Finance 2: Investors and Markets The plan for this Monday April 20, 2009: Practical info; text-book, APSIM, lectures, tutorials, hand-ins, exam, … Scientific contents; the big picture and Sharpe’s Chapter 1. Trading and equilibrium in a simple state- preference model; Sharpe’s Chapter 2.

Practical Matters, I Text-book: W. Sharpe (200[6-7-8]), ”Investors and Markets”, Princeton. Important tool: The APSIM-program which is a (C++-based) Excel plug-in. Get that working on your computer. (Installation problem-free on my XP-laptop. C-drive- acces; Excel security-level. Vista, Linux, Mac … ?)

Practical Matters, II The schedule is lectures 8-10 on Mondays and Wednesdays, and tutorials (w/ Cathrine)13-15 on Wednesdays. ”Odd holidays” and other external factors mean: look at the plan on the course homepage. Should we try to move tutorials?

Practical Matters, III: Evaluation 3 test elements: Hand-In #1. Posted soon. Deadline Monday May 11. Groups of up to 3 are OK. Theme: Manual trading or DIY APSIM 2-hour written exam on Wednesday June 3. ”Pop quiz” in Sharpe. Individual; no cooperation. Hand-In #2: Posted early June. Deadline Friday June 26. Probably freedom of choice. Cooperation is fine, but answers must be individually composed. Final grade (on the 7-scale) is a (~ equally) weighted average of performance on the 3 elements.

Scientific Contents, I You have had courses in microeconomics. Did you think that the dicussion of general equlibrium was too abstract? seen CAPM. Did you think that the equilibirum considerations were partial at best? seen (binomial-model) option-pricing. Did you ever wonder why there are markets for options?

Scientific Contents, II Well, that is what we going to fix. The more dull version is that we study portfolio choice, asset prices and equilibrium in state- preference models. One period, finite #outcomes makes the math (although not necessarily the algebra) simple. Our approach: Experimental; or ”simulation” as Sharpe says.(”Numerical”, ”empirical” could be used too.)

Scientific Contents, III: Sharpe Ch. 2: Trade-to-equilibrium in a simple model. Ch. 3 (Preferences) and 4 (Prices) is ”standard text-book stuff”, but with twists. We uncover details of the trading process. Ch. 5 (Positions): Standard texts mention ”wealth and utility heterogeneity” but usually don’t do anything about it.

Scientific Contents, IV: Sharpe Ch. 6 (Predictions): What if people differ in their the assesments of probabilities? Theory is tricky, experiments are easy. Ch. 7 (Protection): Introducing option-like structures and finding both buyers and sellers.(Meaningful financial engineering.) Ch. 8 (Advice): Uncovering people’s preferences.

Scientific Contents, V: Post-Sharpe We’ll finish Sharpe ~ June 1. Then we could look more closely at option pricing aspects; ”marginal” vs. ”full equilibrium” in incomplete models investigate multi-period investments; dynamic programming, ”myopia” and the Kelly criterion

Sharpe’s Chapter 2 Agents are equipped with initial portfolios and then they trade via a market maker. Equilibrium (”ligevægt”) is when no further trades can be made.

Sharpe’s Chapter 2 The procedure (see Fig. 2.6): Agents submit reservation prices Market maker post a trading price as the average of these Agents submit buy/sell quantities Buy and sell orders are matched as best possible Repeat over securities, rounds ’till equilibrium is reached Alternative – less colorful – version is: this is a numerical procedure for solving first order conditions for equilibrium.

Sharpe’s Chapter 2 Market Risk-Reward Theorem (MRRT) Only market risk is rewarded with a higher expected return. You are not rewarded for taking risk that could be diversified away. A very sobering principle. If you think ”market risk” is vague: fair enough … CAPM is one case where MRRT holds. (Here, the expected return relation is linear; it needn’t be)