Financial Economics
Spring 2008
Vincent Chang
This course provides a basis in the neoclassical theory of finance that underlies other finance courses. This course is primarily concerned with static (one period) theories of finance. Following this course, students should be well prepared for further study of dynamic theories, continuous time finance, empirical finance and advanced corporate finance, and subsequently for doing research in finance.
The course will be lectured in English. Although there are no required textbooks, the following textbooks are recommended:
1. Stephen F. Leroy & Jan Werner, Principles of Financial Economics, Cambridge University Press, 2001
2. John H. Cochrane, Asset Pricing, Princeton University Press, 2001
3. Jonathan E. Ingersoll, Theory of Financial Decision Making, Rowman & Littlefield, 2000
Problems and exercises may be given throughout the lectures, but they will not be counted towards the class grade. The grade will be based on a midterm exam (40%) and a final exam (60%).
Course Outline
1. Finance and Data
a. Stylized Facts
2. Static Portfolio-Consumption Problem
a. Two States of Nature and Complete Markets
b. Arbitrary State Space: One Riskless Asset and One Ricky Asset
c. Finite State Space Model and General Portfolio Problem
d. Arrow-Debreu Markets
e. Complete Market and Options
3. Fundamental Theory of Finance
a. Absence of Arbitrage and Efficient Markets
b. Existence of Positive Linear Pricing Rule
c. Risk Neutral (Martingale) Probabilities and State Pricing
4. Arbitrage Pricing Theory
a. Basic Structure
b. Infinite Dimensional and Hilbert Space Approaches
5. Options, Derivatives and Other Financial Instruments
a. Options
b. Futures and Forwards
c. Valuing Options—Binomial Case
6. Introduction to Corporate Finance
a. Modigliani-Miller (MM) Theorem
7. Preferences and Uncertainty
a. Expected Utility Theory
b. Linear Risk Tolerance Preferences
c. Jensen’s Inequality and Risk Aversion
d. Ordering Preferences by Risk Aversion
e. Stochastic Dominance
f. Insurance and Certainty Equivalence
g. Alternative Psychological and Behavioral Approaches
8. Mean Variance Theory, Spanning and Separation Theorems
a. Distribution vs. Preference Based Approaches to Mean Variance Optimization
b. Skewness and Alternative Approaches
9. Capital Asset Pricing Model (CAPM)
a. Sharpe-Litner-Mossin Theory
b. Riskless Assets and Zero Beta Theory: Linear Pricing and Arbitrage
c. Roll’s Critique and Empirical Testing
d. Short Sales Restrictions and Borrowing Constraints
e. Systematic Risk, Performance Evaluation and Other Approaches
10. Asymmetric Information Models
a. Aggregation with Differential Prior Beliefs
b. Rational Expectations Equilibria: Conditioning on Prices
c. Agency and Signaling Models
d. Market Microstructure