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Seminar in Finance I (Finance Theory)

Course Number:

47721


Faculty

Bryan Routledge, rout@andrew.cmu.edu


Program

PHD


Concentrations

Finance


Course Description

Our course considers the equilibrium in financial markets.  Equilibrium is, of course, simply prices that make “supply” equal “demand”.  In finance, the notions of  “supply” and “demand” are ambiguous since anyone can buy or sell a financial security (what is a financial security?  Good question).  However, this ambiguity is actually very helpful.  In particular, the easy ability to buy and sell is behind the “no arbitrage” condition that is the bedrock of modern finance (analogous to the “perfect competition” setting in microeconomics). 

Finance is the allocation of resources across states and time.  We will start with allocation across states – that is a static, single period model.  Allocation of resources across states is “risk.”  What is it?  We look at arbitrage and its implications, preferences over risky outcomes, portfolio choice, and equilibrium.  Surprisingly (or not) all these topics are tightly related.  Next up we look at the dynamic models.  The topics are the same.  We now just incorporate the new dimension of time along with states.  Here we look at dynamic arbitrage, dynamic preferences, and dynamic portfolio choice.  Lastly we look at equilibrium asset returns.  Here we explore some of the classic issues in finance about the dynamics of equity returns (the equity premium, for example).

Finance is a heavily quantitative branch of economics.  This means that models are judged by how well they help understand, illuminate, explain, contradict, and “fit” measured economic quantities.   Necessary and sufficient conditions for an equilibrium or the sign of a comparative static are important and interesting questions.  But they are not quantitative.  The equity risk premium (the unconditional expected return of a broad portfolio of stocks over a short-term risk free bond; $E[r_{m,t}-r_{f,t}]$) is measured in the data at 6\%. An asset pricing model that makes a quantitative statement about the level of the equity risk premium is quantitative.   

From the lens of the quantitative model, we can ask if 6\% is a big number or whether or not it matches the level of risk we see in other measured aspects of the economy?  There are many other such quantitative questions across all aspects of finance.   (And, of course, there are many interesting quantitative economic questions outside of finance as well.)

Most of our course will be model-based and not directly empirical.  However, the empirical facts will lurk in the background (and occasionally the foreground).   The more you know of the facts (or perhaps, what people believe to be the facts), the better you will be able to identify interesting areas of research.


Format

Lecture: 100min/wk and Recitation: 50min/wk


Pre-requisites

None