CALDWELL COLLEGE

Department of Business Administration

SYLLABUS

BU 455 Financial Economics

Instructor: Anatoly Kandel

Prerequisite: BU 337, BU 338, BU 431, BU 440, BU 452

Required texts:

Eichberg J. and I.R. Harper, Financial Economics. Oxford Un-ty Press, 1997.

Varian H.R., The Arbitrage Principle in Financial Economics. Journal of Economic Perspectives, Vol. 1, Number 2, Fall 1987, pp. 55-72.

Gompers P. and J. Lerner, The Venture Capital Revolution. Journal of Economic Perspectives, Vol. 15, Number 2, Spring 2001, pp. 145-168.

This course builds on the prerequisite courses. Its purpose is to help students to integrate what they have already learned in the aforementioned courses. This integration equips students with a thorough understanding of the interplay between basic concepts in Economics and Finance. Step by step students will learn how the theory of efficiently functioning competitive markets for goods and services (Economics) laid ground for the theory of informationally efficient capital markets, how concepts of opportunity cost and risk aversion (Economics) laid ground for the concept of risk premium in return on risky asset, and so on. The course explains how the CAPM allows to distinguish between systematic risk and nonsystematic risk, and how diversification of assets reduces the systematic risk. Important connections between Economics and Finance are exemplified by Option Pricing, Debt and Deposit Contracts, and Venture (Entrepreneurial) Capital.

Topic 1 (1^st & 2^nd weeks). FINANCIAL ECONOMICS AS APPLICATION OF ECONOMIC THEORY TO PROBLEMS ENCOUNTERED IN FINANCE. The interplay between basic concepts in Economics and Finance. Our starting point is the competitive market model in which decision makers have symmetric information about their environments, face market-determined prices, and decide how much to buy and sell of particular goods and services. In this model, decision makers can specify, agree on, and eventually verify states of the world. They also are assumed to know each other’s preferences and beliefs. Under these assumptions contracts can be anonymously traded such that their equilibrium prices are arbitrage free. A transition to traders with asymmetric information. Financial institutions and contracts that have emerged as rational responses to a world in which information is asymmetrically distributed. In this course, we will repeatedly discuss fundamental economic forces that influence financial decisions.

Topic 2 (3^rd & 4^th weeks). CHOICES UNDER UNCERTAINTY. Financial decisions are intertemporal decisions: they involve choices whose consequences extend into the future. Modeling uncertainty by using a model of states of the world. The expected utility approach as the dominant paradigm of decision making under uncertainty. Ranking probability distributions according to their stochastic dominance. Attitudes towards risk. The risk premium as a difference between the expected value of a lottery and its certainty equivalent. Mean-variance analysis as a special case of the expected utility approach.

Topic 3 (5^th & 6^th weeks). PORTFOLIO CHOICE. From the equilibrium portfolio choice problem to the Capital Asset pricing Model (CAPM). The equivalence of the problem of choosing assets to hold in portfolio and the problem of choosing state-contingent wealth. The focus of our attention is again the concept that equilibrium prices should be free from arbitrage. If trade in asset markets is not to produce unbounded wealth, then asset payoffs and prices must be such that riskless arbitrage is not possible. A mean-variance utility function as the key instrument in establishing an explicit linear relationship among asset prices in an asset market equilibrium (CAPM).

Topic 4 (7^th & 8^th weeks). SYSTEMS OF FINANCIAL MARKETS. Key concepts: spot markets, contingent commodities, contingent claims markets, and ordinary security markets. Systemic and idiosyncratic risks. A special attention is paid to the problem of incompleteness of markets, namely, when some of idiosyncratic risks cannot be insured. When markets are incomplete, activities of decision makers are not well coordinated at equilibrium. The decision makers are limited in their ability to redistribute their incomes across different future contingencies. Instead of the standard Pareto efficiency, that is achieved under complete markets, the economic system has at best a constrained Pareto efficiency.

Topic 5 (9^th & 10^th weeks). ARBITRAGE AND OPTION PRICING. Every asset may have payoffs that can also be obtained by forming an appropriate portfolio of other assets. If markets are complete, then the payoffs to any asset can be synthesized by a portfolio of the existing assets. Since perfect substitutes must command the same price, the price of any asset must equal the price of a portfolio that replicates its payoffs. The possibility of arbitrage imposes constraints on asset prices. In complete (incomplete) markets these constraints uniquely (non-uniquely) determine the discount prices. Call and put option contracts. Option pricing according to the Black-Scholes formula.

Topic 6 (11^th & 12^th weeks). DEBT CONTRACTS AND DEPOSIT CONTRACTS. Moral hazard and adverse selection in insurance markets. Incentive compatible insurance contracts that provide no incentive for any agent to misrepresent his/her private information. Characteristics of incentive compatible debt contracts. Liquidity risk borne by the bank: even with a perfectly riskless investment, the bank may face a liquidity crisis if for some unforeseen reason more deposits are withdrawn than the bank holds reserves. Investment risk borne by the bank: if the investment is risky, the bank may incur losses and default on its obligations before the depositors. Characteristics of incentive compatible deposit contracts.

Topic 7 (13^th & 14^th weeks). VENTURE (ENTREPRENEURIAL) CAPITAL. This capital plays a role of a very important intermediary in financial markets, providing funds to small and young firms that might otherwise have difficulty attracting financing. Our focus is on key phases of the so-called venture capital cycle. This cycle starts with raising a venture fund; proceeds through the investment in, monitoring of, and adding value to small and young firms; continues as the venture capitalists exit successful deals and return capital to investors; and renews itself with the venture capitalists raising new funds. Review of empirical researches that show that venture funding has a strong positive impact on innovation.