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

2. Class is Cancelled for Tuesday, September 11

3. 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

4. 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

5. 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.

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