MSc Finance Birkbeck University of London Theory of Finance I Lecture Notes 2006-07
This course introduces ideas and techniques that form the foundations of theory of finance. The first part of the course, in the Autumn Term, studies individual decision making under certainty and uncertainty and in situations with strategic interaction; how markets allow exchange, their efficiency and sources of market failure; and how information imperfections affect market outcomes. The second part of the course, in the Spring Term, employs mathematical techniques from probability theory, geometry and optimization theory to solve investment and risk management problems. It derives the famous Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theorem (APT). The random nature of financial losses and returns are examined in detail using real data, and risk measures are developed with the aim of controlling large portfolio losses. Objectives Students who complete this course successfully should be able to understand standard models of individual decision-making under certainty and uncertainty; model strategic interaction using game theory; understand how asymmetric information affects market interaction understand models of market microstructure, including auctions explain how beneficial exchange in markets leads to efficient outcomes; understand how risk aversion affects choices; set up and solve an investors portfolio decision problem; understand the mean-variance framework for portfolio analysis and derive the capital asset pricing model (CAPM) within this framework; derive factor models for the evolution of assets prices and develop the arbitrage pricing theorem (APT) for expected returns; use real data to verify the stylized features of random asset returns (eg fat tails, time-dependent volatility); measure the value at risk of a financial portfolio for a given confidence level.
Birkbeck Economics ii Timetable There will be a double lecture on Monday evenings, from 6 to 9 pm. Reading Weeks Autumn Term There will be no lecture on 13 November 2006, as this is the designated reading week for this course. Note that this varies slightly from the usual reading week in the School. Spring Term There will be no lecture on 12 February 2007, as this is the designated reading week for this course. Assessment 80% of the final grade for this course is determined through a three-hour examination in June, based on material covered in each term. The remaining 20% will be based on class tests, as follows. There will be 90 minute class-test in the last week of the Autumn Term, scheduled for 6.15 pm on Monday, 11 December 2006. No resits will be held. There will be a second 90-minute class-test in the Spring Term, scheduled for Monday 20 March 2007. Course Website The primary channel for posting information for this course is http://www.econ.bbk.ac.uk/faculty/kapur/course/finance/tof1.htm In general, you are encourage to discuss your progress with the lecturers. The easiest way to initiate contact outside the classroom is via email Arup Daripa a.daripa@bbk.ac.uk Simon Hubbert s.hubbert@bbk.ac.uk Sandeep Kapur s.kapur@bbk.ac.uk Hope you enjoy the course!
Birkbeck Economics iii Course Material and Textbooks We will provide a set of notes to serve as a route map for the course. For most topics the notes provide an overview of the main issues, but do not really tell you how to solve examination-style problems. Hence, they are not a self-sufficient guide to the course and definitely not a substitute for the lectures or text-books. The choice of a textbook is a matter of individual taste. We will draw on material from more than one source and, when covering a topic, we will try to indicate which sources are best and most relevant for it. In general, the following textbooks are quite good. Autumn Term Hal Varian (1992): Microeconomic Analysis. 3rd edition, Norton. Christian Gollier (2001): The Economics of Risk and Time. MIT Press. Paul Klemperer (2004): Auctions: Theory and Practice. Princeton University Press. Maureen O Hara (1995): Market Microstructure Theory. Blackwell. Spring Term Carol Alexander (2004): Market Models. Wiley. Robert Haugen (1997): Modern Investment Theory. Prentice Hall. Huang and Litzenberger (1988): Foundations for Financial Economics. North Holland. Jonathan Ingersoll (1987): Theory of Financial Decision Making. Rowman and Littlefield. Philippe Jorion (2002): Value at Risk. McGraw-Hill. David Luenberger (1998): Investment Science. Oxford.
A Preliminary Schedule of Lectures Autumn 2 October Individual decision making 9 October Game Theory 16 October Economics of Information 23 October Market Microstructure I 30 October Market Microstructure II 6 November Market Microstructure III 13 November Reading week (no lecture) 20 November Informational problems in Credit Markets 27 November Exchange and Equilibrium. Efficiency and Market Failure 4 December Choice Under Uncertainty and Risk Aversion. Portfolio choice 11 December Class Test iv
Birkbeck Economics v Spring 1. The investment problem. Financial terminology. The two asset problem and solution. The geometric view of the solution 2. Mean variance analysis. Importance of diversification. The multi-asset problem. The optimal portfolio frontier. 3. Mean Variance geometry. The tangent to an efficient portfolio. Determining the zero covariance point of an efficient portfolio. 4. Capital Asset Pricing Model. The introduction of a risk free asset. The market portfolio Derivation of CAPM. 5. Uses of CAPM. Importance of the beta risk measure. CAPM as a pricing model CAPM to evaluate performance of funds 6. Factor Modelling of asset returns. Mathematical model with free choice of driving factors. The no arbitrage assumption. The single factor arbitrage pricing theorem. 7. The Arbitrage Pricing Theorem. Proof of multi factor case. Consistency with CAPM. Strengths and weaknesses of the model. 8. Random nature of asset returns: testing the assumptions. Analysis of real time series data. Computation of key statistics: mean, variance, skewness, kurtosis, autocorrelation etc Inferring distributional properties. 9. Risk Management. The Value at Risk measure to measure portfolio losses. Example calculations using a normal distribution The appropriateness of using a normal distribution. 10. Overcoming the normal assumption. Coping with fat tailed distributions. Modelling time dependent volatility.