Michael Magill
Kaprielian 316 b
Tel: 740 2104
Fax: 740 8543
Office Hours: Mon, Wed 4-5 pm
e-mail: magill@usc.edu
Class meeting: M-W 10-11:50am, KAP147
TA: Dmitri Kantsyrev

Discussion Board

Assignments

OBJECTIVE

A student taking this course will learn the fundamental empirical facts, theoretical concepts and mathematical models of the modern theory of financial markets. There are two general approaches to analyzing financial markets: the first is general equilibrium-this approach is essential for understanding the role that financial markets play in a modern economy, how they achieve risk sharing and coordination of decisions and how new information changes the course of prices over time. The second approach is partial equilibrium-no attempt is made to solve for the whole general equilibrium of the economy, most elements are taken as exogenously given (for example prices of primitive securities) and detailed analysis of the remaining financial markets is undertaken. Partial equilibrium analysis is based on the principle of absence of arbitrage and the most striking example of this approach is the Black-Scholes theory of option pricing which has so profoundly changed the way the Wall Street thinks about the dynamic management of complex forms of financial risk.

GRADING

The final grade will be based on biweekly homeworks (40%), a midterm exam (20%), and a final exam (40%).

REQUIRED TEXTBOOKS

• Magill, M. and M. Quinzii (1996), Theory of Incomplete Markets, MIT Press, (MM+MQ).
• Hull, J.C.(2003), Options, Futures, and Other Derivatives, Prentice Hall, New Jersey. (JH)

OTHER TEXTBOOKS

• Cox, J.C. and Rubenstein (1985), Options Markets, Prentice-Hall.
• Brigo, D.and F. Mercurio, (2002), Interest Rate Models: Theory and Practice, Springer Verlag.
• Benninga, S.(1997), Financial Modeling, Cambridge, MIT Press,
• Huang, C. and R.H. Litzenberger (1988), Fundamentals of Finance, Amsterdam: North-Holland.
• Rebonato, R., (1998), Interest Rate Option Models, Wiley, Chichester.

FUN READING

• Malkiel, B.G. (1973), A Random Walk Down Wall Street, New York: Norton.
• Galbraith, J.K. (1993), A Short History of Financial Euphoria, New York: Viking.
• Mackay, C. (1841), Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, London: Bentley.

COURSE CONTENT

1. Understanding Financial System: key facts and basic components: stocks, bonds, options, insurance, futures; the role of government and monetary policy: domestic versus international finance; getting to know the numbers ( historical time series and basic magnitudes of the key financial sectors).

• Mishkin, F.S. (1995), The Economics of Money, Banking and Financial Markets, 4th Edition, New-York: Harper Collins : Chapters 1,2.
• Magill handout on Basic Financial Time Series.
• Cootner, P. (1967), The Random Character of Stock Market Prices, Cambridge, Mass.: MIT Press.
• Slutsky, E.E. (1937), ``The Summation of Random Causes as the Source of Cyclic Processes'', Econometrica}, 5, 105-146, translation of Russian original in Problems of Economic Conditions, (1927), vol. 3, edited by the Conjuncture Institute, Moscou. Statistical Abstract of the United States, 1998, sections 1, 10,14,15,16,17.

2. Modeling Financial Markets: Describing uncertainty: states of nature, events, information partitions and probability. Space of random variables. Decision making under uncertainty: preference orderings expected utility, measures of risk aversion and comparative statics: formalizing the behavior of agents in an environment of uncertainty . the crucial simplifying assumptions that may sometimes not well represent the way agents actually behave under uncertainty: we have very few satisfactory models of boundedly rational behavior, even though we are very sure that is how agents in fact behave! The validity of our models rests on the fact that they are first approximations which are sufficiently good approximations in many settings. Rational expectations and equiibrium models; real and financial sectors of the economy.

• M. Magill and M. Quinzii: Theory of Incomplete Markets, MIT Press, 1996 (MM+MQ), sections 1-5.
• Muth, J.F. (1961), ``Rational Expectations and the Theory of Price Movements'', Econometrica, 29, 315-335.
• Simon, H.A. (1979a), Models of Thought, New Haven: Yale University Press.
• Simon, H.A. (1983), Reason in Human Affairs, Stanford: Stanford University Press.
• Williamson, O. (1985), The Economic Institutions of Capitalism, New York: Free Press.

3. Contingent Market Equilibrium: characteristics of finance economy; contingent contracts and contingent market equilibrium (also called Arrow-Debreu equilibrium). An ideal market structure, not observed in the real world, but of great theoretical importance as a reference concept: the foundation of the analysis of the efficiency of any other structure of contracts or markets.

• MM+MQ, Sections 6,7.
• Arrow, K.J. (1964): ``The role of securities in the optimal allocation of risk bearing'', Review of Economic Studies, Vol. 31 (1964), pp. 91-96.

4. Financial Market Equilibrium: market structure under uncertainty: bounded rationality, opportunism and incomplete markets; why real world market structure consists of spot markets for goods, financial markets for income and the use of money: basic types of financial contracts; bonds, stocks, insurance, futures, options; portfolio choice problem and concept of financial market equilibrium. The market subspace, absence of arbitrage, existence of state prices and basic asset pricing equation. Complete and incomplete markets: proof that agents gradient vectors are distinct when markets are incomplete. Inefficiency of markets. Special conditions when markets are Pareto optimal even with incomplete markets: LRT preferences: constrained efficiency.

• MM+MQ, Sections 8, 11-13
• Fisher, I. (1930), The Theory of Interest, New York: Macmillan. Reprinted by Augustus, M. Kelley, New York, (1960).
• Working, H. (1958), ``A Theory of Anticipatory Prices'', American Economic Review, 48, 188-199.
• Magill, M. and M. Nermuth (1986), ``On the Qualitative Properties of Futures Market Equilibrium'', Journal of Economics, 46, 233-252.

5. Absence of Arbitrage and Asset Pricing Theory: absence of arbitrage opportunities equivalent to existence of vector of strictly positive state (present value) prices such that the price of every security equals the present discounted sum of its future dividends (under these state prices). Proof of theorem. Its consequences first for equilibrium , and second for partial equilibrium theories of valuation using no-arbitrage. First approach using equilibrium theory-- motivation via CAPM model ; general theory of risk pricing of assets based on the concept of ideal asset: absolute and relative valuation formulas. Representative agent analysis with complete markets.

• MM+MQ, Sections 9, 14-17.
• Markowitz, H. (1952), ``Portfolio Selection'', Journal of Finance, 7, 77-91.\11
• Markowitz, H. (1959), Portfolio Selection: Efficient Diversification of Investments, New York: Wiley.
• Sharpe, W.F. (1964), ``Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk'', The Journal of Finance, 19, 425-442.
• Tobin, J. (1958), ``Liquidity Preference as Behavior Towards Risk'', The Review of Economic Studies, 26, 65-86.

6. Stock Market and Options: in economy with firms facing idiosyncratic and aggregate shocks simple and complex options can serve to complete the markets: in an environment with moral hazard in the provision of effort by CEO's options can create the appropriate incentives to resolve the moral hazard problem. Options as one of the remarkably efficient instruments for bringing us a long way back towards an Arrow-Debreu equilibrium.

• Ross, S.A. (1973), ``The Economic Theory of Agency: The Principal's Problem'', American Economic Review, 63, 134-139.
• Ross, S.A. (1976), "Options and Efficiency" Quarterly Journal of Economics, 90,75-89.
• M. Magill and M. Quinzii, Equity, Options, and Efficiency in the Presence of Moral Hazard, Working paper, University of Southern California, July 1998.

7. Stochastic Financial Markets: extending analysis of financial markets to stochastic (i.e. dynamic-uncertainty) framework where information unfolds gradually and agents trade on the basis of newly acquired information. Frequent trading increases spanning. Long-lived contracts, capital values and the term structure of asset prices.

• MM+MQ, Sections 18-22.
• Duffie, D. (1992), Dynamic Asset Pricing Theory, Princeton: Princeton University Press, chapter2.
• Breeden, D. (1979), ``An Intertemporal Asset Pricing Model with Stochastic Consumption and Investment Opportunities'', Journal of Financial Economics, 7, 265-96.
• Cox, J., J. Ingersoll and S. Ross (1985a), ``An Intertemporal General Equilibrium Model of Asset Prices'', Econometrica, 53, 363-84.

8. Term Structure of Interest Rates: Equilibrium models of term structure:

• JH, Sections 23.1-23.6.
• Cox, J., J. Ingersoll and S. Ross (1985b), "A Theory of the Term Structure of Interest Rates'', Econometrica, 53, 385-407.
• Vasicek, O. A., "An Equilibrium Characterization of the Term Structure", (1977), Journal of Financial Economics, 5, 177-188.
• No-Arbitrage model of term structure: JH, Sections 23.7-23.12.

9. Informational Efficiency of Asset prices: fundamental valuation formula is equivalent to the informational efficiency of asset prices. In an FM equilibrium an asset price is always the best estimate of the future value of its dividend stream. The phenomenon of excess price volatility on stock market: excess volatility of long-term bond prices. Vernon Smith's lab experiments confirm the presence of bubbles in experimental asset markets. Explaining speculative bubbles.

• MM+MQ, Sections 26-28.
• Samuelson, P.A. (1965), ``Proof that Properly Anticipated Prices Fluctuate Randomly'', Industrial Management Review, 6, 41-49.
• Samuelson, P.A. (1973), ``Proof that Properly Discounted Present Values of Assets Vibrate Randomly'', Bell Journal of Economics and Management Science, 4, 369-374.
• Smith, V.L., G.L. Suchanek and A.W. Williams (1988), ``Bubbles, Crashes and Endogenous Expectations in Experimental Spot Asset Markets'', Econometrica, 56, 1119-1151.

10. Production and theory of the firm: How contingent market equilibrium is adapted to incorporate firms, why firms necessarily seek to maximize the present discounted sum of future profits with contingent markets. Sole proprietorship, partnerships, and corporations. Corporations: market value maximization: financial policies of corporations.

• MM+MQ, Sections 29-32.

11. Monetary Economy: introduction of spot markets for good at each date-event; concept of a spot-financial market equilibrium, also called general equilibrium with incomplete markets (GEI). Types of financial contracts: real contracts are inflation proof (equity, equity options, futures contracts): nominal contracts (bonds, financial options: introduction of money: monetary equilibrium and the real effects of money when markets are incomplete. Changes in monetary policy are neutral if all contracts are real or if there are nominal contracts and markets are complete: if markets are incomplete and there are nominal contracts then changes in monetary policy change the real equilibrium allocation.

• MM+MQ, Sections 33-37.
• Friedman, M. (1987), ``Quantity Theory of Money'', in The New Palgrave: A Dictionary of Economics, J. Eatwell, M. Milgate and P. Newman eds., London: Macmillan.
• Magill, M. and M. Quinzii (1992), ``Real Effects of Money in General Equilibrium'', Journal of Mathematical Economics, 21, 301-342.
• Magill, M. and M. Quinizii (1995), ``Which Improves Welfare More: Nominal or Indexed Bond? '', Economic Theory, 10, 1-37.