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.