ECO421 Asset Pricing
Autumn 2019Spring 2020
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 (HL 1, 2)]
- Asset Pricing: Equilibrium vs Arbitrage
- Risk Aversion, Fair Gambles
- Investor Preferences and Risky Investments
- Absolute and Relative Risk Aversion
2. Investment Decisions in a State Contingent Claim Framework [Readings: CWS 4 (HL 5)]
- The Framework
- Optimal Investment Decisions
- Elementary Linear Algebra
- Spanning: Complete versus Incomplete Markets
- Pricing of Securities and No-Arbitrage Conditions
3. Investment Decisions Based on Arbitrage/Replication Arguments [Readings: CWS 7 (HL 8)]
- The Binomial Option Pricing Framework
- American Options, Path Dependence, Exotic Options
4. The Term Structure of Interest Rates [Readings: CWS 8]
- Spanning & pricing using treasuries
- Discount factors, spot rates, and forward rates
- Term Structure Theories
5. Portfolio choice, the CAPM, and APT
- Markowitz' portfolio choice model
- The CAPM with homogeneous beliefs
- Markowitz with heterogeneous beliefs: the Black-Litterman model
- Ross' multi-factor asset pricing model (the APT)
6. Additional topics
- Stochastic Discount Factors & Asset Pricing
- The Equity Premium Puzzle; multi-period consumption-based asset pricing models
- 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.
After completing the course, the students will:
- 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
- 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
- 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
To take this course you should already have skills in
- decisions under uncertainty, similar to those obtained in ECO400,
- optimization, similar to those obtained in ECO401,
- and skills in basic asset pricing, similar to those obtained in FIE400.
Requirements for course approval
To complete this course, the student must obtain course approval (kursgodkjenning), based on homework and other assigned course activities (students who have not obtained course approval prior to the final exam will not be allowed to take the exam). To obtain course approval, the student must complete all course assignments, hand them in, and receive an average passing score. The average score to pass will vary as the assignments and their difficulty may vary from semester to semester. All coursework and assignments must be completed in English.
Four hour written school exam.
The exam will be given in English and has to be answered in English.
Grading scale A-F
Statistical software may be used (e.g. Matlab, Stata, R)
Primary Textbook: Copeland, T. S., Weston, F., & Shastri, K. (2005) (CWS), "Financial Theory and Corporate Policy," Fourth Edition, Addison Wesley, ISBN 0-321-22353-5.
Advanced texts (PhD level):
Huang, Chi-fu & Litzenberger, Robert H., (1988) (HL), "Foundations for Financial Economics", North-Holland.
Dothan, D. (1990), "Prices in Financial Markets" Cochrane, J. H. (2005), "Asset Pricing," Revised Edition
Additional Readings may be assigned.
- ECTS Credits
- Teaching language
- English: the final exam, any other examinations or presentations, all assignments, class participation, etc., must be completed in English.
Spring. Offered spring 2019.
Associate Professors Jørgen Haug and Tommy Stamland, Department of Finance, NHH.