Economics 633
FINANCIAL ECONOMICS
AMERICAN UNIVERSITY
SPRING 2009
Professor Callahan
119 Roper Hall
(202) 885-3737
E-mail: colleen@american.edu
Office Hours: Tuesdays and Fridays 10-11 and 4–5,
Wednesdays 2-4, and by appointment
GOALS OF THE COURSE
At its core, economics is the study of how to best allocate scarce resources. The way in
which those scarce resources should be optimally allocated over time is the focus of the
sub-field of economics known as finance, which has become both popular and
sophisticated over the past two decades. The costs and benefits of financial decisions are
often challenging to evaluate since they are spread out over months or years and are not
known with certainty. The goal of this course is to develop and apply the main tools of
modern finance in order to understand the crucial role of financial markets and financial
decision making in the economy.
We will pay special attention to theories of how assets are priced, including the pricing of
financial derivatives such as options and futures. We will also examine the possible
explanations for the recent financial market turmoil, including events in the mortgage
markets, bond markets and stock markets around the world.
BY THE END OF THIS COURSE, YOU SHOULD BE ABLE TO:
• Explain the ways in which financial markets can contribute (or not) to economic
efficiency and the transfer of risk
• Analyze the principles that underlie optimal portfolio strategies
• Understand the theory of options pricing and its various applications
• Explain the role of the “no arbitrage” condition
• Evaluate hedging strategies
• Describe the development of asset securitization and the risks it may pose, as in the
case of certain mortgage-backed securities
• Use models of securities prices in discrete time
• Understand the limits of the efficient markets hypothesis (EMH)
• Use the capital asset pricing model (CAPM) and its extensions to value securities and
understand the limitations of the theory
• Explain the key insights of “behavioral finance” along with its critique of traditional
finance
• Articulate the possible explanations for the ongoing turmoil in global financial
markets, including the markets for mortgages, mortgage-backed securities, bonds, and
stocks
REQUIRED TEXTBOOK
Cvitanic and Zapatero, Introduction to the Economics and Mathematics of Financial
Markets, MIT Press, 2004.
REQUIRED READINGS
There are a number of journal articles that can be accessed via the Blackboard site for this
course. Look under “E-reserves” or “External Links” for most of the articles. A list of
articles is provided on the weekly schedule of topics.
EVALUATION
There will be one midterm and a final exam, along with four problem sets. (I will include
only your top three scores on the problem sets in computing your final grade.) You may
discuss the problem sets with other students in the class. However, you must write your
own answers to the questions.
You are also required to complete a 10-page paper, which will comprise 25% of your
final grade. The topic is subject to my approval. (This assignment does not meet the
research requirement of the master’s program.) A preliminary outline must be submitted
to me (one page is sufficient) on or before March 18. The paper will be due on the last
day of class, April 22.
Midterm
Problem sets
Paper
Final exam
Important dates
March 4
Throughout semester
April 22
May 6 (Wednesday)
% of final grade
30%
15%
25%
30%
POLICY ON LAPTOPS
Please use your laptop in a responsible way and only for class-related activities. Do not
use it to surf the internet or check e-mail during class.
ACADEMIC INTEGRITY: Standards of academic conduct are set forth in the
University’s Academic Integrity Code. By registering at the university, you have
acknowledged your awareness of the Academic Integrity Code and you are obliged to
become familiar with your rights and responsibilities as defined by the Code. Violations
of the Academic Integrity Code will not be treated lightly, and disciplinary actions will
be taken should such violations occur. Please see me if you have any questions about the
academic violations described in the Code in general or as they relate to particular
requirements for this course.
IF YOU NEED HELP
Please contact me as soon as possible either by e-mail, by telephone, or by visiting my
office. Together we can develop a plan to address whatever problems you may be
experiencing.
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SCHEDULE OF TOPICS
AND REQUIRED READINGS
Most of the journal articles listed below can be accessed via the “E-reserves” or
“external links” section of the Blackboard site for this course.
“C and Z” refers to the textbook by Cvitanic and Zapatero
Wednesday, Jan.14
Overview: The Role of Finance in the Economy
• Households and Firms
• The US Financial System
• Principles of Finance
• Financial markets and economic growth
Readings:
C and Z: pp. xx-xxii, and Chapter 1
AND
Varian, Hal. “A Portfolio of Nobel Laureates:
Markowitz, Miller, and Sharpe,” Journal of
Economic Perspectives, Winter 1993, pp. 159-169.
Levine, Ross and Sara Zervos. “Stock Markets,
Banks and Economic Growth,” American Economic
Review, Vol. 88, June 1998, pp. 537-558.
Cochrane, John. “New Facts in Finance,” NBER
Working Paper # 7169, June 1999.
Wednesday, Jan. 21
Interest Rates
Models of Securities Prices
Readings:
C and Z: Chapters 2 and 3
Wednesday, Jan. 28
Bond Hedging and Securitization
The Term Structure of Interest Rates
PROBLEM SET # 1 DUE
Readings:
C and Z: Chapter 10
AND
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World Bank Bonds (described at the web
site: www.worldbank.org)
AND
Kendall, Leon T. and Michael J. Fishman. A Primer
on Securitization, Cambridge: MIT Press, 1996:
•
Kendall, Leon T. “Securitization: A New Era in
American Finance,” Chapter 1 (pp. 1-16);
•
Baron, Neil. “The Role of Rating Agencies in the
Securitization Process,” Chapter 7 (pp. 81-90);
•
Phillips, Susan. “The Place of Securitization in
the Financial System: Implications for Banking
and Monetary Policy,” Chapter 11 (pp. 129-138)
Estrella, Arturo. “The Yield Curve as a Leading
Indicator: Frequently Asked Questions,” The Federal
Reserve Bank of New York, Oct. 2005. (under
“external links”)
Wednesday, Feb. 4
Asset Valuation Principles
• Arbitrage and its Limits
• Anomalies: When the Law of One Price
Fails
• The Efficient Markets Hypothesis
Readings:
Varian, Hal. “The Arbitrage Principle in
Financial Economics,” Journal of Economic
Perspectives, Fall 1987, pp. 53-72.
Lamont, Owen and Richard Thaler. “Anomalies: The
Law of One Price in Financial Markets,” Journal of
Economic Perspectives, Fall 2003, pp. 191-202.
Shleifer, Andrei and Lawrence H. Summers. “The
Noise Trader Approach to Finance,” Journal of
Economic Perspectives, Spring 1990, pp. 19-33.
Hong, Harrison and Jeremy Stein. “Disagreement and
the Stock Market.” Journal of Economic
Perspectives, Spring 2007, pp. 109-128.
Baker, Malcolm and Jeffrey Wurgler. “Investor
Sentiment in the Stock Market,” Journal of Economic
Perspectives, Spring 2007, pp. 129-151.
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Malkiel, Burton. “The Efficient Market Hypothesis
and Its Critics,” Journal of Economic Perspectives,
Winter 2003, pp. 59-82.
Shiller, Robert. “From Efficient Markets Theory to
Behavioral Finance,” Journal of Economic
Perspectives, Winter 2003, pp. 83-104.
Wednesday, Feb. 11
Optimal Consumption/Portfolio Strategies
PROBLEM SET # 2 DUE
Reading:
C and Z: Chapter 4
Wednesday, Feb. 18
Risk
Readings:
C and Z: Chapter 5
AND
Edwards, Franklin R. “Hedge Funds and the Collapse
Of Long-Term Capital Management,” Journal of
Economic Perspectives, Spring 1999, pp. 189-210.
Stulz, Rene. “Hedge Funds: Past, Present, and
Future,” Journal of Economic Perspectives, Spring
2007, pp. 175-194.
Calomiris, Charles. “Bank Failures in Theory and
History: The Great Depression and Other
‘Contagious’ Events,” NBER Working Paper
#13597, Nov. 2007.
Wednesday, Feb. 25
Arbitrage and Risk-Neutral Pricing
PROBLEM SET # 3 DUE
Readings:
C and Z: Chapter 6
AND
Ross, Stephen A. Neoclassical Finance, Princeton
University Press, 2005. Chapter 1, pp. 1-21.
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Wednesday, Mar. 4
MIDTERM
SPRING BREAK
Wednesday, Mar. 18
Option Pricing
PAPER OUTLINE DUE
Reading:
C and Z: Chapter 7
Wednesday, Mar. 25
Hedging
Readings:
C and Z: Chapter 9
AND
Shiller, Robert. “Derivatives Markets for Home
Prices,” NBER Working Paper #13962, April 2008.
Wednesday, Apr. 1
The Crisis in Financial Markets: 2007-2008
Readings:
Gorton, Gary. “The Subprime Panic,” NBER
Working Paper #14398, October 2008.
Brunnermeier, Markus. “Deciphering the Liquidity
and Credit Crunch of 2007-08, NBER Working Paper
#14612, December 2008.
Kaplan, Steven and Per Stromberg.. “Leveraged
Buyouts and Private Equity,” NBER Working Paper
#14207, July 2008.
Einhorn, David. “Private Profits and Socialized
Risk,” April 2008. A speech delivered at Grant’s
Spring Investment Conference.
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Wednesday, Apr. 8
The Capital Asset Pricing Model (CAPM)
Readings:
C and Z: Chapters 12 and 13
Wednesday, Apr. 15
The Multi-factor CAPM
PROBLEM SET # 4 DUE
Readings:
C and Z: Chapter 14
AND
Mehra, Rajinish and Edward Prescott. “The Equity
Premium in Retrospect,” NBER Working Paper
9525, February 2003.
White, Eugene. “Bubbles and Busts: The 1990s in the
Mirror of the 1920s,” NBER Working Paper # 12138,
Mar. 2006
Wednesday, Apr. 22
Behavioral Finance: Challenges to the
Orthodoxy
PAPER DUE
Readings:
Barberis, Nicholas and Richard Thaler. “A Survey of
Behavioral Finance,” NBER Working Paper, #9222,
September 2002.
Hau, Harold and Helene Rey. “Home Bias at the
Fund Level,” NBER Working Paper #14172, July
2008.
Forbes, Kristin. “Why Do Foreigners Invest in the
United States?” NBER Working Paper #13908, April
2008.
Wednesday, May 6
FINAL EXAM (5:30-8:00 PM)
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