Course description

Theory of Financial Markets


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 begins with Markowitz’s portfolio theory and the Capital Asset Pricing Model (CAPM). We then move on to more theories: Merton’s Intertemporal CAPM, Consumption CAPM and the Arbitrage Pricing Theory. These theories allows us to examine the efficiency of financial markets in view of their role. We then look at how investor behavioural biases may affect the workings of financial markets and close with the fundamentals of pricing contingent claims. 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

  • The role of financial markets and institutions
  • Consumption, production and investment decisions
  • Fundamental valuation and market efficiency

Part II: Portfolio choice and linear factor models

  • Mean-variance portfolio choice
  • Capital Asset Pricing Model
  • Arbitrage Pricing Theory

Part III: Principles of asset pricing

  • Consumption and Intertemporal CAPM
  • State-preference theory
  • Risk-neutral pricing

Part IV: Market imperfections

  • Asymmetric information
  • Behavioral theory and limits to arbitrage

Learning outcome knowledge

At the end of the course, the students should be able to understand the theory of financial markets and apply the asset pricing models in practice.

Acquired 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 the financial markets and how this is connected with their role
  • Why asset pricing and understanding the relation between return and risk is fundamental in finance
  • The classical asset pricing theories: CAPM and APT
  • The connection between consumption risk, consumption and investment choices and the risk-return relation
  • The fundamental theorem of asset pricing, i.e. the connection between arbitrage, the law of one price and linear pricing.
  • How information aggregates in a financial market
  • Certain market imperfections and failures

Exam organisation

  • Written exam: 30%
  • Written exam: 70%