Course description

Theory of Financial Markets

Introduction

The course looks at the purpose of finance and the role of financial markets in an economy. A big part of this theory looks at how asset prices are determined, which includes Markowitz’s portfolio theory, the Consumption-based Capital Asset Pricing Model, the Capital Asset Pricing Model (CAPM), Merton’s Intertemporal CAPM, Arbitrage Pricing Theory, and Production-based Asset Pricing. These theories allow us to examine why and how asset prices are determined. We also examine the concept of market efficiency and how investor behavioral biases may affect the workings of financial markets. The course is rigorous and requires good knowledge of basic calculus and linear algebra. Nevertheless, each topic includes and is motivated by real life examples to be able to relate theory with practice.

Course content

Part I: Fundamentals

  • Fundamental valuation and market efficiency
  • The role of financial markets and institutions

Part II: Portfolio choice

  • Mean-variance portfolio choice

Part III: Principles of asset pricing

  • Consumption CAPM
  • Risk-aversion and risk-neutral pricing
  • CAPM, ICAPM, APT
  • Production-based Asset Pricing

Part IV: Asset Pricing Tests and Market imperfections

  • Tests of asset pricing models
  • Asymmetric information
  • Behavioral theory and limits to arbitrage

Learning outcome knowledge

The students at the end of the course are expected to know

  • The role and value of financial markets in an economy
  • The concept of the efficiency of financial markets
  • Why asset pricing and understanding the relation between return and risk is fundamental in finance
  • Classical asset pricing theories: CCAPM, CAPM, APT, etc.,
  • The connection between consumption risk, consumption and investment choices and the risk-return relation
  • The fundamental theorem of asset pricing
  • How information aggregates in a financial market
  • Certain market imperfections and failures

Exam organisation

  • Written exam: 25%
  • Written exam: 70%
  • Class participation: 5%