Financial Market Theory Thursday, September 6, 2018 Professor Edwin T Burton

Class is Cancelled for Tuesday, September 11

A Key Assumption Made Throught This Course We will always assume, in this course, that anyone can either borrow or lend at the risk free rate As strange as it may sound, this assumption is actually true in the real world for any investor with substantial assets, including all pension funds, endowments, and foundations, though they may not know it. This simple assumption enables us to price many securities and contracts (such as derivative contracts like futures and options) with some precision. In one way or another, this assumption underlies all considerations of value in financial markets September, 6, 2018

How Does One Borrow at the Risk Free Rate? Simply sell any asset for which a futures contract exist Buy the futures Contract This identical transaction can occur with options: sell the asset, buy a call, sell a put short There will be transaction costs, but can be made to be minimal September, 6, 2018

Significance of Bankruptcy Allows for a clear cut distinction between debt and equity Can be a very smooth process with little or no disruption in the activities of the bankrupted entity Ultimately, the company can re-emerge from bankruptcy as NEWCO, with a much better balance sheet.

The Meaning of Diversification Problems with the “continuous state” theory of markets Viewing diversification in the finite state approach