ECM C49F Financial Economics University of Toronto at Scarborough Travis NG Fall, 2005 Credit: This set of notes was first prepared by Prof. Walid Hejazi, Modified by Travis NG

Financial Economics Readings: Course package Textbook (optional): Thomas E. Copeland and J. Fred Weston, Financial Theory and Corporate Policy, Addison Wesley, 1988, third edition (STL) Evaluation: term test worth 50% final exam worth remaining 50% Important Dates: –Term Test: Oct 26, 2005 (Tentative) –Drop Deadline: Nov 6, 2005 –Final Exam: Dec Exam Period This course is designed to introduce students to financial economics. Students will acquire an understanding of the major issues, models, and empirical tests employed in the modern financial economics literature.

Financial Economics Topics to be covered: A) Inter-temporal Optimization of Consumption B) Net Present Value C) Expected Utility Theory D) Asset Pricing Capital Asset Pricing Model (CAPM) Arbitrage Pricing Theory E) Option Pricing Theory F) Market efficiency This material provides students with the necessary knowledge in financial economics to either pursue a career in the financial services sector or proceed to graduate school.

Why the hassles? People on Bay Street knows CAPM, Option pricing, Black-Scholes, Arbitrage, Hedging, Market efficiency hypothesis. They use these knowledge to talk about things around us. E.g., Martha Stewart’s case. (Insider Trading undermines Market efficiency hypothesis?) People do talk about finance. You want to talk with them with a background knowledge to screen the reasonable comments from the unreasonable ones. Ultimately you want to deal with your personal finance by investing with an understanding of financial theories rather than investing with nothing to back you up. Prerequisites Strong understanding of Microeconomics Comfortable Statistics background –A good source of review for probability theory: –

Financial Economics Students will acquire the necessary tools to answer the following kinds of questions: A) Inter-temporal Optimization of Consumption 1) Why do we care about allocation of consumptions across time? What is the objective of an individual investor? What does that have to do with finance? 2) How can we allocate wealth across time? 3) What are the vehicles available to individuals to allocate wealth inter-temporally? (Non-marketable, money market, capital market, derivatives market, investment funds, real assets) Short Answers: 1) Investor’s objective is to maximize utility (happiness). Our utility depends not only on present consumption but also consumptions in the future. By participating in financial market, we can efficiently achieve our objective of maximizing utility. 2) By investing/dis-investing in real assets or financial assets 3) a) Real assets – land, buildings and equipment that are used to produce goods and services, b) Financial assets – claims such as securities to the income generated by real assets

Financial Economics B) Net Present Value 1) What is the objective of the firm? 2) What is the relationship between shareholder’s lifetime consumption and the firm’s value? 3) What is firm’s value? 4) How to maximize firm’s value? Short Answers: 1) Firm’s objective is to maximize the net present value of shareholder’s lifetime consumption. 2) Shareholder’s lifetime consumption is maximized if the firm’s value is maximized. Such maximizing is reflected by the price per share of stock. 3) Firm’s value = Discounted value of future expected cash flows. 4) Invest all projects that has positive net present value.

Financial Economics C) Expected Utility Theory 1) How people make choices under uncertainty? 2) How do we deal with risk? 3) How to identify our risk preference? 4) How much will an individual have to pay in order to reduce a certain amount of risk he faces? Short Answers: 1) They try to maximize their expected utility under uncertainty. 2) Depends on our risk preference. We may hedge risk (e.g., buying insurance) if we are risk-averse. 3) If we are willing to pay to reduce the risk we exposed, we are risk-averse. If we are not willing to do so, we love risk. 4) This is equivalent to calculating risk premium which can be achieved by various method. The drawback is it requires the specific utility function of that individual.

Financial Economics D) Asset Pricing - CAPM 1) What is risk? 2) What is the capital market line? What is the security market line? 3) What is beta? 4) How to measure individual security’s beta? 5) What is the empirical challenges of testing CAPM? Short Answers: 1) Risk is comprised of a) non-systematic (non-diversifiable) risk, which requires a reward in the form of risk premium; and b) systematic (diversifiable) risk, which does not. 2) CML depicts the eqm. Conditions that prevail in the market for efficient porfolios. It gives graphical illustration of the trade-off between expected return and total risk for efficient porfolios; SML graphically depicts CAPM, which relates the expected return on an individual security or portfolio to its market risk as measured by beta. 3) A measure of volatility for stock or portfolio returns. 4) Regress (time-series) total returns for that security against total returns for a market index. Beta is then the estimated coefficient of the later. 5) Empirical evidence remains inconclusive. CAPM is an ex ante model while it is tested with ex post data. However, the important issue is whether the theory provides predictive power.

Financial Economics D) Asset Pricing – Arbitrage Pricing Theory 1) What is arbitrage? 2) How to achieve a well-diversified portfolio? 3) What is the relationship between CAPM and APT? 4) What is an equilibrium in APT? Short Answers: 1) A zero-risk, zero-net investment strategy that still generates profits. When the law of one price assumption is violated, there is an arbitrage opportunity. 2) Equally-weighted portfolio is one example. However, any portfolio for which each security’s weight becomes consistently smaller as the number of securities in the portfolio gets large is well-diversified. 3) They both equilibrium asset pricing models developed to determine the market price for risk and the appropriate measure of risk for a single asset. CAPM is a special case of APT when market rate of return is assumed to be the single relevant factor affecting return of all assets. 4) An equilibrium exists if there is no arbitrage opportunities. APT is derived from setting the conditions of no arbitrage.

Financial Economics E) Option Pricing Theory 1) What is a derivatives? 2) How to define a call option? 3) Can we trade European options in Chicago Board of Options Exchange (CBOE)? 4) What is the single most distinct feature of pricing options? Short Answers: 1) A financial instrument whose value depends on the values of other, more basic underlying variables. Usually the variables underlying derivatives are the prices of traded assets, e.g., stock. 2) A call option gives its holder the right to buy the underlying asset by a certain date for a certain price. 3) Of course, it has nothing to do with geography. 4) To recognize the non-linear payoff structure of options.

Financial Economics F) Efficient Capital Markets 1) What is an allocationally efficient capital market? 2) What is an operationally efficient capital market? 3) Does perfect capital market imply efficient capital market? 4) When would prices of assets be correct signals for capital market participants? Short Answers: 1) When prices of assets are determined in a way that equates the marginal rates of return (adjusted for risk) for all producers and savers. 2) When the intermediaries, who provides the service of channeling funds from savers to borrowers, do so at the minimum cost that provides them a fair return for their services. 3) Yes, but not the reverse. 4) If prices of assets fully reflect all available information.

How to succeed? First Priority –Master the Lecture Notes provided. –Attend the lectures. Most of the questions and material for the term test and final exam will be covered directly in the lectures Second Priority –Old term tests and exams are also provided –There will be overlap between these and the term test and final exam you receive –Look at these old tests and exams early – it will be helpful! Last Priority: Textbook –The textbook is tough. Read it to the extent it reinforces your understanding of materials covered in lectures –I will not test on materials from the book that is not directly covered in lectures