FIN 6446: Financial Theory I

Instructor:   Charles B. Moss
              1175 McCarty Hall

The purpose of this course is to acquaint the student with basic principles of finance theory emphasizing the theory of the firm's investment and financing decisions. To accomplish this goal, this course will focus on basic concepts of decision making under risk, market efficiency, asset pricing, capital structure and dividend policy.

Texts:
- Required Readings.
  - Copeland, T.E. and J.F. Weston. 1988. Finance Theory and Corporate Policy third edition, Addison-Wesley Publishing Company.
  - Ingersoll, J.E. 1987. Theory of Financial Decision Making Rowman & Littlefield Publishers.
- Supplemental Readings
  - Debreu, G. 1959. Theory of Value. Yale University Press.
  - Fama, E.F. and M.H. Miller. 1972. The Theory of Finance. Dryden Press.
  - Hirshleifer, J. 1970. Investment, Interest and Capital . Prentice-Hall.
  - Levy, H. and Marshall S. 1984. Portfolio and Investment Selection: Theory and Practice .Prentice-Hall.

OUTLINE

Lecture I: Basic Concepts of Expected Utility Maximization

Axioms of Expected Utility Theory
- Readings
  - Copeland and Weston, Chapter 4
  - Ingersoll, Chapter 1
  - Moss, C.B. "A Financial Economics Perspective on Utility"
  - Fama and Miller, Chapter 5
  - Hirshleifer, Chapter 8
- Coverage
  - August 27: Expected Utility from the Economics Perspective pdf Notes.
    - Develop indirect utility function and expenditure functions to show linkage between microeconomic theory and financial economics view of utility.
    - Axioms of expected utility — build up mapping basis to support expected utility.
  - August 29: Risk Aversion pdf Notes
    - The basic concept of risk aversion. What does it mean? It is the only possibility?
    - Concepts of absolute and relative risk aversion.
    - Risk aversion in the large and small-a discussion of Pratt.
    - An alternative view-efficiency and stochastic dominance.
  - September 3: Using Expected Utility Directly pdf Notes.
    - The certainty equivalent of a risky gamble-Risk Premium and Insurance.
    - An application of the tree enclosures for young citrus.
    - Review of the lottery notion from Varian and linkage to von Nuemann and Morgenstern.
Applications in an Mean-Variance Setting.
- Readings
  - Copeland and Weston, Chapter 6
  - Ingersoll, Chapter 4
  - Levy and Sarnat, Chapters 7, 8, 10
- Coverage
  - September 5: Mean-Variance I pdf Notes.
    - Measurement of risk and return under normality.
    - Multivariate normality-risk and return on a portfolio.
    - Efficient portfolio -- the mean variance frontier.
  - September 10: Mean-Variance II pdf Notes and pdf Notes (Lecture05b)
    - Minimum variance portfolio.
    - Zero-beta portfolio, Black's theorem and short sales.
    - Efficient set with a risk-free asset.
  - September 12: Towards CAPM pdf Notes
    - Equivalence of mean-variance frontier and expected utility.
    - Optimal portfolio choice.
    - Derivation of the capital market line (CML).
State Preference Models
- Readings
  - Copeland and Weston, Chapter 5
  - Ingersoll, Chapter 2
  - Hirshleifer, Chapter 9
  - Debreu
- Coverage
  - September 17: Basic State Preference Model pdf Notes.
  - September 19: Building on State Preference Models pdf Notes.
September 24: No Class
Catch-up Day -- Quiz over Basic Concepts of Utility Maximization

Market Efficiency
- Readings
  - Copeland and Weston, Chapters 9, 10
  - Ingersoll, Chapter 3
  - Fama and Miller, Chapter 7
  - Levy and Sarnat, Chapter 19
- Coverage
  - October 1: Basic Concepts of Market Efficiency pdf Notes.
Asset Pricing
- Capital Asset Pricing Model
  - Readings
    - Copeland and Weston, Chapter 7
    - Ingersoll, Chapter 4
    - Levy and Sarnat, Chapter 11
  - Coverage
    - October 3: The Basic Capital Asset Pricing Model pdf Notes.
    - October 8: Switch Back to Market Efficiency
      - Cover the concept of the joint test of the CAPM and the hypothesis of efficient markets.
      - Review empirical evidence supporting market efficiency.
    - October 10: Makeup, Empirical Setup, Quiz
      - Review of market efficiency.
      - Empirical estimation of the CAPM (Generalized Least Squares).
      - Quiz over market efficiency.
    - October 15: Uses of CAPM Betas
      - Defining Risk Adjusted Discount Rates (RADRs) and Certainty Equivalents.
      - Use of RADRs and Certainty Equivalents in capital budgeting.
      - Concept of an event study.
      - Quiz over CAPM.
October 17: Midterm Examination

Arbitrage Pricing Theorem
- Reading
  - Ingersoll, Chapters 7
- Coverage
  - October 22: Overview of the Arbitrage Pricing Theorem
    - The factor model of asset returns.
    - Intuitive basis for arbitrage equilibrium.
    - Mathematical manifestations of arbitrage equilibrium
  - October 24: Review Midterm
  - October 29: Linear Factor Models and Arbitrage
    - Following Ingersoll, discuss the development of arbitrage equilibrium for two assets.
    - Start working the concepts behind multiple assets noting that this is the riskless arbitrage model.
  - October 31: Ross's Theorem
    - Finish the multiple asset model.
    - Provide the "proof" or a discussion involving risk. Highlight the more important parts of the proof without too much mathematics.
  - November 5: Risk Premiums and Discounts, Interpretations and Empirical Models
    - Discussion of what the parameters estimated in the Arbitrage Pricing Model mean and how they can be used.
    - Estimation and testing of the Arbitrage Pricing Model.
  - November 7: Finish and Quiz
    - Make up and review on the Arbitrage Pricing Theorem.
    - Quiz on the Arbitrage Pricing Theorem.

Term Structure of Interest Rates
- Readings
  - Copeland and Weston, Chapter 3
  - Ingersoll, Chapter 18
Option Pricing Theory
- Readings
  - Copeland and Weston, Chapter 8
  - Ingersoll, Chapter 14
  - Levy and Sarnat, Chapters 16, 17
- Coverage
  - November 19: An Overview of Options
    - What is an option?
    - Terminology.
    - Develop the concept of derived and contingent assets.
  - November 21: Pricing Options I
    - Two state and combinatorial pricing of options.
    - Introduction to Black-Scholes.
  - November 26: Pricing Options II
    - Finish Black-Scholes.
    - Advanced topics in option pricing.
    - Quiz on options.
Capital Structure Theory and Evidence
- Readings
  - Copeland and Weston, Chapters 12, 13
  - Ingersoll, Chapter 19
- Coverage
  - December 3: Capital Structure for a Corporation
    - Optimum capital structure for a sole proprietorship.
    - Corporation, arbitrage and the Modigliani-Miller theorem.
    - Implications for capital budgeting.
  - December 5: The Capital Structure Puzzle
    - Survey of literature -- Meyers
    - Empirical evidence -- Tittman and Wessels
Dividend Policy
- Readings
  - Copeland and Weston, Chapters 14, 15
- Coverage
  - December 10: Overview of Dividend Policy
  - Review
Final

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