UNIVERSITY OF LETHBRIDGE FACULTY OF MANAGEMENT Finance Area Lethbridge, AB, T1K 3M4

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1 UNIVERSITY OF LETHBRIDGE FACULTY OF MANAGEMENT Finance Area Lethbridge, AB, T1K 3M4 (Final Update December 4, 2008) MGT 5200a: M.Sc. (Management) Seminar for Finance FALL 2008 Wednesdays, 9:00am 11:50am in E415 Prof. Cornelis A. Los, PhD Office hours: Wednesdays 3-5pm Office: University of Lethbridge, E441, 4401 University Drive, Lethbridge, AB, Canada T1K 3M4 Tel: (403) URL: Objective for Participating Students To propose (choose), research, write and defend a Master Thesis in Finance Academic tasks to be mastered Reviewing (reading, analyzing) and critiquing of academic Finance journal articles Producing a reasoned literature review in the student s area of Finance research Appreciation of range of research methods employed in that Finance area Appreciation of range of research issues in Finance area from multidisciplinary perspectives Appreciation of range of data resources in Finance area Understanding the quality range of journals in Finance area Researching and writing of a publishable working paper (max. 25 pages, incl. references) Presenting a working paper (in 20 minutes) with accompanying Power Point Presentation Seminar sessions Introduction by instructor or academic visitor Commentary by other faculty, when present Commentary by students based on prepared 2-page synopses Follow-up from preceding week s topic (new articles, data, programs found by students or faculty) Course description This seminar-style course is designed as a series of concentrated modules that address specific topic areas in the various fields of Finance, with particular attention to the persistence of financial markets, credit and energy derivatives, financial engineering, and global fund management. In each topic module, students are expected to be prepared to discuss the collected and assigned readings in a one-to-one or seminar session with the assigned professor.

2 Finance Topic Areas (2 weeks for each topic module. Readings and Lecturettes are required, References are not) 1. Financial Literature and Research (Sept 3) a. Working papers and blind-peer-reviewed academic journals ii. Reading: Cooley, Philip, L. and Jean L. Heck, Prolific Authors in the Finance Literature: A Half Century of Contributions, Journal of Finance Literature, Winter 2005, b. Epistemology: a scientific perspective i. Reading: Los, Cornelis A., A Scientific View of Economic data Analysis, Eastern Economic Journal, 17-1, January-March 1991, Global Financial Markets (Sept 10 17) a. Capitalism = innovation, entrepreneurship, credit formation, legal property rights and uncertainty ii. Reading: Schumpeter, Joseph A., Science and Ideology, The American Economic Review, 39-2, March 1949, b. Uncertainty and profits ii. Reference: Knight, Frank H., Risk Uncertainty and Profit, Dover Publications, New York, 2006 (original: 1921) iii. Reference: Taleb, Nassim Nicholas, The Black Swan: The Impact of the Highly Improbable, Random House, New York, NY, c. Knightian uncertainty versus Keynesian probability-measured risk ii. Reference: Keynes, John Maynard, A Treatise on Probability, BN Publishing, 2008 (original: 1920) iii. Reference: Bernstein, P. L., Against the Gods: The Remarkable Story of Risk, John Wiley and Sons, New York, NY, d. Market structures and their dynamics i. Non-stationarity and non-ergodicity of markets 1. Reading: Los, Cornelis A., The Changing Concept of Financial Risk, The ICFAI Journal of Financial Risk Management, 2-1, March 2005, ii. Market efficiency, degrees of persistence and fractality 1. Reading: Los, Cornelis A., Measuring the Degree of Financial Market Efficiency: An Essay, Finance India, 22-4, December 2008 (Cf. also Los, 2003, Chapter 2) 2. Reading: Osborne, M. F. M., Brownian Motion in the Stock Market, Operations Research, 7, 1959, and Reading: Fama, Eugene, Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, 25-2, 1970, Reading: Fama, Eugene, Efficient Capital Markets: II, Journal of Finance, , Reading: Los, Cornelis A., Measurement of Financial Risk Persistence, The ICFAI Journal of Financial Risk Management, 2-3, September 2005, Reading: Los, Cornelis A., and Bing Yu, Persistence Characteristics of the Chinese Stock Markets, International Review of Financial Analysis, 17, 2008, Reference: Malkiel, Burton, G., A Random Walk Down Wall Street, 5 th ed., W. W. Norton & Co, New York, NY iii. Turbulent, laminar and chaotic functioning of markets

3 1. Reading: Los, Cornelis A., Visualization of the Road to Chaos for Finance and Economics Majors, The ICFAI Journal of Financial Economics, 4-4, December, 2006, Valuation of Fundamental Securities (Sept 24 Oct 1) a. Accounting balance equation i. Reading: Los, 2001, Chapter 1 b. Metrics of financial dynamics i. Reading: Los, 2001, Chapter 2 c. Valuation of bonds, stocks, real estate i. Reading: Los, 2001, Chapters 3 and 11 d. Theories of the term structure of interest rates ii. Reading: Murphy, J.E. and M. F. M. Osborne, Brownian Motion in the Bond Market, The Review of Futures Markets, 6-3, December 1987, iii. Reading: Jamdee, Sutthisit and Cornelis A. Los, Multi-fractal Modeling of the US Treasury Term Structure and Fed Funds Rate, Working Paper, Version 8.0, 2008 (submitted for publication) iv. Reference: Cox, J.C., J. E. Ingersoll, Jr. and S. A. Ross, A Theory of the Term Structure of Interest Rates, Econometrica, 53, March 1985, v. Reference: Roll, Richard, The Behavior of Interest Rates: The Application of the Efficient Market Model to U.S. Treasury Bills, Basic Books Publishers, New York, NY. 4. Valuation of Derivative Securities (Oct 8 15) a. Futures, options, swaps ii. Reading: Los, 2001, Chapters 12 and 13 iii. Reference: MacDonald, Robert L., Derivatives Markets, 2 nd ed., Addison-Wesley, Boston, b. Risk-neutral valuation ii. Reading: Los, 2001, Chapters 9 and 10 c. Modigliani-Miller valuation of corporations using option theory ii. Reading: Modigliani, Franco and Merton H. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48-3, June 1958, pp iii. Reading: Black, Fisher and Myron Scholes, The Pricing of Options and Corporate Liabilities, Journal of Political Economy, 81, May June, 1973, d. Call-put balance equation: the financial engineer s main tool ii. Reading: The Asian Wall Street Journal, Tuesday, September 30, 2008, p. 4, article on TARP US Treasury s bail-out e. Ito s Lemma and risk-neutral valuation in continuous time ii. Reading: Merton, Robert C., On the Pricing of Corporate Debt: the Risk Structure of Interest Rates, Journal of Finance, 29-2, May 1974, Financial Engineering (Oct 22 29) a. Derivative trading strategies i. Two dimensions: price and volatility ii. Reading: Reference: MacDonald, Robert L., Derivatives Markets, 2 nd ed., Addison-Wesley, Boston, 2006, Chapter 3. b. Spread balance equation = asset swap spread + credit default swap spread i. Reading: Altman, E. I. and V. M. Kishore, Almost Everything You Wanted to Know About Recoveries on Defaulted Bonds, Financial Analysts Journal, 52-6, November December, 1996,

4 ii. Reading: Jarrow, R.A. and S. M. Turnbull, Pricing Derivatives on Financial Securities Subject to Credit Risk, Journal of Finance, 50-1, March 1995, (Only the two-period example). c. Risk management, banking and insurance i. Reference: Merton, R. C., On the Application of Continuous-Time Theory of Finance to Financial Intermediation and Insurance, The Geneva Papers on Risk and Insurance, 4 52, 1989, d. Analysis of market-making ii. Reading: MacDonald, Robert L., Derivatives Markets, 2 nd ed., Addison-Wesley, Boston, 2006, Chapter 13 e. Long memory effects on risk measurement ii. Reading: Jamdee, Sutthisit and Cornelis A. Los, Long Memory Options: LM Evidence and Simulations, Research in International Business and Finance, 21, 2007, f. Strategic investments: real options and corporate games ii. Reading: Lehrman (1998) iii. Reference: Amram, Martha, and Nalin Kulatilaka, Managing Strategic Investment in an Uncertain World, Harvard Business school Press, Boston, MA, iv. Reference: Smit, Han T. J. and Lenos Trigeorgis, Strategic Investment: Real Options and Games, Princeton University Press, Princeton and Oxford, Portfolio Selection (Nov 5 12) a. System analysis of inexact data ii. Reading: Los, 2001, Chapters 4 and 5 b. Capital Market Line (CML) ii. Tobin s liquidity preference iii. Risk preference iv. Sharpe s ratio: abnormal return versus risk c. Securities Market Line (SML) ii. Capital asset pricing 1. Reading: Los, 2001, Chapter 7 2. Reading: Los, Cornelis A., Galton s Error and the Under-Representation of Systematic Risk, Journal of Banking and Finance, 23-12, December 1999, Reading: Sharpe, William F., Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk, Journal of Finance, 19-2, 1965, iii. Arbitrage theory of asset pricing 1. Reading: Ross, Stephen, A. Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, 13, d. Knightian uncertainty and info-gap theory: CML and SML ii. Reading: Los, Cornelis A. Investment Modeling Uncertainty and Fair Pricing, Working Paper, Faculty of Management, University of Lethbridge, 2008 (submitted for publication) 7. Portfolio Optimization in Multi-Dimensions (Nov 19 26) a. Markowitz return and risk optimization ii. Reading: Los, 2001, Chapter 6 iii. Reading: Markowitz, Harry M., Portfolio Selection, Journal of Finance, 7 1,

5 iv. Reading: Markowitz, Harry M., The Early History of Portfolio Theory: , Financial Analysts Journal, 55 4, July August 1999, b. Value-at-Risk and extreme events i. Reading: Los, Cornelis A., Why VaR Fails: Long Memory and Extreme Events in Financial Markets, The ICFAI Journal of Financial Economics, 3-3, September 2005, ii. Reference: Jorion, P., Value at Risk: The New Benchmark for Controlling Market Risk, Irwin Professional, New York, NY, Global Fund Management (Dec 3) a. Global investment (hedge) funds ii. Reading: Los, 2001, Chapter 14 (sections ) iii. Reading: Solnik, B. C. Boucrelle and Y. Le Fur, International Market Correlation and Volatility, Financial Analysts Journal, 52-5, September October 1996, b. Multi-country/multi-currency/multi-asset cash flow accounting metrics ii. Reading: Los, Cornelis A., Optimal Multi-Currency Investment Strategies with Exact Attribution in Three Asian Countries, Journal of Multinational Financial Management, 8-2/3, 1998, c. Exact portfolio performance attribution analysis (based on CAPM) ii. Reading: Los, 2001, Chapter 14 (sections 14.5 and 14.6) d. Sovereign wealth funds i. Reading: Article assignments Journal articles and book chapters will be weekly assigned for the five required synopses and the choice of topic for the required 25-page working paper Regular references I will make frequent references to my own compact and very basic textbook Computational Finance, for a clear scientific perspective on finance and financial modeling and to familiarize you with the issues such as modeling risk due to Knightian uncertainty, which more recently have come to the foreground. Since I m also working on a 2 nd edition of this book to be published in 2009, your comments and suggestions for improvement will be welcomed and acknowledged in the Preface to this 2 nd edition: - Los, Cornelis, A. (2001), Computational Finance: A Scientific Perspective, World Scientific Publishing Co., Singapore (ISBN: , paperback). - I m also working on the 2 nd edition of my more advanced and technical Financial Market Risk. Anyone finding a substantial number or typos, mistakes or has serious suggestions for improvement, will be acknowledged in the Preface to this 2 nd ed., also scheduled to be published in 2009: - Los, Cornelis A. (2003) Financial Market Risk: Measurement and Analysis, Routledge/Taylor&Francis Group (ISBN: , hardcover, July 2003; and ISBN: , paperback; ISBN: , electronic, August 2006). One of the best comprehensive and understandable guides to financial engineering is the following book: - Neftci, Salih N. (2004) Principles of Financial Engineering, Elsevier Academic Press, Amsterdam (ISBN: , hardback). The following book is a much simplified version for the same topic area:

6 Capinski, Mark and Thomas Zartawriak, Mathematics for Finance: An Introduction to Financial Engineering, Springer, 2003 (ISBN-13: ). An incredibly lucid reference remains the following book, which was ahead of its time and is still new : Luenberger, David G., Investment Science, Oxford University Press, New York, 1998 (ISBN-13: , hard cover). These books can be useful starting points for a literature search and some of their chapters will be assigned as required readings. Assessment - Five 2-pg synopses of assigned articles, each due at the end of the corresponding 2-week period, typed, double-spaced 30% - Written 25-page working paper (incl. references), to be approved in advance by the instructor 30% - Working paper Power Point Presentation, to be approved in advance by the instructor 10% - Comprehensive Final Exam, based on the assigned readings 30% It is highly recommended to start thinking about possible thesis topics of interest immediately from the beginning of this course. The working paper should be written as a publishable scientific conference paper (e.g. following the North-Holland/Elsevier format), with Introduction, Research Question, Organization of Paper, Data Sources, Methodology, Analysis, Results and Conclusion. The following is the letter grade distribution that has been adopted by the Faculty of Management as a suggested grade scale/breakdown for all management courses and will be followed in this course: A B C D A B C D A B C F Procedures Plagiarism and Cheating (with thanks to Dr. Chris Holsworth, Geoffrey Kneller and Dr. Kelly Williams. I was a member of the Committee on Plagiarism and Cheating at the Nanyang Technological University in Singapore, so I take this VERY seriously) Plagiarism is defined as to steal and pass off the ideas and words of another as one s own (Webster s Dictionary). Plagiarism and cheating, e.g., on exams, will not be tolerated, will automatically result in a zero grade for the submission, and will be reported. Any student caught plagiarizing or cheating may also be subject to additional University sanctions. Special care should be taken to understand and avoid Academic Offenses of Plagiarism and Cheating listed in the Student Discipline Policy. For the current University Policy on Cheating and Plagiarism, please, consult pages of the University of Lethbridge calendar. The University of Lethbridge subscribes to a plagiarism detection service. Students may be required to submit their written work in electronic form for plagiarism checking. Make-up Exams Students who fail to write final exams or to produce the required items for assessment must provide satisfactory evidence of illness or extenuating circumstances AND must have the approval of the Dean for a makeup exam. For missed exams, a grade of F (0 marks) will be given.