ECONOMICS 479
FINANCIAL ECONOMICS
Professor ThorntonWinter 2007
Th, 6:30-9:10 Pray-Harrold 317
Office and Phone: Pray-Harrold 707-F, 487-0080
Email:
Office Hours: T, Th, 3:00-3:30, 4:45-6:30, and by appointment.
Texts: Zvi Bodie and Robert Merton, Finance, Prentice Hall, First Edition, 2000.
Burton Malkiel, A Random Walk Down Wall Street, W.W. Norton and Company, 2003.
Financial Economics is the branch of Economics concerned with the allocation of scarce resources over time and under conditions of risk and uncertainty. Economic decisions involving time, risk, and uncertainty include consumption/savings decisions, asset allocation decisions, and borrowing decisions of households, and investment decisions, financing decisions, and dividend payout decisions of firms. When making these types of economic decisions, households and firms make use of financial markets. Financial markets play a pivotal role in the social organization of economic activity, and the outcomes of interactions that take place in these markets have important consequences for the wealth and prosperity of individuals, firms, and the nation as a whole. The objective of this course is to provide you with an understanding of important concepts and principles used in making rational economic decisions with costs and benefits that are uncertainty and spread over time, the types of financial markets that exist to facilitate these decisions, how these markets have evolved over time, and the efficiency of these markets. The focus of the course is on three important topics in financial economics: intertemporal economic decision making, economic valuation of assets, and risk management. Special attention will be given to the economic analysis of the stock market because of the important role it plays in the financial sector of the economy.
Your grade in the class will be based on two examinations, a midterm and final, two quizzes, and a book review. Each exam is 30% of your final grade, each quiz 10%, and the book review 20%. A three to five page review of the book, A Random Walk Down Wall Street, by Burton Malkiel is due Thursday, April 19th at the beginning of class. The book review should include a succinct summary of what the book is about and an evaluation of the author’s argument. To evaluate the author’s argument, discuss the essential message of the book, whether you agree, disagree, or are ambivalent about this message, and why.
OUTLINE OF TOPICS AND ASSIGNMENTS
1. Introduction to Financial Economics
a. What is financial economics?
b. Risk and uncertainty
b. Financial decisions of households and firms
c. Classical financial economics view of the household and firm
d. Objectives of the household and firm
Reading: Bodie and Merton, chapter 1.
2. Overview of the Financial System
a. Flow of funds in the economy
b. Functions of the financial system
c. Financial markets and institutions
c. Interest rates and rates of return on risky assets
d. Nominal and real interest rates and rates of return
Reading: Bodie and Merton, chapter 2.
3. Economic Interpretation of Financial Statements: Basic Concepts and Measures
a. Functions of financial statements
b. Balance sheet, income statement, statement of cash flows
c. Market value, accounting value, and intrinsic value
d. Fixed cost, variable cost, opportunity cost, and economic profit
Reading: Bodie and Merton, chapter 3.
4. Intertemporal Economic Decision Making
a. Time preference and time value of money
b. Present value, future value, discounting, and compounding
c. Rational economic decision making and net present value
d. Firm analysis of investment projects
e. Utility maximization and the intertemporal budget constraint
Reading: Bodie and Merton, chapter 4.
5. Risk, Uncertainty, and Risk Management
a. What is risk?
b. Risk exposure and risk management
c. Risk transfer: hedging, insuring, diversifying
d. Market mechanisms for transferring risk
Reading: Bodie and Merton, chapters 10, 11.
6. Introduction to Economic Valuation of Assets
a. Discounted cash flow valuation approach
b. Relative valuation approach
c. Law of one price and arbitrage
d. Information content of asset prices
Reading: Bodie and Merton, chapter 7.
7. Bond Market and Economic Valuation of Bonds
a. Institutional aspects of the bond market
b. Bond valuation
Reading: Bodie and Merton, chapter 8.
8. Stock Market and Economic Valuation of Stocks
a. Institutional aspects of the stock market
b. Stock valuation
Reading: Bodie and Merton, chapter 9.
9. Modern Portfolio Theory, Asset Pricing Models, and Economics of the Stock
Market
a. Choosing an investment portfolio and asset allocation
b. Efficient diversification among risky assets
c. Selecting a portfolio to maximize expected return and minimize risk
c. Capital asset pricing model
d. Arbitrage, multifactor, and regression asset pricing models
c. Efficient markets hypothesis
Reading: Bodie and Merton, chapters 12 and 13. Malkiel.
10. Financial Derivatives: Markets and Pricing
a. Forward contracts
b. Futures contracts
c. Swap contracts
d. Options contracts
Reading: Bodie and Merton, chapters 14, 15.