COURSE TITLE
Theory of Finance
Course lecturer
dr Krzysztof Spirzewski
Course description
The aim of this course is to provide students with the fundamental topics from Theory of
Finance and Derivatives.
The course begins with the reminder of basic concepts from financial statistics and
mathematics with special attention to time value of money essential to understand pricing of
financial instruments.
Next, theory of portfolio will be presented with special attention to cases when the assumptions
of models presented during bachelor studies are not met. The pricing of stocks, bonds,
managing the risk of bond portfolio and term structure of interest rates will be presented during
next classes.
Additionally, students will be introduced to the topic of derivatives (futures and forward
contracts options and swaps) through the description of the mechanics of derivatives markets,
the fundamental pricing models and the main motivation why market participants use them.
Finally, students will be familiarized with VaR methodology which is the main concept in risk
management.
Course outline
The main emphasis during this lecture will be put on presentation of theories and pricing
models in case when their assumptions are not met and we observe the departure from
theoretical world to practical market reality. Additionally, the lecture will be enriched with
practical application of presented theories and models in real financial problems.
The detailed content of this course is presented below:
1. The review of basic concepts in financial mathematics and statistics - 2 hours.
The value of money in time. The calculation of returns and risk on capital market.
References:
[1], [2], [3], [5],
2. Markowitz theory - 2 hours.
Finding the efficient set. Finding the set of minimum risk in the case when short sale is/is not
available. The addition of risk-free asset.
References:
[2], [3], [5],
3. Factor models - 2hours.
One-factor model. Multi-factors models. Portfolios conditionally optimal.
References:
[2], [3], [5],
4. The Capital Asset Pricing Model - 2 hours.
The assumptions of CAPM. The basic form of CAPM. CAPM in case when there is no any
risk-free asset (zero-beta model). Empirical Tests of the Capital Asset Pricing Model.
References:
[2], [3], [5],
5. The Arbitrage Pricing Theory - 2 hours.
The fundamentals of APT. Empirical tests of APT. The compatibility of APT with CAPM.
References:
[2], [3], [5],
6. Measuring Portfolio Performance - 2 hours.
The measurement of portfolio returns. Portfolio performance measures independent from the
differences in risk. The errors of portfolio performance measures connected with Jensen,
Treynor and Sharpe indicators. Portfolio performance measures based on APT.
References:
[2], [3], [5],
7. Stocks and bonds valuation - 2 hours.
Dividend discount model. The fundamental stock pricing models and their assumptions. The
basic characteristics of debt securities. Bonds pricing models.
References:
[1], [2], [3], [5], [6],
8. The term structure of interest rates - 2 hours.
Historical tendencies and the character of term structure. The presentation of term structure
theories. Spot rates. Yield to maturity (YTM). Forward rates. The forecast of forward rates on
the basis of term structure.
References:
[2], [3], [5], [6],
9. Managing the risk of debt securities - 2 hours.
Duration and convexity. The estimation of debt portfolio risk based on duration. Cash flow
matching for multiple liabilities. Immunization for multiple liabilities.
References:
[2], [3], [5], [6],
10. Futures and forwards - 2hours.
The specification of forwards and futures markets. The characteristics of basis instruments.
Pricing models. The fundamental investment motivation of derivatives market participants.
References:
[4], [5],
11. Swaps - 2 hours.
The characteristics of swap market. The types of swap contracts. Interest rate and currency
swap pricing models. Nonstandard types of swaps and the motivation behind them.
References:
[4], [5],
12. Options - 2 hours.
Types of options and their basis instruments. The mechanics of option market. The basic
option strategies. Put-call parity.
References:
[4], [5],
13. Option pricing models - 2 hours.
Binomial tree model. Model modifications in case of dividends. Black-Scholes-Merton model.
The price of options in case when the assumption of model are not met.
References:
[4], [5],
14. The risk of option portfolio - 2 hours.
The sensitivity of option pricing model on the basic parameters of pricing. The Greek letters.
The construction of portfolio insensitive to various parameters of pricing.
References:
[4], [5],
15. Value at risk as the basic tool in estimation of investment portfolio risk - 2 hours.
The fundamentals of VaR. The basic techniques of VaR estimation. Stress-testing and backtesting as the basic ways of VaR assessment. The selection of the most optimal VaR measure
in case of investment risk management.
References:
[4], [7],
Official requirement:
The condition of participation is to pass elementary finance course and courses from
mathematics and statistics on the undergraduate level.
Learning outcomes:
The student after completion of this course should be able to:
1. optimize portfolio basing on portfolio theories presented during the course and characterize
the weakest points of these theories when implemented to real market conditions,
2. characterize the process of securities pricing and plan the immunization strategy of bond
securities,
3. price derivatives and plan when they should be used taking into account various investment
motives of market participants,
4. calculate VaR for portfolio of investments.
Assessment criteria and evaluation methods:
Final assessment will consist from three parts:
1. written assessment project - the description of one scientific paper focusing on verification
of models and theories presented during the lectures or focusing on press article covering
current economic situation,
2. mid-term exam,
3. final exam.
The student has to give back the project and pass the mid-term exam in order to be admitted to
final exam.
Class presence according to common University of Warsaw rules.
Compulsory readings:
1. Cuthberston K., Nitsche D., 2004, Quantitative Financial Economics, Wiley, Chichester.
2. Elton E.J., Guber M.J., 2004, Modern Portfolio Theory and Investment Analysis, Wiley.
3. Haugen R.A., 2007, Modern Investment Theory, Prentice Hall, New Jersey.
4. Hull J.C., 2008, Options, Futures and Other Derivative Securities, Prentice-Hall.
5. Sharpe W.F., 1995, Alexander G.J., Bailey J.V., Investments, Prentice Hall, New Jersey.
6. Fabozzi F.J., 2004, Fixed Income Analysis, Wiley, New Jersey.
7. Jorion P., 2007, Value at Risk 3rd edition, McGraw-Hill, New York.
Supplementary readings:
8. Bernstein P., 1992, Capital Ideas, The Free Press, New York.
9. Blake D., 2000, Financial Market Analysis, Wiley.
10. Cootner P.H., 2000The Random Character of Stock Market Prices, Risk Books, London.
11. Fabozzi F.J., Bond Markets. Analysis and Strategies, Prentice Hall, New Jersey 1996.
12. Lhabitant F.S., 2004, Hedge Funds. Quantitative Insight, John Wiley&Sons, Chicester.
13. Lo A.W., 1997, Market Efficiency. Stock Market Behaviour in Theory and Practice.
Volume I and II, Edward Elgar Publishing, Cheltenham.
14. Merton R., 1992, Continuous Time Finance, Blackwell Publishing, Malden.
15. Rose P.S., 2000, Money and Capital Markets, Irwin McGraw-Hill.
16. Willmott P., 1995, Howinson S., Dewynne J., The Mathematics of Financial Derivatives,
Cambridge University Press.
17. Wilmott P., Paul Wilmott On Quantitative Finance, 2nd Edition, John Wiley & Sons,
Chichester 2006.
- the topics presented during lectures will be enriched by up-to-date scientific papers,