw
Hill
Education

Course Principles of Investments

Course Number First Australian Edition
Zvi Bodie, Michael E.Drew,
Anup Basu, Alex Kane,
Alan J . Marcus
McGraw-Hill Education

The end of 2008 capped three decades of rapid and profound
change in the investment industry with a financial crisis of historic
magnitude. The vast expansion of financial markets over recent
decades was due in part to innovations in securitisation and
credit enhancement that gave birth to new trading strategies.
These strategies were in turn made feasible by developments in
information technology, as well as by advancements in the theory
of investments.
The crisis can be traced in part to macroeconomic imbalances
in global trading patterns. Huge savings in exporting countries fed
low interest rates and historically high leverage in business and
investment portfolios around the world. Yet the crisis was rooted
in cracks of the financial system. The innovation-driven, massive
capacity of the system to facilitate highly leveraged investments
was coupled with, and indeed enhanced by, relaxation of
regulation as well as incentive schemes that reduced transparency
and masked the overvaluation of investment assets.
These developments highlight the importance of 1wo innovations that
were coincidentally emerging in the theory of investments, namely, the
centrality of liquidity in asset valuation and the importance of investor
behaviour that contribute to herding and at times low-quality, wildly
optimistic forecasts. Broadly speaking, asset liquidity is often hard to
measure and investors may at times become overly optimistic or
pessimistic-but these are just additional factors in the assessment
and incorporation of overall market risk in asset valuation, a central
theme of this text. Still, the idea that security markets are nearly efficient,
meaning that most securities are usually priced appropriately given
their risk and return attributes, nevertheless remains a justifiably
powerful approach to security valuation. While the degree of market
efficiency is and will always be a matter of debate, this first principle of
valuation, specifically that in the absence of private information prices
are the best guide to value, is still valid. Greater emphasis on risk
analysis is the lesson we have weaved into the text.
This text also emphasises asset allocation more than most other
books. We prefer this emphasis for two important reasons. First, it
corresponds to the procedure that most individuals actually follow
when building an investment portfolio. Typically, you start with all
of your money in a bank account, only then considering how much
to invest in something riskier that might offer a higher expected
return. The logical step at this point is to consider other risky
asset classes, such as stock, bonds or real estate. This is an asset
allocation decision. Second, in most cases the asset allocation
choice is far more important than specific security-selection
Principles of Investments, First Australian Edition 3
decisions in determining overall investment performance. Asset
allocation is the primary determinant of the risk-return profile of
the investment portfolio, and so it deserves primary attention in a
study of investment policy.
Our book also focuses on investment analysis, which allows
us to present the practical applications of investment theory,
and to convey insights of practical value. In this edition we offer
a systematic collection of Excel spreadsheets that give you tools
to explore concepts in depth. These spreadsheets are available
online and provide a taste of the sophisticated analytic tools
available to professional investors.
In our efforts to link theory to practice, we also have attempted
to make our approach consistent with that of the CFA Institute.
The Institute administers an education and certification program
to candidates for the title of Chartered Financial Analyst (CFA).
The CFA curriculum represents the consensus of a committee of
distinguished scholars and practitioners regarding the core of
knowledge required by the investment professional.
'Investments' nowadays is a truly global discipline both in
theory and practice. For example, today it is impossible to imagine
an Australian fund manager to hold a portfolio comprising of
just Australian assets. In fact, doing so would go against the
tenets of modern portfolio theory and also current industry
practice. Therefore, while this text is written from an Australasian
perspective and mainly aimed at students within this geographic
region, we have included several cases and examples from other
markets around the world. As the United States is the largest
market for financial securities and also a major source of financial
data and research findings, examples from that market feature
prominently in many chapters.
This text will introduce you to the major issues of concern to
all investors. It can give you the skills to conduct a sophisticated
assessment of current issues and debates covered by both the
popular media and more specialised finance journals. Whether
you plan to become an investment professional or simply a
sophisticated individual investor, you will find these skills essential.
Zvi Bodie
Michael E. Drew
Anup Bosu
Alex Kane
Alan J. Marcus
4 Principles of Investments
xiv
ABOUT THE AUSTRALIAN AUTHORS
MICHAEL E. DREW
Griffith University
Michael Drew is a Professor of Finance
at the Griffith Business School. Michael's
research has studied and developed
new approaches to the design of the
default option in defined contribution
funds, as well as devising winning
strategies for lifecycle and target date
funds. In 2009, Michael was invited
to appear before a joint hearing of
the US Department of Labor and the
Securities Exchange Commission in
Washington DC where he presented
testimony relating to his research on
target date funds. Michael's research on
superannuation was extensively cited by
the recent Cooper Review, and has been
widely cited by industry, academic,
regulatory and government agencies.
Michael has completed numerous
consulting projects and industry
assignments, including senior roles at
QSuper and the Queensland Investment
Corporation. In 2011, Michael was
awarded the Finsia (Financial Services
Institute of Australasia) Pinnacle Award
for Most Outstanding Thought leader
to celebrate 125 years for the peak
industry body.
ANUP BASU
Queensland University of Technology
Anup Basu is a Senior lecturer of
Finance at OUT Business School. Prior
to completing his PhD and joining
academia, he worked in the financial
services industry in Asia and North
America where he served in different
management positions. Dr. Basu has
several publications on investments and
capital markets in leading academic
and professional journals. His research
has been cited by World Bank and
IMF policy research report on pension
plans, OECD Working Party on Private
Pensions, United States Government
Accountability Office, and the United
States Senate Hearing before the Special
Committee on Aging, joint hearing of the
United States Government Department
of Labor and the Securities & Exchange
Commission (SEC) and the Cooper Review
of Superannuation System in Australia.

ZVI BODIE
Boston University
Zvi Bodie is Professor of Finance and
Economics at Boston University School of
Management. He holds a PhD from the
Massachusetts Institute of Technology
and has served on the finance faculty at
Harvard Business School and MIT's Sloan
School of Management. Professor Bodie
has published widely on pension finance
and investment strategy in leading
professional journals. His books include
Foundations of Pension Finance, Pensions
in the U.S. Economy, Issues in Pension
Economics, and Financial Aspects of the
U.S. Pension System. Professor Bodie
is a member of the Pension Research
Council of the Wharton School, University
of Pennsylvania. His latest book is
Worry-Free Investing: A Safe Approach to
Achieving Your Lifetime Financial Goals.
Principles of Investments, First Australian Edition
ALEX KANE
University of California, San Diego
Alex Kane is Professor of Finance and
Economics at the Graduate School of
International Relations and Pacific Studies
at the University of California, San Diego.
He holds a PhD from the Stern School of
Business of New York University and has
been Visiting Professor at the Faculty of
Economics, University of Tokyo; Graduate
School of Business, Harvard; Kennedy
School of Government, Harvard; and
Research Associate, National Bureau of
Economic Research. An author of many
articles in finance and management
journals, Professor Kane's research is
mainly in corporate finance, portfolio
management, and capital markets.
5
ALAN J. MARCUS
Boston College
Alan Marcus is Professor of Finance
in the Wallace E. Carroll School of
Management at Boston College. He
received his PhD from MIT, has been a
Visiting Professor at MIT's Sloan School of
Management and Athens Laboratory of
Business Administration, and has served
as a Research Fellow at the National
Bureau of Economic Research, where
he participated in both the Pension
Economics and the Financial Markets
and Monetary Economics Groups.
Professor Marcus also spent two years
at the Federal Home loan Mortgage
Corporation (Freddie Mac), where he
helped to develop mortgage pricing and
credit risk models. Professor Marcus has
published widely in the fields of capital
markets and portfolio theory. He currently
serves on the Research Foundation
Advisory Board of the CFA Institute.
6 Principles of Investments

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Communication:
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 Principles of Investments, First Australian Edition 7

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8 Principles of Investments

LEARNING OBJECTIVES
Each chapter begins with a summary of the
chapter objectives, providing students with
an overview of the concepts they should
understand after reading the chapter.
A chapter overview follows.

CHAPTER OVERVIEW
Each chapter begins with a brief narrative to
explain the concepts that will be covered in
more depth.
I NVESTMENT
commitmen1of curren1
resources in the
expectation of deriving
greater resources In !he
future
An invQs1ment Is the current commitment of money or other resources In the expectation ol reaping
futvre benef11s For exomple. ¢.n mdivtdvol might pure.hose shores of stock onticipoting that lhe
future proceeds from lhe shares will justify both the time thol their money is lied up os well os lhe
risk of the investment The time you will spend studying this tcx.1 lnot to mention its cosU is also on
investment. You ore forgoing either curren1 let.sure time°' the uxome you could be earning ot a job in
the expectation thot yovr future co1eer will be sufflc-ently enho.nced 10 rusllfy this comm1tmen1 of hme
ond effort. While these two investments differ in many woys they share one key ottribute Ihot is central
to all investments: you sacrifice something of votue now expecting to benefit from that sacrifice later.
This te>d can help you become aninfo,med practitioner of investments. Wew,11 focus on investments
1n secutities such as shores, bonds or options ond futures conuocrs. but much of what we dJSCUSS wlll
be useful in the anatysas of any type of investment. The text will prOVide you wilh background in lhe
a<ganisation of various securilies markets, will survey the valuation ond risk·monogemenl principles
useful in particular markets, such os those for bonds or shares, and \'1itl introduce you to the principlc,s
of portfoho construction.
a,oodly speoking, lhi$ chople, oddresses lhree lopics lhot will prov,de o vselvl perspec11ve lor lhe
material that is lo come later. First. before delving into the topic of 'inveslments', we consider the ro4e
of financial assets in the economy. We discuss the relationship between securities ond the 'reoJ' ossets
thol actually produce goods and services tor consume<s and we consider why tinonetol assets are
1mpor1on1 to the functioning of the economy We inves119ote three mo1or types of finanool assets thol
form on importont par1 of mos! investment portfolios. before discussing the role of financial markets
in the wider economy. Given this background, we then take o first look at the types of decisions that
confront investors as they assemble a portfolio of osse1s.
Finally, we conclude wl1h on 1ntroduc1lon 10 rhe orgon1sohoo of security mortte1s and lhe vonous
ploye,s lhol porl,c:,po1e in lhose mor1<e1s Togelhef, lhese topies should grve you o leel 10< who lhe
major porticiponls ore in the securities markels as well as the setting in which they oct. The chapter
closes with an overview of the remainder of the text

KEY TERMS AND MARGIN MONEY MARKETS

DEFINITIONS
Key terms are indicated in colour and defined
in the margin the first time the term is used.
A glossary is available on the endmatter.
al.so play an important role as ar, indication, or bendunark, for interest rates.
An impomnt feature: of mcme)' market instruments is the face: value, o r par value. This
include shO~·term. highly
liQuid and relatively low·
nsk debt Instruments
is the amoum the borrower wiJJ repay when the innrumcnt mawrcs. J,.,ta.ny money·m:.uket
insrrumencs are discount se<:ul'ities, chat is, they are iniciaJlysold at a price ch.ea per than the fu.ce
value. Discouot securiries do 001 make periodic interest pay1neo1s, like some ocher instrumems.
FACE VALUE
The: interest sim ply ace.Tues each day. slowly increasing the value o f che instrument) at a rate::
the amount cepaid when
an instrument matures
consistent with the interest c.u ncd on the invcnmem. \\;'hen the security scnlcs, that is, ,he
loan is repaid, che pavmem includes the initial money borrowed plu.s the imcrcst that was

NUMBERED EQUATIONS
Key equations are called out in the text and
identified by equation numbers.
income: the share has p rovided . 1"he r:uc of rct11rn is defined as dollars earned over ,he i nvc:stmc:nt
period (price appreciation as well as dividends) per dollar invested.
HOLOING· PERIOO
HPR = end ing price - beginning price+ cash dividend
beginning price (5.1)
RETURN (HPR)
rate ot return over a gi\1en
investment period This definition of rhc: HPR assume:$ ,har ,he d ividend is paid :u rhc: <::nd o f rhc: holding
period. To the extent chat dividends arc received car)jcr, the definition ignores rcinvesm1ent
income between the receipl of the dividend and the end of the holding period . Recall also that
rh.e percentage return Crom dividends is called the dividend yield and so the dividend yield,
ca..'ih d ividend/beginning p rice:. plus the c.-ipi~ I gains yield equals the H PR.
lhis dehnhion of holding rcnirn is easy fO modi!)• fo r other types of invcs,mems. For
 Principles of Investments, First Australian Edition 9

ON THE MARKET FRONT

Current articles from financial publications such
as The Wall Street Journal are featured as boxed
readings. Each box is referred to within the
narrative of the text, and its real-world relevance
to the chapter material is clearly defined.

CONCEPT CHECKS You o e creol ng on 1n·,·~111e-n1 porl1o 10 and moi<1ng a chCkce be1v..eeo d ~erenl ,nv~t"llenl:. Wh,<h
Concept check 1.2 of ·he following Ole as.sel o locolion dem.i0ns and -.·,nich ore secur ty selec oo dee sions?
These self-test questions in the body of the o Bonds or c4!J•ics
b ~eol cs.tote or com.mod I es
I
chapter enable students to determine whether c BHP Bi 1on o< Ro Tinlo shores

the preceding material has been understood and

then reinforce understanding before they read
further. Detailed solutions to the Concept checks
are found at the end of each chapter.

NUMBERED EXAMPLES
EXAMPLE3.4
Numbered and titled examples are integrated in
each chapter. Using the worked-out solutions to
these examples as models, students can learn
how to solve specific problems step-by-step
as well as gain insight into general principles
MARGIN CALLS ON SHORT POSITIONS
Suppose the broker has a maintenance margin of 30% on short saJe.s. This meam the
equity in your account must be 3 t least 30% of the ,,aJuc of your short position at all
times. I low much can the price of Dot Bomb shares- rise before you ger a ma_rgin c.111?
Lee P be d\e price of Dot Bomb shares. Then rhe value of the shares you must pay
back is lOOOPand the eq uity in your ac:-count is $ 1;0 000- IOOOP. Your sho rt position
margin ratio i$ equity/value of stock = ( 150 000 - I 000/l'J/ I OOOP. The critical value of
P is rhu.s

by seeing how they are applied to answer Equity = 150000- IOOOP = 0.3
Value of sha= owed IOOOP
concrete questions.
which implies d1at P = $1 15.38 per share. If Doc Bomb share should rise above
$115.38 per share, you will get a mari,'ln call and you will either have to put up
additional cash or cover your short posit io n by buying shares to replace the ones
borrowed.
10 Principles of Investments

EXCEL APPLICATIONS Excel applications

Since many courses now require students to per- Buying on margin
1hc Excel spreadsheet model below makes it easy to analyse the impacts of different margin
••• levels a.od the volatifjl}' o f nock prices. lt also aJlows you co compare return on investment
form analyses in spreadsheet format, Excel has •••
••• for a margin trade with a trade using no borrowed funds.
been integrated throughout the book. It is used in
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to the Web to work with an interactive version of

the spreadsheet. The student can obtain the ac-
tual spreadsheet online available spreadsheets
are denoted by an icon. As extra guidance, the
spreadsheets include a comment feature that
documents both inputs and outputs. Solutions for
these exercises are available only to instructors,
so instructors can assign these exercises either
for homework or just for practice.

Excel application spreadsheets are available for the following:

Chapter 3: Buying on margin; Short sale Chapter 15: Parity and Spreads
Chapter 7: Estimating the index model Chapter 18: Performance measures; Performance attribution
Chapter 10: Immunisation; Convexity

Spreadsheet exhibit templates are also available for the following:

Chapter 5: Spreadsheet 5.1 Chapter 10: Spreadsheets 10.1 & 10.2
Chapter 6: Spreadsheets 6.1-6.7 Chapter 11: Spreadsheets 11.1 & 11.2
Chapter 9: Spreadsheets 9.1 & 9.2 Chapter 14: Spreadsheet 16.l

PROBLEM SETS
We strongly believe that practice in solving
problems is a critical part of learning investments,
so we provide a good variety, organised by level
of difficulty: Basic, Intermediate, and Challenge.
CFA PROBLEMS
We provide several questions from recent
CFA exams in applicable chapters. These
questions represent the kinds of questions that
professionals in the field believe are relevant to
the practicing money manager.
WEBMASTER EXERCISES
A great way to allow students to test their skills
on the internet. Each exercise consists of an
activity related to practical problems and real-
world scenarios.
Principles of Investments, First Australian Edit ion 11
PROBLEM SETS
QUESTIONS
Basic
1. Vilhat is the difference between an IPO OnitiaJ public offerTlg} and placement? LO 3,2
2. VI/hat are some different components of tho etfec1lve costs of buying or sel!lng shclfes? LO 3.6
3. Wtlal ,stile dlffel'Gfloa be.tween a primary and secondary ma1ke1? LO 3.3
4. A publie company can raise addi1ional capi1a1in a number or ways. Which WrJ'/ would YoV recommend to a oornpany
in1erested in raising capital Qt,.lici<fV? LO 3.t
5. What are the cifferences between a stop k>ss order, a lirrit sell order and a market order? LO 3.5
6. How do margin trades magnify both the upside potent>al and downside risk of an l'lvestment portfolio? LO 3.7
Intermediate
7. Here is some price intormati(;(l on Fi'lcorp shares. $oppose frst that Fincorp trades in a oo•r market.
Bid Asked
55.25 55.50
1. ff yov place a stop loss order to sell 100 shares of stock at $55 when the c1.Xrent price is $62, how much will
receive fo, each share ~ the pnce dr¢PS to $50?
.. $50
b. $55
c. $54.87
d. Cainno11eu from the informabOn gNen. LO 3.5
2. You wish to sell short 100 shares of XYZ C-0rDCl'ation stock. ff the last two transactions were at $34.12 lolowed by
$34.25. you can sell short on the next transaction only at a prioe of:
a. 34. 12 or higher
b. 34.25 or togher
c. 34.25 or lower
d. 34.12 or IO\IJ'Elt LO 3.8
SOLUTIONS TO CONCEPT CHECKS
Concect check 3.1.
WEB MASTER • DATA ON BOND ISSU ES
Use data from Yahoo Finance at finance.yahoo.com/bonds to answer the folowlng question.
1. Use the search feat...-e to search for five well·known US companies that issue corporate bonds. Note the bond
ratings (if possible choose companies with a wide range of bond ratings). Next use too Financials section to obtain
the companies' financiaJ reports and calc.Jate some key financial ratios. Vv11at is the relationship between boOO
rating and these ratios? can
you tell from your sample which of these ratios are the more important determrlants of
bond rating?
The FINRA cperates the TRACE (Trade Reporting and Compliance Engine) system. vklich reports over th&-oovn1er 4
secondary market trade$ of fixed inoc.ne -securities. Go to the FIN.RA. hOme page a1...11,w.•.finra.org and dick on the
link tor 'Industry Professionals'. Search ('bcated at the lop righl) tor the ·TRACE Facl Book' a,ld cliek the first link thal
appears. Find the detailed dala tatltes and local& th& tabl& w,th i0f0tmation on issues. axcluek"lg con~ bollCIS
(typically Tablo 1).
1. For each of the last three years, ca!Q..llate the following:
a. the percentage of bonds that were poolicly traded and the percentage that were pivatetf traded
b. the percentage of bonds that wG<e lnvostment grade and the pGtcentage that wem hlgh~yletd
c. the percenlag& ~ bonds thal had fixed ooupo,i rates and the percootage that had fk>aling mies.
2. Do any patterns emerge over time?
3. Repeat the calculations using the infCfmation for convertible bond issues (typically in Table 2).
12 Principles of Investments

CHAPTERS IN THIS PART

1 Investments: background and issues
2 Asset classes and financial markets
3 Securities markets
4 Managed funds and investment management

Even a cursory glance at The Australian
Financial Review reveals a bewildering
collection of securities, markets and financial
institutions. But although it may appear so,
the financial environment is not chaotic: there
is rhyme and reason behind the vast array
of financial instruments and the markets in
which they trade.
These introductory chapters provide a
bird's-eye view of the investing environment
and how markets and securities have evolved
to meet the changing and complex needs of
different participants in the financial system.
Markets innovate and compete with each
other for traders' business just as vigorously
as competitors in other industries. Competition
between the Australian Securities Exchange
(ASX), the newly established Chi-X stock
Principles of Investments, First Australian Edit ion 13
exchange and a number of electronic and
non-Australian exchanges (e.g. the New York
Stock Exchange, the London Stock Exchange)
is robust.
The explosive growth of online trading has
saved investors many millions of dollars in
trading costs. Even more dramatically, new
electronic communication networks promise
to allow investors to trade directly without
a broker. These advances will change the
face of the investments industry and market
players will scramble to formulate strategies
that respond to these changes.
These chapters will give you a good
foundation to understand the basic types of
securities and financial markets as well as
how trading in those markets is conducted.
14 Principles of Investments

CHAPTER 1

INVESTMENT An invest111ent is the current commitment of money or other resources in the expectation of reaping
commitment of current future benefits. For example, an individual might purchase shares of stock anticipating that the
resources in the future proceeds from the shares will justify both the time that their money is tied up as well as the
expectation of deriving risk of the investment. The time you will spend studying this text (not to mention its cost) is also an
greater resources in the
investment. You are forgoing either current leisure time or the income you could be earning at a job in
future
the expectation that your Mure career will be sufficiently enhanced to justify this commitment of time
and effort. While these two investments differ in many ways they share one key attribute that is central
to all investments: you sacrifice something of value now expecting to benefit from that sacrifice later.
This text can help you become an informed practitioner of investments. We will focus on investments
in securities such as shares, bonds or options and futures contracts, but much of what we discuss will
be useful in the analysis of any type of investment. The text will provide you with background in the
organisation of various securities markets, will survey the valuation and risk-management principles
useful in particular markets, such as those for bonds or shares, and will introduce you to the principles
of portfolio construction.
Broadly speaking, this chapter addresses three topics that will provide a useful perspective for the
material that is to come later. First, before delving into the topic of 'investments', we consider the role
of financial assets in the economy. We discuss the relationship between securities and the 'real' assets
that actually produce goods and services for consumers and we consider why financial assets are
important to the functioning of the economy. We investigate three major types of financial assets that
form an important part of most investment portfolios, before discussing the role of financial markets
in the wider economy. Given this background, we then take a first look at the types of decisions that
confront investors as they assemble a portfolio of assets.
Finally, we conclude with an introduction to the organisation of security markets and the various
players that participate in those markets. Together, these topics should give you a feel for who the
major participants are in the securities markets as well as the setting in which they act. The chapter
closes with an overview of the remainder of the text.
 Principles of Investments, First Australian Edition 15

CHAPTER 1 I Investments: background and issues I 5

1.1 REAL ASSETS VERSUS FINANCIAL ASSETS

The material wealth of a society is ultimately determined by the productive capacity of its
economy, that is, the goods and services its members can create. This capacity is a function of
the real assets of the economy: the land, buildings, equipment and knowledge that can be used
to produce goods and services.
In contrast to such real assets are financial assets such as shares and bonds. Such securities
are no more than sheets of paper; these assets are the means by which individuals in well-
developed economies hold their claims on real assets. Financial assets are claims to the income REAL ASSETS
generated by real assets (or claims on income from the government). assets used to produce
While real assets generate net income to the economy, financial assets simply define the goods and services
allocation of income or wealth among investors. The distinction between real and financial
FINANCIAL ASSETS
assets is apparent when we study the balance sheet of Australian households, shown in
claims on real assets
Table 1.1. Household wealth includes real assets, such as personal dwellings, and financial or the income generated
assets, such as bank accounts, corporate shares or bonds. These securities, which are financial by them
assets of households, however, are liabilities of the issuers of the securities. For example, a bond
owned by a household is considered an asset, as it gives you a claim on interest income and
the future repayment of the principal. From the perspective of the company that issued the
bond, however, it is considered a liability as it is obligated to make the interest payments along
with repaying the principal. The household's asset is the company's liability. Therefore, when
we aggregate overall balance sheets, these claims cancel out, leaving only real assets as the net
wealth of the economy.
This text will focus almost exclusively on financial assets. But you shouldn't lose sight of the
fact that the successes or failures of the financial assets we choose to purchase ultimately depend
on the performance of the underlying real assets.

Assets S billion TABLE 1.1

Real assets
Australian household
Real estate-dwel lings & investment 1 619.7 21.3% balance sheet at 30
Other non-financial assets 3 099.7 40.8% June 2011
Consumer durab les 269.4 3.5%
Total real assets 4 988.8 65.6%
Financial assets
Cash & deposits 669.1 8.8%
Insurance & superannuation reserves 1 571.5 20.7%
Corporate & other equ ity 261.9 3.5%
Other securities 94.8 1.3%
Other 5.0 0.1 %
Total financial assets 2 602.3 34.4%
Total assets 7 591.1 100.0%
Liabilities and net worth
Mortgage and other loans 1 504.5 20.5%
Source: Australian Bureau
Security cred it 24.8 0.1 % of Statistics, 'Table 41 :
Other 60.9 1.0% Household Balance Sheet,
Total liabilities 1 590.2
Current prices - as at 30
21.6%
June', Australian System of
Net worth 6 000.9 78.4% National Accounts 2010-11,
Total 7 591.1 100.0% Cat. 5204.0, ABS, Canberra.
16 Principles of Investments
6 I PART l I Elements of investments
Concept check 1.1
FIXED-INCOME (DEBT)
SECURITIES
a financial asset that pays
a specified cash flow over
a specific period
EQUITY
an ownership share in a
corporation
DERIVATIVE SECURITIES
securities providing payoffs
that depend on the values
of other assets
Are the following assets real or financial?
a. patents b. lease obligations c. customer goodwill
d. a college education e. a $5 bill
1.2 TYPES OF FINANCIAL ASSETS
It is common to distinguish among three broad types of financial assets: debt, equity and
derivatives. Fixed-income or debt securities promise either a fixed stream of income or a stream
of income that is determined according to a specified formula. For example, a corporate bond
would typically promise that the bond holder will receive a fixed amount of interest each year.
Other so-called floating-rate bonds promise payments that depend on current interest rates. An
example is a bond with an interest rate fixed at two percentage points above the rate paid on a
13-week Treasury note issued by the Reserve Bank of Australia (RBA). Unless the borrower is
declared bankrupt the payments on these securities are either fixed or determined by a formula.
For this reason, the investment performance of debt securities is not closely tied to the financial
condition of the issuer.
Nevertheless, debt securities come in a tremendous variety of maturities and payment
provisions. At one extreme, the money market refers to fixed-income securities that are short-
term, highly marketable and generally very low-risk. Examples of money market securities
are Treasury notes or bank certificates of deposit (CDs). In contrast, the fixed-income capital
market includes long-term securities such as Treasury bonds, as well as bonds issued by state
and local governments and corporations. These bonds range from very safe in terms of default
risk (e.g. Treasury securities) to relatively risky (e.g. high yield or 'junk' bonds). They also are
designed with extremely diverse provisions regarding payments provided to the investor and
protection against the bankruptcy of the issuer.
Unlike debt securities, ordinary share, or equity, in a firm represents an ownership share
in the corporation. Equity holders are not promised any particular payment. They receive any
dividends the firm may pay and have prorated ownership in the real assets of the firm. If the
firm is successful, the value of equity will increase; if not, it will decrease. The performance of
equity investments, therefore, is tied directly to the success of the firm and its real assets. For
this reason, equity investments tend to be riskier than investments in debt securities.
Finally, derivative securities such as options and futures contracts provide payoffs that are
determined by the prices of other assets such as bond or share prices. For example, a call option
on a share of ANZ shares might turn out to be worthless if ANZ's share price remains below a
threshold or 'exercise' price such as $20 a share, but it can be quite valuable if the share price
rises above that level.* Derivative securities are so named because their values derive from the
prices of other assets. For example, the value of the call option will depend on the price ofANZ
shares. Other important derivative securities are futures and swap contracts.
Derivatives have become an integral part of the investment environment. One use
of derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties.
This is done successfully every day and the use of these securities for risk management is so
commonplace that the multitrillion-dollar market in derivative assets is routinely taken for
• A call option is the right co buy a share of stock at a given exercise price on or before the option's expiration dace. If the market
price of ANZ remains below $20 a share, the right co buy for $20 will turn out co be valueless. If the share price rises above
$20 before the option expires, however, the option can be exercised co obtain the share for only $20.
 Principles of Investments, First Australian Edition 17

CHAPTER 1 I Investments: background and issues I 7

granted. However, derivatives can also be used to take highly speculative positions. Every
so often, one of these positions blows up, resulting in well-publicised losses of hundreds of
millions of dollars. While these losses attract considerable attention, they do not negate the
potential use of such securities as risk management tools. Derivatives will continue to play an
important role in portfolio construction and the financial system. We will return to this topic
later in Part 5.
In addition to these financial assets, individuals might invest directly in some real assets. For
example, real estate or commodities such as precious metals or agricultural products are real
assets that might form part of an investment portfolio.

1.3 THE ROLES OF FINANCIAL MARKETS IN THE

ECONOMY
We stated earlier that real assets determine the wealth of an economy, while financial assets
merely represent claims on real assets. Nevertheless, financial assets and the markets in which
they trade play several crucial roles in developed economies. Financial assets allow us to make
the most of the economy's real assets.

CAPITAL ALLOCATION
In a capitalist system, financial markets play a central role in the allocation of capital resources.
Investors in the stock market ultimately decide which companies will live and which will die.
If a corporation seems to have good prospects for future profitability, investors will bid up its
stock price. The company's management will find it easy to issue new shares or borrow funds to
finance research and development, build new production facilities and expand its operations.
If, on the other hand, a company's prospects seem poor, investors will bid down its stock price.
The company will have to downsize and may eventually disappear.
The process by which capital is allocated through the stock market sometimes seems
wasteful. Some companies can be 'hot' for a short period of time, attract a large flow of investor
capital and then fail after only a few years. But that is an unavoidable aspect of economic
uncertainty. It is impossible to predict with absolute precision which ventures will succeed and
which will fail. The stock market encourages allocation of capital to those firms that appear
at the time to have the best prospects. Many smart, well-trained and well-paid professionals
analyse the prospects of firms whose shares trade on the stock market. Share prices reflect their
collective judgement.

CONSUMPTION TIMING
In high-earnings periods you can invest your savings in financial assets such as shares and
bonds. In low-earnings periods you can sell these assets to provide funds for your consumption
needs. By so doing you can 'shift' your consumption over the course of your lifetime, thereby
allocating your consumption to periods that provide the greatest satisfaction. Thus, financial
markets allow individuals to separate decisions concerning current consumption from
constraints that otherwise would be imposed by current earnings.

ALLOCATION OF RISK
Virtually all real assets involve some risk. For example, when Toyota builds its auto plants it
cannot be certain what cash flows those plants will generate. Financial markets and the diverse
financial instruments traded in those markets allow investors with the greatest taste for risk
18 Principles of Investments

8 I PART l I Elements of investments

to bear that risk, while other less risk-tolerant individuals can, to a greater extent, stay on the
sidelines. If Toyota raises the funds to build its auto plant by selling both shares and bonds to
the public, the more optimistic or risk-tolerant investors can buy shares of stock in Toyota,
while the more conservative ones can buy Toyota bonds. Because the bonds promise to provide
a fixed payment the shareholders bear most of the business risk but reap potentially higher
rewards. Thus, capital markets allow the risk that is inherent to all investments to be borne by
the investors most willing to bear that risk.
This allocation of risk also benefits the firms that need to raise capital to finance their
investments. When investors are able to select security types with the risk-return characteristics
that best suit their preferences, each security can be sold for the best possible price. This
facilitates the process of building the economy's stock of real assets.

SEPARATION OF OWNERSHIP AND MANAGEMENT

AGENCY PROBLEMS
conflicts of interest
between managers and
shareholders
Many businesses are owned and managed by the same individual. This simple organisation is
well suited to small businesses. Today, however, with global markets and large-scale production,
the size and capital requirements of firms have skyrocketed. For example, in 2011 Telstra listed
$21.79 billion of property, plant and equipment and total assets of $37.91 billion on its balance
sheet. Corporations of such size simply cannot exist as owner-operated firms. At that time,
Telstra had 12.44 billion issued shares held by 1.3 million shareholders, of which 1.19 million
shares are held by small shareholders holding a parcel of less than 5000 shares.
Such a large group of individuals obviously cannot actively participate in the day-to-day
management of the firm. Instead, they elect a board of directors that in turn hires and supervises
the management of the firm. This structure means that the owners and managers of the firm are
different parties. This gives the firm a stability that the owner-managed firm cannot achieve.
For example, if some shareholders decide they no longer wish to hold shares in the firm, they
can sell their shares to other investors, with no impact on the management of the firm. Thus,
financial assets and the ability to buy and sell those assets in the financial markets allow for easy
separation of ownership and control.
How can all the disparate owners of a firm, ranging from large pension funds holding
hundreds of thousands of shares to small investors who may hold only a single share, agree on
the objectives of the firm? Again, the financial markets provide some guidance. All may agree
that the firm's management should pursue strategies that enhance the value of their shares.
Such policies will make all shareholders wealthier and allow them all to better pursue their
personal goals, whatever those goals might be.
Do managers really attempt to maximise firm value? It is easy to see how they might be
tempted to engage in activities not in the best interest of shareholders. For example, they might
engage in empire building or avoid risky projects to protect their own jobs or may overconsume
luxuries such as corporate jets, reasoning that the cost of such perquisites is largely borne by the
shareholders. These potential conflicts of interest are called agency problems because managers,
who are hired as agents of the shareholders, may pursue their own interests instead.
Several mechanisms have evolved to mitigate potential agency problems. First, compensation
plans tie the income of managers to the success of the firm. A major part of the total
compensation of top executives is typically in the form of stock options, which means that the
managers will not do well unless the share price increases, benefiting shareholders. (Options
can create an incentive for managers to manipulate information to prop up a share price
temporarily, giving them a chance to cash out before the price returns to a level reflective of the
firm's true prospects.) Second, while boards of directors are sometimes portrayed as defenders
of top management they can, and in recent years increasingly do, force out management teams
 Principles of Investments, First Australian Edition 19

CHAPTER 1 I Investments: background and issues I 9

that are underperforming. Third, outsiders such as security analysts and large institutional
investors can publicly criticise poor performers, creating bad publicity for the managers and
making their lives uncomfortable. Finally, poor performers are subject to the threat of takeover.
If the board of directors is lax in monitoring management, unhappy shareholders in principle
can elect a different board. They can do this by launching a proxy contest in which they seek to
obtain enough proxies (i.e. rights to vote the shares of other shareholders) to take control of
the firm and vote in another board. However, this threat is usually minimal. Shareholders who
attempt such a fight have to use their own funds, while management can defend itself using
corporate coffers. Most proxy fights fail. The real takeover threat is from other firms. If one firm
observes another underperforming, it can acquire the underperforming business and replace
management with its own team. The share price should rise to reflect the prospects of improved
performance, which provides incentive for firms to engage in such takeover activity.

XSTRATA'S BID FOR POOR PERFORMING MIM HOLDINGS EXAMPLE 1.1

In 2002, the Australian miner MIM was seen by many as a potential t akeover target.
Despite the potential value in the company's coal reserves, the share price had been
languishing due to weak management and underperforming operation s. Recognising
this, Xstrata, a global mining company, launched a bid for MIM in November 2002 at
$ 1.25 per share. To gain control of the company Xstrata needed the bid to be approved
by half the MIM shareholders.
The CEO of MIM, Vince Gauci, resisted the offer. A large shareholder, Platinum
Asset Management, also resisted, maintaining the bid undervalued the company. Gauci
commissioned an independent valuation of the company to help defend against the Xstrata
bid. The valuation subsequently confirmed that the $1.25 bid undervalued the company
and a proxy war ensued.
To entice shareholders, Xstrata lifted the initial bid to $1.72. Despite the continued
resistance from Platinum and Gauci, the increased offer persuaded shareholders to accept
the bid and the takeover was approved.

1.4 THE INVESTMENT PROCESS

An investor's portfolio is simply his or her collection of investment assets. Once the portfolio is
established, it is updated or 'rebalanced' by selling existing securities and using the proceeds to
buy new securities, by investing additional funds to increase the overall size of the portfolio, or
by selling securities to decrease the size of the portfolio.
Investment assets can be categorised into broad asset classes, such as shares, bonds, real
estate, commodities and so on. Investors make two types of decisions in constructing their
portfolios. The asset allocation decision is the choice among these broad asset classes, while ASSET ALLOCATION
the security selection decision is the choice of which particular securities to hold within each allocation of an investment
asset class. portfolio across broad
'Top-down' portfolio construction starts with asset allocation. For example, an individual asset classes
who currently holds all of his/her money in a bank account would first decide what proportion SECURITY SELECTION
of the overall portfolio ought to be moved into shares, bonds and so on. In this way, the broad choice of specific
features of the portfolio are established. While the average annual return on the ordinary shares securities within each
of large Australian firms since the 1950s has been about 14o/o per annum, the average return on asset class
Australian Treasury notes has been around 6.5%. On the other hand, shares are far riskier, with
20 Principles of Investments

10 I PART l I Elements of investments

SECURITY ANALYSIS
analysis of the value of
securities
annual returns over the same period ranging as low as -40o/o and as high as 67%. In contrast,
Treasury note returns are effectively risk-free: you know what interest rate you will earn when
you buy the note. Therefore, the decision to allocate investments to the stock market or to the
money market, where Treasury notes are traded, will have great ramifications for both the risk
and the return of the portfolio. A top-down investor first makes this and other crucial asset
allocation decisions before turning to the decision of the particular securities to be held in each
asset class.
Security analysis involves the valuation of particular securities that might be included in the
portfolio. For example, an investor might ask whether BHP Billiton, Rio Tinto, Woolworths
or Wesfarmers are more attractively priced. Both bonds and shares must be evaluated for
investment attractiveness, but valuation is far more difficult for shares because a share's
performance is usually far more sensitive to the condition of the issuing firm.
In contrast to top-down portfolio management is the 'bottom-up' strategy. In this process,
the portfolio is constructed from the securities that seem attractively priced without as much
concern for the resultant asset allocation. Such a technique can result in unintended bets on
one or another sector of the economy. For example, it might tum out that the portfolio ends up
with a very heavy representation of firms in one industry, from one part of the country, or with
exposure to one source of uncertainty. However, a bottom-up strategy does focus the portfolio
on the assets that seem to offer the most attractive investment opportunities.

Concept check 1.2
You are creating an investment portfolio and making a choice between different investments. Which
of the following are asset allocation decisions and which are security selection decisions?
a. Bonds or equities
b. Real estate or commodities
c. BHP Billiton or Rio Tinto shares

1.5 THE MAIN PARTICIPANTS

From a bird's-eye view, there would appear to be three major players in the financial markets:

1. Firms are net borrowers. They raise capital now to pay for investments in plant and
equipment. The income generated by those real assets provides the returns to investors
who purchase the securities issued by the firm.
2. Households are net savers. They purchase the securities issued by firms that need to raise
funds.
3. Governments can be borrowers or lenders, depending on the relationship between tax
revenue and government expenditure. For a long time the Commonwealth Government
of Australia's fiscal expenditure exceeded tax revenue and it had to rely on borrowings to
finance the deficits. This meant the government had to issue securities (Treasury bonds) to
fund the deficit. Historically, the first Australian public bonds were issued in 1915 to fund
the World War I effort in the form of War Savings Certificates. These were issued during
both world wars and were purchased mainly by the public and retail investors. 1 Issues of
Treasury bonds continued to fund budget deficits following the global recession of the
early 1990s. By 2006, government debt was reduced to zero following years of economic
growth and budget surpluses. However, by 2008-09 the Commonwealth had to resort
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at the end of 1902, was the death of the Hadda Mullah on December
23, when the Afghan Government devoted a sum of 30,000 rupees
towards the funeral obsequies of their sainted protégé.
The removal of the obstacles in the way of any cordial
understanding between Russia and Great Britain in respect of
Afghanistan was not assisted when, on January 14, 1903, the
Foreign Office in St. Petersburg issued, in reference to the
declaration made by Lord George Hamilton, the following
communique:
As regards Russia’s relations with Afghanistan, it is
necessary to declare that Russia addressed no request of any
sort to the British Cabinet, but simply notified it of her desire
and purpose to enter into direct relations with Afghanistan in
the future.
No further declarations were made on this subject.
If language is to have any meaning at all in diplomacy, as in
ordinary life, this utterance can only be characterised as one of the
most flagrant perversions of truth that have ever disgraced the
history of even Russian politics. Quite rightly the request of February
6, 1900, had been interpreted as a veiled demand for the right to
establish a Russian representative at Kabul. The proposal admits of
being supported by the plausible contention that such an agency
would be a convenient means of settling disputes and avoiding
collisions on the Russo-Afghan border. It must not be forgotten that it
was over almost an identical question—the reception of the Stolietoff
Mission by Shir Ali—that Great Britain fought the Second Afghan
War; and it can hardly be denied that, if the concession demanded
by the Note of 1900 were granted, the result would be to set up an
influence in Kabul hostile in spirit to our own and from the first day of
its existence there devoted to the sapping of our position.
Great inconvenience of course attaches to a system by which the
smallest detail in the adjustment of any difficulty along the Russo-
Afghan frontier must be referred for settlement from the Oxus to
Tashkent, from Tashkent to St. Petersburg, from St. Petersburg to
London, from London to the Government of India, and from the
Viceroy’s Council to Kabul where, after much delay, the same
process is repeated over the return journey. Unfortunately, the
maintenance of such a cumbersome procedure is essential to the
harmony of Anglo-Afghan relations since, although Russia professes
to require facilities for frontier intercourse in commercial matters
alone, similar protestations reduced Manchuria to the level of a
Russian protected State until Japan intervened. Great Britain does
not wish to embark upon a campaign in Central Asia and there need
be no war so long as Russia, observing the pledges which she has
given, tempers her desires with discretion. But continuation of the
mischievous interference in Persia and Afghanistan, which has
distinguished her actions hitherto, is a menace to the world’s peace,
as the indulgent nature of the British Government has now been
pushed to the limit of its endurance.
So far as Anglo-Afghan relations were concerned the New Year of
1903 held out little prospect of improvement. Possibly the mass of
business, associated with Habib Ullah’s installation as Siraj-ul-Millat
wa ud-Din, early in April, did prevent the Amir of Afghanistan from
visiting India in the spring of this year. But, aside from the irregularity
of the Amir’s behaviour, the incident of April 6, when Lieutenant-
Colonel A. C. Yate, commanding the 24th Baluchistan Infantry
Regiment and stationed at Chaman, was arrested by Afghan officials
for an innocent trespass beyond the Indo-Afghan border and
removed to the fort at Baldak Spin, may be regarded as throwing
light upon the precise quality of the bonds of amity which were
uniting the two countries. Again, serious exception could be taken at
the manner in which the Amirs of Afghanistan were employing the
permission to import munitions of war which had been granted by the
Government of India. The arrival of the thirty Krupp guns, acquired
by Abdur Rahman on the eve of his death, had revealed the
presence of a large number of castings for heavy ordnance which
had been secretly obtained from Essen by the late Amir. A small
army of carts and camels, lent by the Government of India, carried
the thirty guns from Peshawar to Jelalabad, whence forty elephants,
sent by Habib Ullah for the purpose, bore them to Kabul. Very
properly transport was denied to that part of the purchase which
disclosed Abdur Rahman’s strange dereliction of his treaty rights.
Moreover, it was not difficult for Habib Ullah to recognise the
irregularity of his father’s procedure, the immediate consequence of
which was the repudiation of the order by the son. Unhappily, before
this particular incident could be considered to have closed an
immense consignment of rifle cartridges, numbering several millions
of rounds, many of which were found to be of the explosive character
condemned by the Hague Conference, arrived from the Amir’s
agents in England. Since it never had been intended that the right to
import munitions of war accorded to the late Amir of Afghanistan
implied the power to amass an unlimited amount of war matériel in
Kabul, no other course was open to the Viceroy of India than to see
that these other stores were likewise detained by the frontier
authorities.
Something more important than considerations of prestige,
therefore, was embroiled in the indifference which the Amir of
Afghanistan displayed towards India as the paramount state, making
it incumbent upon the Government to repeat their earlier
representations. There was no need, indeed the occasion had hardly
arisen, for any violent coercion. The situation required merely such
tightening of the reins as would bring to the ruler of Kabul a proper
comprehension of the actual ties between his country and India. In
the correspondence which ensued, the Amir claimed the right to
import munitions of war under the treaty which had given similar
powers to Abdur Rahman. Unfortunately Habib Ullah had no such
right; nor was any moral obligation to honour the debit notes which
Habib Ullah had drawn every month against the Indian Treasury
attaching to the Government of India. These points were made clear
to the Amir who had neither the funds to pay for nor the authority to
order the armaments which were then waiting at the frontier. The
lesson had been driven home, and the loftiness of tone, which the
Amir of Afghanistan had adopted in the initiatory letter, was hardly
discernible in his concluding statement. Since there was no malice in
the attitude of the Government of India, the Amir of Afghanistan was
again invited to visit India for purposes of a conference with the
Viceroy. A visitation of cholera, which swept through Kabul and
North-eastern Afghanistan in 1903, the worst since the epidemic of
1879, permitted an excuse to be offered at which no exception could
be taken. Before the scourge had subsided Russia had repeated her
designs against Afghanistan. This, in view of the explicit
denouncement of her treaty requirements, implied by the
communique of January 1903, was not perhaps surprising. Their
renewal was denied by Lord Cranbourne in the House of Commons
both in the spring and autumn sessions of 1903. Nevertheless, in the
middle of February, Sirdar Ali Khan, the governor of Afghan
Turkestan, had sent to Kabul four Russian spies whom he had
arrested near Mazar-i-Sharif; but the most flagrant of these insidious
encroachments upon a British preserve occurred in the following
August, when the governor of Russian Turkestan sent back some
deserters from the Afghan army who had escaped into Russian
territory. Obviously the note of defiance in the message which
accompanied them was addressed to the suzerain power.
 It ran:
As the Tsar and the Amir are amicably disposed the one to
the other, His Imperial Majesty has given orders that every
effort shall be made to continue the friendly relations existing
between Russia and Afghanistan.
As representative of the Tsar I am directed to send back all
refugees and evil-doers who come to my territory from
Afghanistan. This is the reason why I send back to you these
eleven soldiers with their arms.
Please be kind enough to communicate this to the Amir.
In spite of these persistent endeavours to establish friendly
relations with Kabul there is little reason to believe that Habib Ullah
offered any encouragement to the Russian frontier officers.
Inveterate suspicion of foreign influence characterises every aspect
of his external policy and Russia and Great Britain are made to feel
impartially the effect of this attitude. Abdur Rahman accepted the
good faith of the Indian Government unquestioningly and understood
his northern neighbour sufficiently to realise that it was less a wish
for the friendship of Afghanistan than a desire to pin-prick India
which prompted her overtures. Habib Ullah has yet to learn how to
stand where his father strode with perfect confidence, a foolish
mistrust sapping the strength of the son. Under a less skilful
statesman than Lord Curzon it is conceivable that the patience of the
Government of India would long since have been exhausted. That
exceptional familiarity with the affairs of Asia, which preeminently
distinguishes the late Viceroy, enabling him to tread Oriental
labyrinths with wise discrimination, permitted him upon this occasion
to bridge once more a crisis between Afghanistan and India. Almost
in defiance of Kabul obstruction, he proceeded to the solution of
difficulties which did not require any personal discussion with a
refractory potentate. Early in the winter of 1903-04, the Government
of India took up for consideration those sections of the Afghan
boundary which, ever since the withdrawal of the Udny Mission eight
years previously, had required demarcation. Surprised into ruffled
acquiescence, the Amir in January 1904 began to make extensive
preparations for a meeting between Major Roos-Keppel, the chief of
the British Commission, and his own representative. Through the
brief absence of Lord Curzon from the helm of state, the vacillation
of the Amir precipitated a collapse of these plans at the last moment.
Wilfully stupid, too, only a little later—in July 1904—was Habib
Ullah’s order to Nasr Ullah Khan to select twenty-four officers who
were to be detailed as envoys to England, France, Germany, Russia,
Persia, China, Japan, Turkey and Egypt in the Old World, and
America in the New World.
If the break-down in the negotiations anent the Mohmand
boundary had increased the tension between Kabul and Calcutta, it
was certainly impossible to tolerate this more direct perversion of the
principles out of which the fabric of our relations with Afghanistan
had been woven. Concerned at the rupture which was threatening
between India and Afghanistan at a moment when Lord Curzon was
absent from India and too timid to insist upon the Amir’s acceptance
of the Viceroy’s invitation to a conference, the Imperial Government,
as the only means of renewing the Agreements upon which they
were set which remained to them, decided to despatch a Mission to
Kabul. At the instance of the Secretary of State for India, Mr. St.
John Brodrick, the acting Viceroy of India, Lord Ampthill, acquainted
Habib Ullah with the wishes of His Majesty’s Government. In reply
His Highness, with the hope of improving his position when the time
came for diplomatic discussion and as an act of conciliation towards
the Viceroy, intimated his willingness to send his son Inayat Ullah
Khan—a charming, intelligent boy of sixteen and a remarkable
instance of that youthful precocity which attains so abnormal a
development in the Oriental—to meet Lord Curzon upon his return to
India. However pressing may have been the questions outstanding
between the Government of India and the Amir of Afghanistan, the
visit of a British Mission to Kabul—no doubt desirable and in that
sense opportune—was derogatory in a Government whose
invitations to the head of the country, which it was proposed to
honour in such an emphatic fashion, had been treated with
contumacy. Lord Curzon’s opposition to the project is well-known;
but with the exception of this distinguished statesman few were
prepared for the unfortunate set back which the mission received. A
grievous miscalculation undoubtedly was made. But the blunder,
which determined its existence and brought about a complete
miscarriage of Anglo-Indian policy, lay not so much in sending the
mission as in His Majesty’s Government not having decided, if the
Amir proved recalcitrant, how far and upon what ground the Cabinet
should stand firm.

festival in honour of the dane mission

As constituted, the Mission comprised Mr., now Sir, Louis Dane,

Foreign Secretary at Simla, Mr. H. R. Dobbs—who, together with
Major Wanliss, had recently returned from replacing the boundary
pillars on the Perso-Afghan border—Major W. Malleson, R.A.,
Captain Victor Brooke, 9th Lancers, and a British doctor. Leaving
Peshawar on November 27, the mission reached Dakka on
November 29, and was met at Lundi Khana by 200 Afghan cavalry
under the Sipah Salar Ghulam Hussein, the Sarhang of Dakka, and
Mahommed Hasan Khan. Major Roos-Keppel, political agent for the
Khyber, accompanied the party for a few miles beyond Lundi Khana
to Torkhana, where a guard of honour of the Khyber Rifles was
drawn up, the mission ultimately arriving at Kabul on December 10.
Elaborate gifts were conveyed by Mr. Dane for presentation to the
Amir, among many others a £700 motor-car and several cases of
sporting equipment. As a compliment to the ladies of the harem the
Government of India thoughtfully included a cinematograph,
providing at the same time the necessary operator. Among the
presents to the Mission from his Highness were a gold watch and a
set of gold cuff links which Habib Ullah had offered to Mr. Dane. The
note struck by the negotiations was scarcely in the same pitch as the
festivities by which the withdrawal of the Mission was celebrated,
when seven gramophones simultaneously discharged bursts of
discordant revelry. Nevertheless, the din of these instruments fell on
the ears of those who had every cause to be relieved at the peaceful
termination of their labours, since the clouds had hung low over
Kabul throughout the Anglo-Afghan conferences of 1904-05.
Many things in our buffer state of course required to be improved
as much for the enhancement of its own interests as for the
advantage of India. There was the Amir’s perpetuation of Abdur
Rahman’s objection to Afghan subjects using the northern extremity
of the Quetta-Chaman railway to be discussed, as well as the
projection of railways from Chaman to Kandahar and from Peshawar
to Kabul. Besides these important subjects there were the
prolongation of the Indian system of telegraphs to Kabul and
Kandahar; the provision of telegraphic communication between
Kabul, Mazar-i-Sharif and Herat; Kabul and Kandahar; Kandahar
and Herat. The re-organisation of the Afghan army had also to be
considered, while the demarcation of the Mohmand boundary and
the Seistan border, the definition of the Amir’s control over border
tribes, the question of the subsidy and Habib Ullah’s powers in
respect of the importation of munitions of war were topics, the
examination of which would be, it was expected, to the mutual
benefit of the contracting parties in an Anglo-Afghan alliance. In India
it was understood that there might be a difficulty in the arrangement
of the terms which were to be secured from the Amir; but that
ultimately, and after protracted negotiations, our demands would be
conceded. To this end the chief of the Mission was provided with a
treaty, drawn up under the personal supervision of Lord Curzon
during his brief residence in London in 1904, which was designed to
bring about a discussion of every aspect of the old agreements with
a view to removing previous difficulties and arriving at a clear
understanding for the future.

scene of the audiences between habib ullah and sir louis dane

This treaty comprised three clauses, but Habib Ullah, simulating

annoyance at the terms of the clause which attempted to restrict the
importation of arms, would not enter into any discussion over it. After
the Mission had passed four months in the Afghan capital, the limit,
to which the Amir of Afghanistan would permit himself to go,
reproduced simply the formal renewal on both sides of the
engagements entered into between Abdur Rahman, the late Amir of
Afghanistan, and the Government of India.
The Dane Treaty therefore was as follows:
He is God, Extolled be His perfection,
His Majesty Siraj-ul-millat-wa-ud-din, Amir Habib Ullah
Khan, Independent King of the State of Afghanistan and its
Dependencies, on the one part, and the Honourable Mr. Louis
William Dane, C.S.I., Foreign Secretary of the Mighty
Government of India and the Representative of the Exalted
British Government on the other part.
 His said Majesty doth hereby agree to this, that in the
principles and in the matters of subsidiary importance of the
Treaty regarding internal and external affairs, and of the
engagements which his Highness my late father, that is, Zia-
ul-millatwaud-Din, who has found mercy, may God enlighten
his tomb! Concluded and acted upon with the Exalted British
Government, I also have acted, am acting, and will act upon
the same agreement and compact, and I will not contravene
them in any dealings or in any promise.
The said Honourable Mr. Louis William Dane does hereby
agree to this, that as to the very agreement and engagement
which the Exalted British Government concluded and acted
upon with the noble father of his Majesty Siraj-ul-millatwaud-
Din, that is, his Highness Zia-ul-millatwaud-Din, who has
found mercy, regarding internal and external affairs of
principle or subsidiary importance, I confirm them and write
that they (the British Government) will not act contrary to
those agreements and engagements in any way or at any
time.
Made on Tuesday, the 14th day of Muharram-ul-haram of
the year 1323 Hijri, corresponding to the 21st day of March of
the year 1905 a.d. (Persian Seal of Amir Habib Ullah Khan.)
This is correct. I have sealed and signed.
Amir Habib Ullah,
Louis W. Dane, Foreign Secretary,
Representing the Government of India.
Thus the situation upon the arrival of Mr. Dane from Kabul differed
in no way from that which had preceded his departure for the Afghan
capital, save that substantial concessions had been awarded to the
Amir of Afghanistan who, in return, had conceded nothing. In
addition to an astonishing and entirely unnecessary elevation in the
style and title of the ruler of Afghanistan—conveyed in the charge
“Independent King of the State of Afghanistan and its
Dependencies,” and the reference to “His Majesty,” which the
precious instrument reveals—inevitable corollaries of the transaction
were the continuation of the annual subsidy of eighteen lakhs to
Abdur Rahman’s successor, the release of the arrears—
approximately amounting to £400,000—which had been
accumulating since a little previous to the demise of the late Amir,
and the right to an unrestricted importation of arms.

escort outside the gate of the quarters occupied by the dane mission

It must not be supposed that the mere ratification of the

engagements was sufficient for the purposes of British policy in
Central Asia. Much more was needed; and, since facilities were
deliberately withheld and the Amir rejected consideration of our
pledged responsibility, it is evident that the subjugation of
Afghanistan to the interests of India is incomplete. It is of value
perhaps to have ascertained that the Amir is disaffected and
untrustworthy. There was always a doubt but it was hoped that the
affront, which he offered so sedulously to the British Government,
was due to his own conspicuous vanity rather than the manifestation
of actual ill-will. The Kabul conference made that point clear; but, as
the Imperial Government have elected to observe an impressive
reticence upon the circumstances of this unfortunate episode, it is no
less incumbent upon others to do likewise. Nothing can be gained by
revealing to the world the details of a rebuff without parallel in the
history of Indian politics, unless such acknowledgment were made to
assist public opinion in appreciating the issues involved in the
absence of any satisfactory understanding between Kabul and
Calcutta. That this course formed no part of the late Government’s
policy was disclosed on June 21, 1905, by the debate in Parliament
upon the Indian budget and, at a later date, upon Mr. Balfour’s
speech on Imperial Defence. The Ministers, who spoke on these
occasions, concealed the truth rather than stated it, and their
utterances cannot be accepted as either correct or adequate. Mr.
Balfour’s statement that the construction “of strategic railways by
Russia in Afghanistan” would provoke Great Britain to war does not
render the character of Anglo-Afghan policy more intelligible, nor
remove the disadvantages from our position. On the contrary, the
utterance was most misleading since no such contingency, as the
construction of Russian railways in Afghanistan itself, is likely to
occur until Russia is prepared to strike with all her strength in Persia
and Afghanistan. The question of Anglo-Afghan relations, therefore,
remains for solution, having given rise to a situation which was
regarded by the late Viceroy and every member of his Council with
the gravest apprehension.
 the walls of bokhara

[44] Funeral service.

APPENDICES
 APPENDIX I
names of stations on the orenburg-tashkent
railway
Name of Station and distance from Orenburg.

(1) Orenburg
(2) Myenovoi dvor
(3) Donguzskaya
(4) Mayatchnaya
(5) Iletsk (72 versts)
(6) Grigoryevskaya
(7) Ak Bulak
(8) Yaksha
(9) Yaisau
(10) Aksu
(11) Kara Tugai
(12) Kuraili
(13) Aktiubinsk (255 versts)
(14) Bish Mamak
(15) Tamdi
(16) Akkemir
(17) Kandagatch
(18) Temirskaya
(19) Ker
(20) Kuduk
(21) Emba
(22) Kirghizskaya
(23) Mugodjarskaya (400 versts)
(24) Rodniki
(25) Karaganda
(26) Kauldjir
(27) Solenaya
(28) Ulpan
(29) Tchelkar
(30) Biriuk
(31) Djilan
(32) Tuguz
(33) Kara-Tchokat
(34) Altin
(35) Saksaoulskaya
(36) Kontu
(37) Arabskoye Morye (790 v’sts)
(38) Sappak
(39) Andreevskaya
(40) Kamyshli Bash
(41) Bik Bauli
(42) Kazalinsk (942 versts)
(43) Bashkara
(44) Mai Libash (978 versts)
(45) Ak Suat
(46) Turatan
(47) Durmen Tubeh
(48) Khor Khut
(49) Karmakchi (1108 versts)
(50) Kizyl Tam
(51) Kara Ketkeu
(52) Ak-Su
(53) Teren Uzyak
(54) Kara Uzyak
(55) Perovski (1246 versts)
(56) Ber Kazau
(57) Solo Tubeh
(58) Tar Tugai
(59) Djulek (1343 versts)
(60) Skobelevo (1367 versts)
(61) Tumen Arik (1394 versts)
(62) Yani Kurgau
(63) Ak Kum
(64) Sauran
(65) Tchornak
(66) Turkestan (1514 versts)
(67) Ikan (1543 versts)
(68) Otrar (1558 versts)
(69) Kara Kungur
(70) Aris (1570 versts)
(71) Kabul Sai
(72) Uzun Sai
(73) Tchanak
(74) Sari Agatch
(75) Djilga
(76) Darbaza
(77) Keless (1740 versts)
(78) Tashkent (1762 versts)
 APPENDIX II—(A)
list of stations from tashkent to merv, with
distances from krasnovodsk and tashkent
Distance from Distance from
Name of Station.
Krasnovodsk. Tashkent.
Versts. Versts.
(1) Tashkent 1747
(2) Kauffmanskaya 1721 26
(3) Vrevskaya 1698 51
(4) Syr-Darinskaya 1672 75
(5) Golodnaya Steppe 1637 110
(6) Chernaievo 1605 142
(7) Obrutchevo 1557 190
(8) Lomakino 1548 199
(9) Jizak 1522 225
(10) Milyutinskaya 1498 249
(11) Kuropatkino 1473 274
(12) Rostovtsevo 1445 302
(13) Samarkand 1415 332
(14) Djuma 1394 353
(15) Nagornaya 1365 382
(16) Katta-Kurgan 1343 404
(17) Zirabulak 1316 431
(18) Ziadin 1291 446
(19) Kermine 1269 478
(20) Malik 1243 504
(21) Kizil-Teppe 1223 524
(22) Kuyu-Mazar 1206 541
(23) Kagan 1182 565
(24) Murgak 1160 587
(25) Yakatut 1142 605
(26) Kara-Kul 1117 630
(27) Khodja-Davlet 1098 649
(28) Farab 1078 669
(29) Charjui 1070 677
(30) Barkhani 1038 709
(31) Karaul-Kuyu 1020 727
(32) Repetek 1003 744
(33) Pesski 970 777
(34) Utch-Adja 954 793
(35) Ravnina 924 823
(36) Annenkovo 904 843
(37) Kurban-Kala 885 862
(38) Bairam-Ali 869 878
(39) Merv 842 905
 APPENDIX II—(B)
murghab valley railway

list of stations from merv to kushkinski post

with distances from krasnovodsk and merv
Height above Distance from Distance from
Station.
Caspian Sea. Merv. Krasnovodsk.
Sagenes. Versts. Versts.
Merv 118.01 — 842
Talkhatan Baba 127.06 37 879
Yulatan 134.16 56 898
Sultan-i-Band 139.55 76 918
Imam Baba 148.60 120 962
Sari Yazi 155.57 157 999
Tash Kepri 164.00 197 1039
Kala-i-Mor 202.07 244 1086
Kushkinski Post 303.04 293 1135