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
- 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
- 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
- The relationship between state prices and risk-adjusted probabilities/option pricing theory
- The binomial option pricing model
4. The Term Structure of Interest Rates
- 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.