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FINANCIAL ECO217 MARKETS: THEORIES & EVIDENCE Spring 2002 Time: Place: Instructor: Mondays and Wednesdays, 2pm to 3.15pm Dewey 2110D Thomas Renstr m Wallis Institute of Political Economy 110 Harkness Hall tel: 275-6834 e-mail: rnsm@troi.cc.rochester.edu Mondays 12.00-1.00 p.m. Wednesdays 12.00-1.00 p.m. Other times by appointment Office Hours: Class Web Site: http://www.econ.rochester.edu/Wallis/Renstrom/Eco217.html TAs: Juan Carlos Hatchondo, e-mail: hatch@troi.cc.rochester.edu Nathan Ringelstetter, e-mail: nr001h@mail.rochester.edu Once a week, Group 1: Wednesdays 5.00-5.5pm, in Meliora 219, Group 2:Fridays 2.00-2.50pm, in Meliora 208 Recitations: Aims The course introduces topics in financial economics at an intermediate level, focusing on methodology. Students will develop skills and learn tools for analysing and understanding financial markets. The main focus of the course is on finance from a microeconomic perspective. Objectives The students should be able to obtain a critical understanding of choice under uncertainty, portfolio formation, and equilibrium asset pricing (such as the CAPM and APT). Students should be able to derive asset-pricing relations from first principles, and understand the consequences if some of the underlying assumptions are relaxed. Students will gain understanding of how to formulate equations for empirical testing, and become aware of results from the empirical finance literature. Financial Markets: Theories & Evidence 2 General information The core material will be covered through classes. Exercises will be discussed in the weekly recitations, under the direction of the TA. Homework: During the course three sets of problems will be marked. You need to hand these selected sets (and only these) before the assigned recitation. The mark on those problem sets will count for 10% toward you final grade (see below under "Grades"). Exams: There will be two midterms and a final exam. The two midterms will be administered during regular class time, on February 27, 2002 and April 3, 2002. Midterm papers will be marked and returned to you in about a week. The final exam will take place on Tuesday May 7, 2002, starting at 8.30 am, place to be announced. There will be no make-up exams, and any conflicts or emergencies should be approved by Thomas Renstr m in advance of the exams. Grades: In determining your course grade, the following weights will be used: Homework: 10% Midterm 1: 20% Midterm 2: 20% Final Exam: 50% If a midterm exam is missed for a legitimate reason which has been pre-approved by me, the other midterm will count toward 40% of the final grade and the final exam will count toward 50% of the final grade. Lecture notes Lecture notes, problem sets, and further communication will be posted on the web (see link above) Topics to be covered Decision-making under uncertainty: expected utility, risk aversion, risk premia, insurance premia, portfolio choice. Asset pricing: standard Capital Asset Pricing Model (CAPM), Zero-Beta CAPM, APT. Empirical testing of asset pricing relations Course literature Copeland, T.E., and J.F. Weston, Financial Theory and Corporate Policy, Addison-Wesley. Main course reference. Other useful references Chiang, Alpha C. (1984), Fundamental Methods of Mathematical Economics, McGraw-Hill. Useful for mathematical requirements. Easy to read. Elton, J., Edwin and Martin J. Gruber (1995), Modern Portfolio Theory and Investment Analysis, Wiley. Useful for empirical applications of asset pricing models. Huang, C.F., and R.H. Litzenberger (1988), Foundations for Financial Economics, PrenticeHall. Useful for topics not covered in Copeland and Weston, but slightly more difficult to read. Hull, John, (1997), Options, Futures, and Other Derivatives, Prentice-Hall. Useful for option pricing and explanation of continuous-time stochastic processes. Jonathan E. Ingersoll, Jr. (1987), Theory of Financial Decision Making, Rowman & Littlefield. Useful for complementing Copeland and Weston, but is a rather difficult text. Financial Markets: Theories & Evidence 3 Course outline Lecture 1: Return and Risk. Copeland and Weston: chapter 6 (part A, and B1-B3), appendix B. Return, Risk and Choice under Uncertainty. Copeland and Weston: chapter 4 (introduction + part A + part B), appendix B. Choice under Uncertainty: Risk and Insurance Premia. Copeland and Weston chapter 4 (parts C-D, F - H), appendix D (part D). Introduction to Mean-Variance Efficient Portfolios. Copeland and Weston: chapter 6 (parts B4-B6, E1, and E3). Huang and Litzenberger: chapter 3, parts 3.6-3.7, and first paragraph of part 3.8. Ingersoll: first two pages of chapter 4. The Efficient Frontier and Mean-Variance Efficient Portfolios. Copeland and Weston: chapter 6 (parts B4-B6, E1, and E3). Huang and Litzenberger: chapter 3, parts 3.8-3.10. Ingersoll: pp. 82-87. The Investment-Opportunity Set. Copeland and Weston: chapter 6, part C (part B and E can be substituted with lecture notes and/or Huang and Litzenberger). Huang and Litzenberger: chapter 3, parts 3.11-3.13; chapter 4, part 4.1. Ingersoll: pp. 87-88. The Capital Asset Pricing Model (CAPM). Copeland and Weston: chapter 6, parts E4-E5; chapter 7, parts A-F. (Results regarding fund separation in Huang and Litzenberger, pp. 83-92, and in Ingersoll, pp. 143-145, [146-162 more difficult material], and p.164.) Relaxing the assumptions: Zero-Beta CAPM, Taxation and Borrowing-Lending constraints. Copeland and Weston: chapter 7, parts G1, G3-G5. (Huang and Litzenberger, pp. 70-72.) The Arbitrage Pricing Theory (APT). Copeland and Weston: chapter 7, part J. (Huang and Litzenberger: chapter 4, parts 4.19-4.22. Ingersoll: chapter 7, pp.166-170.) Lecture 2: Lecture 3: Lecture 4: Lecture 5: Lecture 6: Lecture 7: Lecture 8: Lecture 9: Lecture 10: Empirical Applications of the Capital Asset Pricing Model. Copeland and Weston: pp. 212-219. (Optional reference: Elton, Edwin J., and Martin J. Gruber (1995), Modern Portfolio Theory and Investment Analysis, Wiley, pp. 341-355, 359-362.) Lecture 11: Empirical Applications of the Arbitrage Pricing Theory. Copeland and Weston: chapter 7, part K. (Optional reference: Elton, Edwin J., and Martin J. Gruber (1995), Modern Portfolio Theory and Investment Analysis, Wiley, pp. 374-388.) Financial Markets: Theories & Evidence 4 Lecture 12: Introduction to Options. Copeland and Weston: chapter 8, parts A-C. (Optional reference: Hull, John, (1997), Prentice-Hall, chapters (6)-7.) Lecture 13: Introduction to Continuous-Time Finance and Option Pricing. Copeland and Weston: chapter 8, parts E-F, H. (Optional reference: Hull, John, (1997), Options, Futures, and Other Derivatives, Prentice-Hall, chapters (10)-11.)

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