ECON215 --- MIDTERM I TOPICS
PROPERTIES & PRICING OF FINANCIAL ASSETS
• Types of financial assets: stocks, bonds, money market instruments
• Holding period return, yield to maturity, total return
• Present value (PV) and discounting (know how to set up and interpret the “magic pricing
equation”)
• Inverse relationship between asset prices and interest rates
Key idea: Asset prices equal the discounted value of future cash flows.
INTEREST RATES
(A) LEVELS OF INTEREST RATES
• Nominal vs real interest rates
• Fisher equation (approximation)
• Determinants of interest rates:
– Inflation expectations
– Risk
– Liquidity
– Maturity
(B) TERM STRUCTURE & YIELD CURVE
• Definition of the yield curve
• Bond yield behavior during recessions, inflation, and default episodes
• Shapes: upward sloping, flat, inverted
• Theories:
– Expectations hypothesis
– Liquidity premium
– Market segmentation
• Interpreting what the yield curve implies about future economic activity
(C) DURATION (INTEREST RATE RISK)
• Duration measures bond price sensitivity to interest rate changes
• Longer maturity and lower coupons increase duration
• Higher duration = greater interest rate risk
Rule of thumb: Duration approximates percent price change for a 1% change in yields.
RISK AND RETURN
• Expected vs realized return – need to know the formula
• Variance and standard deviation as measures of risk – need to know the formula
• Diversification and correlation
• Systematic vs idiosyncratic risk
• Diversification reduces firm-specific risk but not market risk
CAPM
• CAPM equation and expected return calculation
• Interpreting the beta in the CAPM equation
• Interpreting alpha: overpriced vs underpriced stocks
EFFICIENT MARKET HYPOTHESIS
• Three forms: weak, semi-strong, strong
• Identifying violations from trading strategies (past prices, public info, insider info)
• Logical nesting of the three forms
BASICS OF STOCK EXCHANGES
• Know the basics of stock exchanges, the services they provide and the reasons for their
existence