UNIVERSIDAD CARLOS III DE MADRID FINANCIAL ECONOMICS

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1 Javier Estrada September, 1996 UNIVERSIDAD CARLOS III DE MADRID FINANCIAL ECONOMICS Unlike some of the older fields of economics, the focus in finance has not been on issues of public policy We have emphasized positive economics rather than normative economics, striving for solid empirical research built on foundations of simple, but powerful organizing theories Now that our field has officially come of age, as it were, perhaps my colleagues in finance can be persuaded to take their noses out of their data bases from time to time and to bring the insights of our field, and especially the public policy insights, to the attention of a wider audience MERTON MILLER, 1990 Nobel Memorial Prize Lecture in Economics Sciences This course is made up of several (seemingly-unrelated but) related and integrated topics It is broader than the typical course in Corporate Finance, and attempts to provide students with a solid introduction to some of the issues discussed in Financial Economics It also attempts to integrate theory, empirical evidence, and applications The theory simplifies reality and formally derives testable hypotheses; the empirical evidence gives support to or rejects a theory; and the applications put the theory to deal with real-world problems Thus, in general, our methodology will be that of approaching an issue from a theoretical point of view, then moving to discuss whether the empirical evidence supports or rejects the underlying theory, and finally putting the theory at work on some practical problems The course starts with an overview of some widely-used financial instruments It then moves to address several topics, some of them issues of Corporate Finance and some others issues of the Theory of Finance Our main reference will be Ross, Westerfield, and Jaffe s Corporate Finance (4th edition, 1996); George Pinches Financial Management (1st edition, 1994) is an excellent complementary reference The additional papers contained in the last two pages of this syllabus include the three 1990 Nobel Prize Lectures in Economics given by Harry Markowitz, Merton Miller and William Sharpe, which you are strongly advised to read Just to in order to avoid surprises, let it be clear from the very beginning that the references indicated as required are in fact required Out of the four weekly hours of the course, one hour will be allocated to work on a problem set, which will generally be put in the copy shop a week in advance These problem sets are crucial to the understanding of the course and you should work on them before class The only requirement for the course is a final exam that will count for 100% of your credit

2 2 OUTLINE INTRODUCTION Brief introduction to stocks, bonds, futures, options, and mutual funds CAPITAL BUDGETING The Net Present Value (NPV), the Payback Rule, the Discounted Payback Period Rule, and the Internal Rate of Return (IRR) Applications RATIONAL CHOICE Investment under certainty Investment under uncertainty: Expected utility theory; attitudes toward risk; Markowitz and Pratt-Arrow risk aversion Mean-variance behavior PORTFOLIO ANALYSIS Statistics review Portfolios Diversification Optimal portfolio choice with two assets Optimal portfolio choice with n assets The efficient set and the capital market line MARKET EQUILIBRIUM AND ASSET VALUATION The Capital Asset Pricing Model (CAPM) Empirical evidence on the CAPM Applications of the CAPM The Arbitrage Pricing Theory (APT) CAPITAL STRUCTURE AND THE COST OF CAPITAL The cost of capital The value of the firm (Modigliani-Miller proposition I) The return on equity (Modigliani-Miller proposition II) Extensions The pecking-order theory Empirical evidence DIVIDEND POLICY Dividend-valuation models Lintner s model of dividends Another policy-irrelevance result Signaling theories Taxes and the clientele effect Empirical evidence THE EFFICIENT MARKETS HYPOTHESIS Weak, semistrong, and strong efficiency Implications of the theory for firms and investors Empirical evidence OPTION PRICING THEORY Calls and puts: general characteristics Put-call parity Options valuation: binomial pricing and Black-Scholes pricing model

3 3 A BRIEF HISTORY OF FINANCE : Markowitz publishes Portfolio Selection, where he showed how to find portfolios with the largest possible return given a chosen level of risk This was the beginning of modern financial theory : Modigliani and Miller argue that the value of the firm is independent of its capital structure This irrelevance result (usually referred to as MM Proposition I) eventually became one of the cornerstones of modern financial theory : Miller and Modigliani develop another irrelevance result This time they argued that the value of the firm is independent of its dividend policy : Sharpe simplifies Markowitz s model by developing the Single-Index Model This simplification made portfolio theory practical : Sharpe (1964), Lintner (1965) and Mossin (1966) individually and simultaneously develop the Capital Asset Pricing Model (CAPM) This model addresses the equilibrium relationship between risk and return and is widely used in practice : Fama publishes his dissertation thus originating the Efficient Market Hypothesis (EMH) This theory argues that securities prices reflect all information relevant to securities valuation, and has critical practical implications for firms and investors : Black and Scholes develop a model to price options The popularity of the model has increased with that of the options it prices : Ross develops an alternative to the CAPM The Arbitrage Pricing Theory (APT) is more general than the CAPM and its assumptions are less demanding : Roll delivers a blow to the popularity of the CAPM; he argued that the single empirical prediction of this model is not testable The issue of the testability of the CAPM is not yet settled : Harry Markowitz, Merton Miller and William Sharpe are awarded the Nobel Prize in Economics for their contributions to the field of Finance

4 4 REFERENCES TEXTBOOK: Ross, Stephen, Randolph Westerfield, and Jeffrey Jaffe (1996) Corporate Finance Irwin COMPLEMENTARY TEXTBOOK: Pinches, George (1994) Financial Management Harper Collins INTRODUCTION (*) Ross, Westerfield, and Jaffe (1996) Chapters 1 and 14 Varian, Hal (1993) A Portfolio of Nobel Laureates Journal of Economic Perspectives, 7, 159 CAPITAL BUDGETING (*) Ross, Westerfield, and Jaffe (1996) Chapters 4-6 Copeland, Thomas, and Fred Weston (1988) Financial Theory and Corporate Policy Addison- Wesley Chapter 2 RATIONAL CHOICE (*) Ross, Westerfield, and Jaffe (1996) Chapter 3 Copeland and Weston (1988) Chapters 1 and 4 PORTFOLIO ANALYSIS (*) Ross, Westerfield, and Jaffe (1996) Chapter 9 Copeland and Weston (1988) Chapter 6 Markowitz, Harry (1952) Portfolio Selection Journal of Finance, 7, 77 Markowitz, Harry (1991) Foundations of Portfolio Theory 1990 Nobel Memorial Prize Lecture in Economics Sciences Journal of Finance, 46, 469 MARKET EQUILIBRIUM AND ASSET VALUATION (*) Ross, Westerfield, and Jaffe (1996) Chapters 10 and 11 Sharpe, William (1964) Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk Journal of Finance, 19, 425 Ross, Stephen (1976) The Arbitrage Theory of Capital Asset Pricing Journal of Economic Theory, 13, 341

5 5 Roll, Richard (1977) A Critique of the Asset Pricing Theory s Tests Part I: On the Past and Potential Testability of the Theory Journal of Financial Economics, 4, 129 Fama, Eugene, and Kenneth French (1992) The Cross-Section of Expected Stock Returns Journal of Finance, 47, 427 Sharpe, William (1991) Capital Asset Prices with and without Negative Holdings 1990 Nobel Memorial Prize Lecture in Economics Sciences Journal of Finance, 46, 489 CAPITAL STRUCTURE AND THE COST OF CAPITAL (*) Ross, Westerfield, and Jaffe (1996) Chapters 15 and 16 Modigliani, Franco, and Merton Miller (1958) The Cost of Capital, Corporation Finance and the Theory of Investment American Economic Review, 48, 261 Myers, Stewart (1984) The Capital Structure Puzzle Journal of Finance, 39, 575 Miller, Merton (1991) Leverage 1990 Nobel Memorial Prize Lecture in Economics Sciences Journal of Finance, 46, 479 DIVIDEND POLICY (*) Ross, Westerfield, and Jaffe (1996) Chapter 18 Black, Fisher (1976) The Dividend Puzzle Journal of Portfolio Management, 2, 5 Miller, Merton, and Franco Modigliani (1961) Dividend Policy, Growth and the Valuation of Shares Journal of Business, 34, 411 THE EFFICIENT MARKETS HYPOTHESIS (*) Ross, Westerfield, and Jaffe (1996) Chapter 13 Fama, Eugene (1970) Efficient Capital Markets: A Review of Theory and Empirical Work Journal of Finance, 25, 383 Fama, Eugene (1991) Efficient Capital Markets: II: Journal of Finance, 46, 1575 OPTION PRICING THEORY (*) Ross, Westerfield, and Jaffe (1996) Chapter 21 Black, Fisher, and Myron Scholes (1973) The Pricing of Options and Corporate Liabilities Journal of Political Economy, 81, 637 (*) Required reference