ECO421 Asset Pricing

• Topics

  The course focuses on the economic principles behind rational valuation and investment choice. This allows the student to better understand the strengths and weaknesses of important finance models. The overall aim is to increase the student's sophistication and help the student avoid naive/misleading model applications. The course sets out by clarifying the foundation of financial economics; the relationship between equilibrium or the absence of arbitrage opportunities and the existence of a system of state prices. All asset prices are then shown to be bundles/portfolios of state prices; stocks, bonds, derivatives etc. The course also demonstrates that classic models like the Capital Asset Pricing Model (CAPM) and the Black-Scholes-Merton option pricing formula are special instances of the same basic economic framework. To keep the mathematics at a minimal level, results are generally formulated in a discrete-time setting, with an emphasis on one-period models. Topics include, but are not limited to

  1. Introduction             [Readings: CWS 3]

  • Equilibrium vs arbitrage asset pricing
  • Investor preferences
  • Measuring risk aversion: absolute and relative risk aversion
  • Basic results of optimal capital allocation

  2. Investment Decisions in a State Contingent Claim Framework       [Readings: CWS 4]

  • The Framework
  • Optimal investment decisions
  • Elementary linear algebra
  • Spanning: Complete versus incomplete markets
  • No-arbitrage conditions and pricing of securities

  3. Investment Decisions Based on Arbitrage/Replication Arguments      [Readings: CWS 7]

  • The relationship between state prices and risk-adjusted probabilities/option pricing theory
  • The binomial option pricing model

  4. The Term Structure of Interest Rates            [Readings: CWS 8]

  • Discount factors, spot rates, and forward rates
  • Spanning & pricing using treasuries
  • Term structure theories

  5. Portfolio choice, the CAPM, and APT

  • Mean-variance portfolio choice: the Markowitz model
  • The CAPM with homogeneous beliefs
  • Mean-variance portfolio choice with market deviating beliefs: the Black-Litterman model
  • Ross' multi-factor asset pricing model (the APT)
  • Understanding linear multi-factor models, like the Fama-French 3-factor model

  6. Additional topics

  • Stochastic discount factors
  • Multi-period consumption-based asset pricing models
    • The equity premium puzzle
  • Current topics in the academic asset pricing literature, e.g. recent empirical findings

  This syllabus is tentative. Changes to topics and plans for this course are likely, for instance to accommodate student interests, new developments, or current events.

• Learning outcome

  After completing the course, the students will:

  Knowledge

  • know the fundamental theory of financial economics
  • understand the economic reasoning underlying financial economics
  • know the origin of finance models and understand the relationship between these models
  • understand the distinction between equilibrium and arbitrage asset pricing, the key elements of each approach, and their relative strengths and weaknesses
  • understand the relationship between spanning and pricing in arbitrage models
  • understand the relationship between portfolio choice, partial/general equilibrium, and asset prices in equilibrium models

  Skills

  • be able to discern the important assumptions, features and empirical predictions of theoretical models in financial economics
  • be able to formulate and conduct quantitative analyses

  General competences:

  • be able to use the tools from asset pricing to related tasks such as hedging, return & risk modeling
  • be able to discuss recent empirical research and current events in financial markets from an asset pricing standpoint.
  • be able to extract key insights from asset pricing research
  • be able to communicate key insights from asset pricing

• Teaching

  Regular lectures, problem solving exercises, student presentations. All activities will be fully accessible to students, regardless of their ability to attend physical lectures.

• Required prerequisites

  To take this course you should already have basic insights corresponding to

  • decisions under uncertainty, similar to those obtained in ECO400,
  • optimization, similar to those obtained in ECO401,
  • skills in basic asset pricing, similar to those obtained in FIE400.

• Requirements for course approval

  Course approval is based on homework and other assigned course activities (for instance student presentations).

• Assessment

  Individual four hour home exam.

• Grading Scale

  A-F

• Computer tools

  The lectures will use R to illustrate some aspects of the course topics. Some of the assignments must be solved using R. Students do not need to know R before attending the course. Assignments that require the use of R will be offered in two versions: one for those who do not already know R, and one for those who are already proficient in R.

• Literature

  Lecture notes.

  Textbook: Copeland, T. S., Weston, F., & Shastri, K. (2005) (CWS), "Financial Theory and Corporate Policy," Fourth Edition, Addison Wesley, ISBN 0-321-22353-5.

  Additional Readings may be assigned.