Financial Economics: Syllabus
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1 : Syllabus Shuoxun Hellen Zhang WISE & SOE XIAMEN UNIVERSITY Sep, / 16
2 Administrative Group QQ: ; My office hours: Tuesday and Thursday 15:00 16:00, room B211 Grade=Homework 20% + Midterm 30% + Final 40% +Class Performance 10% Essential to work with problem sets and read the textbook, Bodie, Merton and Cleeton(BMC), Financial Ecomonics, 2nd edition Teaching Assistant: Xu DU, with duxu90@sina.com TA hour: Friday 2:30-4:10 pm, Lian Xing / 16
3 Why the hassles? People on Wall Street knows CAPM, Option pricing, Black-Scholes, Arbitrage, Hedging, Market efficiency hypothesis. They use these knowledge to talk about things around us. E.g., Martha Stewart s case. (Insider Trading undermines Market efficiency hypothesis?) People do talk about finance. You want to talk with them with a background knowledge to screen the reasonable comments from the unreasonable ones. Ultimately you want to deal with your personal finance by investing with an understanding of financial theories rather than investing with nothing to back you up. 3 / 16
4 Students will acquire the necessary tools to answer the following kinds of questions: A) Inter-temporal Optimization of Consumption 1 Why do we care about allocation of consumptions across time? What is the objective of an individual investor? What does that have to do with finance? 2 How can we allocate wealth across time? 3 What are the vehicles available to individuals to allocate wealth inter-temporally? (Non-marketable, money market, capital market, derivatives market, investment funds, real assets) 4 / 16
5 Answer: 1 Investor s objective is to maximize utility (happiness). Our utility depends not only on present consumption but also consumptions in the future. By participating in financial market, we can efficiently achieve our objective of maximizing utility. 2 By investing/dis-investing in real assets or financial assets 3 a) Real assets land, buildings and equipment that are used to produce goods and services, b) Financial assets claims such as securities to the income generated by real assets 5 / 16
6 B) Net Present Value 1 What is the objective of the firm? 2 What is the relationship between shareholder s lifetime consumption and the firm s value? 3 What is firm s value? 4 How to maximize firm s value? 6 / 16
7 Answer 1 Firm s objective is to maximize the net present value of shareholder s lifetime consumption. 2 Shareholder s lifetime consumption is maximized if the firm s value is maximized. Such maximizing is reflected by the price per share of stock. 3 Firm s value = Discounted value of future expected cash flows. 4 Invest all projects that has positive net present value. 7 / 16
8 C) Expected Utility Theory 1 How people make choices under uncertainty? 2 How do we deal with risk? 3 How to identify our risk preference? 4 How much will an individual have to pay in order to reduce a certain amount of risk he faces? 8 / 16
9 Answer 1 They try to maximize their expected utility under uncertainty. 2 Depends on our risk preference. We may hedge risk (e.g., buying insurance) if we are risk-averse. 3 If we are willing to pay to reduce the risk we exposed, we are risk-averse. If we are not willing to do so, we love risk. 4 This is equivalent to calculating risk premium which can be achieved by various method. The drawback is it requires the specific utility function of that individual. 9 / 16
10 D) Asset Pricing CAPM 1 What is risk? 2 What is the capital market line? What is the security market line? 3 What is beta? 4 How to measure individual security s beta? 5 What is the empirical challenges of testing CAPM? 10 / 16
11 Answer 1 Risk is comprised of a) non-systematic (non-diversifiable) risk, which requires a reward in the form of risk premium; and b) systematic (diversifiable) risk, which does not. 2 CML depicts the eqm. Conditions that prevail in the market for efficient portfolios. It gives graphical illustration of the trade-off between expected return and total risk for efficient porfolios; SML graphically depicts CAPM, which relates the expected return on an individual security or portfolio to its market risk as measured by beta. 3 A measure of volatility for stock or portfolio returns. 4 Regress (time-series) total returns for that security against total returns for a market index. Beta is then the estimated coefficient of the later. 5 Empirical evidence remains inconclusive. CAPM is an ex ante model while it is tested with ex post data. However, the important issue is whether the theory provides predictive power. 11 / 16
12 D) Asset Pricing Arbitrage Pricing Theory(APT) 1 What is arbitrage? 2 How to achieve a well-diversified portfolio? 3 What is the relationship between CAPM and APT? 4 What is an equilibrium in APT? 12 / 16
13 Answer 1 A zero-risk, zero-net investment strategy that still generates profits. When the law of one price assumption is violated, there is an arbitrage opportunity. 2 Equally-weighted portfolio is one example. However, any portfolio for which each security s weight becomes consistently smaller as the number of securities in the portfolio gets large is well-diversified. 3 They both equilibrium asset pricing models developed to determine the market price for risk and the appropriate measure of risk for a single asset. CAPM is a special case of APT when market rate of return is assumed to be the single relevant factor affecting return of all assets. 4 An equilibrium exists if there is no arbitrage opportunities. APT is derived from setting the conditions of no arbitrage. 13 / 16
14 E) Option Pricing Theory 1 What is a derivatives? 2 How to define a call option? 3 Can we trade European options in Chicago Board of Options Exchange (CBOE)? 14 / 16
15 Answer 1 A financial instrument whose value depends on the values of other, more basic underlying variables. Usually the variables underlying derivatives are the prices of traded assets, e.g., stock. 2 A call option gives its holder the right to buy the underlying asset by a certain date for a certain price. 3 Of course, it has nothing to do with geography. 15 / 16
16 How to succeed? First Priority Master the Lecture Notes provided. Attend the lectures. Most of the questions and material for the term test and final exam will be covered directly in the lectures Second Priority Exercises and assignments are also provided There will be overlap between these and the mid-term exam and final exam you receive Do the exercises and assignment independently it will be helpful! Last but Not Least The textbook is tough. Read it to the extent it reinforces your understanding of materials covered in lectures I will not test on materials from the book that is not directly covered in lectures 16 / 16
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