1. Economics 434: The Theory of Financial Markets
Professor Burton
Fall 2016
August, 25, 2016

2. Update on Class Information
Office Hours: 11am-12pm Tues/Thurs at 1900 Arlington Blvd; Suite C
Monroe Office: Room 262,
VNB Office: Arlington Blvd., Suite C,
Student lunches almost every weekday
Class Website:
New Readings for This Week:
Chapters 1 – 3 in Textbook Section of Resources Tab in Collab
August, 25, 2016

3. Fundamental Concepts
Asset: something of value that represents real or potential monetary value in the future
Default Free: a security that pays exactly what it promises to pay
Risk Free: a security is risk free if the return is the same under all circumstances.
The Risk Free Asset: this is the risk free security with the highest return
The Risk Free Rate: the rate of return of the risk free asset
August, 25, 2016

4. Arbitrage
Buying and selling identical things simultaneously at different prices. An arbitrage profit means the selling price is higher than the buying price.
If the timing of the buy and sell are not the same, then arbitrage is a return higher than that of the risk free asset, even though the transaction is risk free.
August, 25, 2016

5. The No-Arbitrage Assumption
Most finance theory does not rely on equilibrium models (though traditional CAPM is an equilibrium model)
Instead, the usual assumption is that asset prices are such that no arbitrage opportunities exist
August, 25, 2016

6. Imagine a security that pays in each period:
So, what is risk?
Uncertainty?
Imagine a security that pays in each period:
$ 100 if a coin flip is heads
Minus $ 100 if a coin flip is tails
What do you expect to make, in each period, if you own this security? On average?
August, 25, 2016

7. August, 25, 2016