THE UNIVERSITY OF NEW SOUTH WALES SCHOOL OF BANKING AND FINANCE

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1 THE UNIVERSITY OF NEW SOUTH WALES SCHOOL OF BANKING AND FINANCE SESSION 1, 2005 FINS 4774 FINANCIAL DECISION MAKING UNDER UNCERTAINTY Instructor Dr. Pascal Nguyen Office: Quad #3071 Phone: (2) Consultation hours: Monday 14:00 16:00 Appointments can be taken outside regular hours Course description Objectives of the course Provide the foundations for analyzing investment and corporate financial decisions Introduce fundamental concepts (e.g., expected utility, risk aversion, diversification, risk-adjusted returns, risk neutral pricing, equilibrium pricing, Nash equilibrium, moral hazard, adverse selection, signaling, etc.) Present some important analytical tools (e.g., portfolio optimization, risk analysis, cash flow duplication, dynamic programming, game theory, etc.) Analyze the implications in terms of asset pricing (e.g., risk neutral pricing) and behavior of financial and non-financial organizations (e.g., credit rationing, IPO underpricing, managers performance remuneration, etc.) Approach of learning Emphasize the logical structure in developing financial theories Insist on the intuition rather than the technical details FINS 4774 Financial Decision Making under Uncertainty_S

2 Pay special attention to the similarities and differences between different models Underline the link between the assumptions and the implications Require students to develop a simple, yet complete, game theoretic model Combine formal lectures with exercises and paper presentations In this respect, the exercises and reading materials have been carefully selected. Students are especially advised to Familiarize themselves with the course contents, Read the indicated articles before attending classes Work out the exercises Position of the course in the finance curriculum No prior exposure to finance theory is required However, general understanding of the organization and role of capital markets and financial institutions, and investment management (portfolio management) and corporate financial management (financing) will be useful Basic knowledge of calculus, functional analysis, and probability is assumed Examples: partial derivation, optimization, calculations involving random variables This course is not directly concerned with Empirical testing of asset pricing theory (see, advanced asset pricing) Practical investment applications (see, portfolio management) Valuation of specific derivative securities (see, options and futures, risk management) Practical financial management (see, advanced corporate finance) Course assessment Paper presentation 20 % Assignments 30 % Mid Session 20 % Final Exam 30 % Total 100 % Reference Textbooks Huang and Litzenberger, Foundations for Financial Economics, Prentice Hall, 1988 Cochrane, Asset pricing, Princeton University Press, 2000 Campbell, Lo and McKinlay, The Econometrics of Financial Markets, Princeton University Press Rasmussen, Games and information, Oxford University Press, 1989 FINS 4774 Financial Decision Making under Uncertainty_S

3 Course schedule PART I RISK, RISK AVERSION & THE PRICING OF RISKY ASSETS Week Expected Utility Theory Objective: provide a framework for understanding how risk affects investors decisions; show that the demand for risky assets depends on risk, risk aversion and the risk premium The structure of investor preferences Axiomatic foundations of utility Examples of utility functions Measures of risk aversion Certainty equivalence, risk premium Risk aversion and the demand for risky assets Readings: Huang & Litzenberger, chapter 1 Week Portfolio theory Objective: solve the optimal demand for risky assets in the mean variance framework; illustrate the benefit of diversification; analyze the set of frontier/efficient portfolios; decompose the risk of an asset into a contributor to the portfolio s risk and a residual component Risk vs. return: the mean variance framework Characterizing the mean variance investor s portfolio The efficient frontier of risky assets Decomposition of efficient portfolios Readings: Huang & Litzenberger, chapter 3 Week CAPM Objective: provide a theoretical foundation for the pricing of risky assets based on the structure of investors demand for risky assets and the assumption of market equilibrium; show that the risk premium depends only on the systematic risk component, not the residual risk component Market equilibrium: definition Market price of risk, decomposition of risk Beta and the security market line (SML) Readings: Huang & Litzenberger, chapter 4 FINS 4774 Financial Decision Making under Uncertainty_S

4 Assignment #1: Choose a paper that uses the CAPM for adjusting asset returns for risk Describe the general objective of the paper. Detail the procedure used for computing risk-adjusted returns. Discuss the procedure and indicate alternative ways to proceed Paper length: 3-5 pages; submission date: week 5 marks: 10/100 Week APT Objective: provide an alternative foundation for the pricing of risky assets that does not depend on preferences, but requires a factor structure for asset returns and the assumption of no arbitrage Show that expected returns depend on factor loadings and the risk premium on each risk factor Limitations of CAPM One (market) risk factor may not be enough to describe asset returns Linear factor models Development of APT: Ross (1976) Identifying the underlying risk factors Readings: Huang & Litzenberger, chapter 3 Week Arbitrage & Derivative pricing Objective: show how arbitrage arguments allow derivative asset pricing without the explicit knowledge of investors preferences; show that investors preferences have already been factored in the price of the primitive (underlying) assets; introduce risk neutral pricing techniques Introduction to arbitrage pricing Replication of derivative cash flows Change of probability measure and risk neutral pricing Readings: John Cox, Stephen Ross, and Mark Rubinstein (1979) Option Pricing: A Simplified Approach, Journal of Financial Economics, vol. 7, pp Fischer Black and Myron Scholes (1973) The Pricing of Options and Corporate Liabilities, Journal of Political Economy, vol. 81, pp Vasicek (1977) An equilibrium characterization of the term structure, Journal of Financial Economics, Volume 5, Pages Merton (1974) On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance, vol. 29, pp FINS 4774 Financial Decision Making under Uncertainty_S

5 Week Presentation of asset pricing papers Richard Roll and Stephen Ross (1980) An Empirical Investigation of the Arbitrage Pricing Theory, Journal of Finance, vol. 35, pp Nai-Fu Chen, Richard Roll and Stephen Ross (1986) Economic Forces and the Stock Market, Journal of Business, vol. 59, pp Eugene Fama and Kenneth French (1993) Common risk factors in the returns on stocks and bonds, Journal of Financial Economics, vol. 33, pp Feedback on assignment #1 Week Mid-term exam PART II GAME THEORY & APPLICATIONS IN FINANCE Week Introduction to Game Theory Objective: analyze situations where the payoff (welfare) of one player depends not only on her own actions, but also on the actions of other players Modeling strategic interactions Prisoner s dilemma and other stylized games Solution concepts: dominance, backward induction Definition of Nash Equilibrium, Readings: Rasmussen, chapter 1 Week Games and information Objective: analyze situations where players have different information; show how informational asymmetry influences the strategies of players Games with imperfect information Mechanism design, optimal contracts, incentive compatibility The principal agent framework Moral Hazard, Adverse selection, and signaling problems in finance and insurance Readings: Rasmussen, chapter 2 & beginning of chapter 7 The Economist, May 2003, the problem with banks FINS 4774 Financial Decision Making under Uncertainty_S

6 Assignment #2: Develop a simple financial model using game theoretic concepts Describe the objective of the model; what phenomenon does it aim to explain? Detail the players and their payoffs, why the players may inherently be in conflict Work out the Nash equilibrium Describe the model s properties; what are the testable implications? How would you test your model; indicate potential data sources and procedures You may wish to take your inspiration from a published paper In that case, underline the differences you introduce Explain why your assumptions may be better suited to the problem Paper length: 5-10 pages, submission date: week 12 marks: 20/100 Week Moral Hazard Objective: analyze the situation where the agent can take some action unobserved by the principal; show how the principal can structure the contract so that, nevertheless, the agent will take an optimal action in the principal s interest Moral Hazard in the principal agent framework Controlling Moral Hazard: Incentive contracts Agency problems in corporate finance Agency cost from ownership/management separation Readings: Rasmussen, chapter 7 Class presentations: Michael Jensen and William Meckling (1976) Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics, vol. 3, pp Stewart Myers and Nicholas Majluf (1984), Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, vol. 13, pp Week Adverse selection Objective: analyze the situation where the agents have private information unknown to the principal; show how the principal can structure the contracts so that each agent will choose the contract that is intended for her type Readings: Rasmussen, chapter 9 George Akerloff (1970) The Market for 'Lemons': Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics, vol. 84, pp FINS 4774 Financial Decision Making under Uncertainty_S

7 Class presentations Adverse selection in the job market; in the used car market; in the insurance market: Michael Rothschild and Joseph Stigliz (1976) Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, Quarterly Journal of Economics, vol. 90, pp Helmut Bester (1985) Screening vs. Rationing in Credit Markets with Imperfect Information, American Economic Review, vol. 75, pp Week Signaling Objective: show how the agent can credibly convey his private information to the principal when doing so is likely to improve her welfare (utility) Readings: Rasmussen, chapter 11 Michael Spence (1973) Job Market Signaling, Quarterly Journal of Economics, vol. 87, pp Stephen Ross (1977), The Determination of Financial Structure: The Incentive Signaling Approach, Bell Journal of Economics, vol. 8, pp Signaling with dividend policy Signaling with retained share in the firm Class presentations: Hayne Leland and David Pyle (1977) Informational Asymmetries, Financial Structure, and Financial Intermediation, Journal of Finance, vol. 32, pp Sudipto Bhattacharya (1979) Imperfect Information, Dividend Policy, and the Bird in the Hand Fallacy, Bell Journal of Economics, vol. 10, pp Week Review of part II IPO underpricing Moral Hazard and signaling Class presentations: Kevin Rock (1986) Why new issues are underpriced, Journal of Financial Economics, vol. 15, pp David Baron (1982) A Model of the Demand for Investment Banking Advising and Distribution Services for New Issues, Journal of Finance, vol. 37, pp Feedback on assignment #2 FINS 4774 Financial Decision Making under Uncertainty_S

8 FINS 4774 & FINS 5574 Semester Timetable Week Date Topic 1 28-Feb Expected Utility Theory 2 7-Mar Portfolio theory 3 14-Mar CAPM 4 21-Mar APT 5 4-Apr Arbitrage pricing 6 11-Apr Paper presentations (asset pricing) 7 18-Apr Mid-term exam 8 2-May Introduction to Game Theory 9 9-May Games and information May Moral Hazard May Adverse selection May Signaling 13 6-Jun Review of game theoretic models Indications regarding paper presentations Submit a clear and well-written document in Word or Power point Emphasize the structure of the underlying model For example, if the model involves a game, detail the game structure (actors, their strategies, the payoffs, the Nash equilibrium, etc.). Marking will heavily depend on this aspect Time for presentation: about 30 minutes Time for discussion: minutes FINS 4774 Financial Decision Making under Uncertainty_S