Financial Economics I

This course introduces you to the basic ideas in finance. It uses two textbooks:

1. Investment Science by David Luenberger

2. Quantitative Financial Economics: Stocks, Bonds and Foreign Exchange by Keith Cuthbertson and Dirk Nitzsche

3. Investments by Zvi Bodie, Alex Kane, Alan J. Marcus and Pitabas Mohanty

The first two are two top books at the MSF / Ph.D. level. The third is simpler and elaborates on concepts in detail in a relatively simple manner, with lots of examples. The class will cover a substantial part of the first two books. In addition, the following are highly recommended general reading:

• A random walk down Wall Street by Burton G. Malkiel.
• Capital Ideas by Peter Bernstein.
• The Economics of Financial Markets by Houthakker and Williamson.

The class will also get a view of finance in India. This is a different locale, which a simple learning from the textbooks will not cover. Thinking about the Indian financial problems often has to be done from scratch, reasoning with empirical evidence and first principles. As of now, reading the Journal of Finance does not create expertise on India.

The course runs from 3rd July to 14th November. I plan to have a total of at least 26 lectures of 1.5 hours each. This will be a program of lectures by me and by guest speakers. I will repeatedly make demands upon your time as this is the only way the scheduling will work. There will be homeworks that demand substantial intellectual work on your part. You will be expected to achieve genuine knowledge. Neither rote memory nor algebraic manipulation will suffice.

This class does not cover:

• Fixed income derivatives
• Dynamic portfolio strategies
• Asset pricing theory beyond the foundations
• Corporate finance
• A serious treatment of financial intermediaries, e.g. banks, asset fund managers.
• Household finance

I expect to teach a Financial Economics 2 course (in Spring 2018), which will focus only on paper readings. There will be 30 lectures and each will contain one paper presentation. Each student is expected to study and present at least 2 papers. Each student will be expected to one research project. Financial Economics 2 will segue you from reading finance to doing finance. The purpose of Financial Economics 1 is to prepare you for Financial Economics 2.

Course evaluation

• All homework is expected to be submitted before the mid-term exam or in the extra sessions of discussions.
• All quantitative work will be done in the R statistical package.
• Evaluation will include:

  1. Exam on probability, 10 percent.

     Time-Date: 9:00-11:00, 14 January.

     The book for this exam is Sheldon Ross "A first course in probability", 8th edition, 2010. The material required to be mastered is from Chapters 2, 3, 4, 5, 6, 7 and 8.

     All those who want to audit this course must obtain higher than the passing grades in this exam.

  2. The National Certificate for Financial Markets (NCFM), Securities Markets (Advanced) Module exam, 10 percent for marks above 60 percent.

     Time-Date: anytime before the 9th of October.

  3. Mid-term exam, 30 percent.

     Time-Date: 4:15-6;15, 11 October.

  4. Final exam (full course content), 50 percent.

     Time-Date: To be finalised with Student Office.

Course structure

S1. Introduction to financial economics, 24 July

• What is a firm?
• The financing of firms: debt, equity.
• Types of firms.
• Relationship between creditors and shareholders in a limited liability firm.
• Measurement and the firm: Balance Sheet, P&L.
• Data sources.

S2. Markets: form and function, 28 Jul

• Securities for financing: bonds, shares
• Markets to trade securities
• Form: Microstructure
  • Products
  • Participants
  • Trading, clearing, settlement
  • Laws and regulation
• Functions:
  • Price discovery
  • Liquidity provision
  • Risk measurement and management

S3. Markets and microstructure, 3 Aug

• Microstructure of markets:
  • Different types of trading systems
  • Clearing as counterparty risk management
  • Settlement
• Examples of different markets and their microstructure:
  • National Stock Exchange
  • Muzaffarnagar Futures Exchange

S4. Basic concepts in finance, 14 Aug

S5. Basic concepts in finance: utility functions, 21 Aug

Exam on Probability 23 Aug

S6. Efficient markets and predicting returns, 4 Sep

• Market prices and returns
• What the efficient market hypothesis (EMH) implies for the data generating process of price?
• Tests of EMH, categorised by assumption of information:
  • Weak form: (examples - autocorrelation functions, runs tests, variance ratio)
  • Semi-strong form: (examples - event studies)
  • Strong form: (examples - tests of market timing, fund management expertise)

S7. Portfolio choice theory, 8 Sep

S8. Pricing risk -- the Capital Asset Pricing Model (CAPM), 11 Sep

S9. Portfolio measurement, CAPM and APT, 18 Sep

• Portfolio performance evaluation
• Factor models -- the Single Index Market Model and Arbitrage Pricing Theory

S10. Empirical evidence on CAPM and APT, 22 Sep

• Tests of CAPM: time series and cross-sectional approaches (Fama-Macbeth 1973)
• Tests of APT: factor models (Fama-French, 1993)

S11. Returns, prices and volatility, 22 Sep

• From expected returns to prices
• From prices to price volatility
• The volatility puzzle (Shiller, 1981; LeRoy-Porte, 1981)
• Variance tests

SG1. Guest Lecture, Harsh Vardhan The role of banks in finance, 14:30-16:00, 25 Sep

SG2. Guest Lecture, Ajay Shah. International portfolio diversification,16:30-18:00, 25 Sep

• Shifting the efficient frontier with foreign assets.
• Currency risk in international portfolio diversification.

S12. Derivatives and their pricing 2:30pm, 23 October and 10am, 10 November

• Derivatives: futures and options
• Pricing futures: cost of carry model
• Pricing options: no-arbitrage pricing approach
• Pricing options: Binomial lattice models

S13. Models of asset dynamics 11:30am, 10 November

• Calibrating the binomial lattice model
• Binomial models in pricing options
• Introducing Ito processes