FIN 6446: Financial Theory I
FIN 6446: Financial Theory I
Instructor: Charles B. Moss
1121 McCarty Hall B
(352) 392-1845 Ext. 404
Office hours by appointment
Email: cbmoss@mail.ifas.ufl.edu
The purpose of this course is to acquaint the student with basic principles of finance theory
emphasizing the theory of the firm's investment and financing decisions. To accomplish this goal,
this course will focus on basic concepts of decision making under risk, market efficiency, asset
pricing, capital structure and dividend policy.
Style of presentation: Because of the content, this class will be conducted in an lecture
format. However, interaction through questions is encouraged. While points will not be awarded for
class participation, class participation tends to make the semester an enjoyable learning experience
for all concerned.
Grades will be based on two tests and seven quizzes. The two tests will be given as a midterm
and a final, each worth 100 points. The quizzes will be worth 20 points each, and will follow the
completion of each major component of the course. Thus, the total points are:
100 points Midterm
100 Final
140 Quizzes
340
Maximum grade scale: 95 - 100% A
90 - 94 B+
85 - 89 B
80 - 84 C+
75 - 79 C
70 - 74 D+
65 - 69 D
Below 65 E
I reserve the right to lower the grade scale.
Texts:
Required Readings
Copeland, Thomas E. and J. Fred Weston. Finance Theory and Corporate Policy third
edition (Reading, Massachusetts: Addison-Wesley Publishing Company, 1988).
Ingersoll, Jonathan E. Theory of Financial Decision Making (Totowa, New Jersey:
Rowman & Littlefield Publishers, 1987).
Supplemental Readings
Debreu, Gerard. Theory of Value (New Haven: Yale University Press, 1959).
Fama, Eugene F. and Merton H. Miller. The Theory of Finance (Hinsdale, Illinois:
Dryden Press, 1972).
Hirshleifer, J. Investment, Interest and Capital (Englewood Cliffs, New Jersey:
Prentice-Hall, Inc., 1970).
Levy, Hiam and Marshall Sarnat. Portfolio and Investment Selection: Theory and
Practice (Englewoods Cliffs, New Jersey: Prentice-Hall, Inc., 1984).
OUTLINE
Basic Concepts of Expected Utility Maximization
Axioms of Expected Utility Theory
Readings
Copeland and Weston, Chapter 4
Ingersoll, Chapter 1
Moss, C.B. "A Financial Economics Perspective on Utility"
Fama and Miller, Chapter 5
Hirshleifer, Chapter 8
Coverage
August 27: Expected Utility from the Economics Perspective pdf Notes
Develop indirect utility function and expenditure functions to show linkage between microeconomic
theory and financial economics view of utility
Axioms of expected utility -- build up mapping basis to support expected utility
August 29: Risk Aversion pdf Notes
The basic concept of risk aversion. What does it mean? It is the only possibility?
Concepts of absolute and relative risk aversion
Risk aversion in the large and small-a discussion of Pratt
An alternative view-efficiency and stochastic dominance
September 3: Using Expected Utility Directly pdf Notes
The certainty equivalent of a risky gamble-Risk Premium and Insurance.
An application of the tree enclosures for young citrus
Review of the lottery notion from Varian and linkage to von Nuemann and Morgenstern
Applications in an Mean-Variance Setting
Readings
Copeland and Weston, Chapter 6
Ingersoll, Chapter 4
Levy and Sarnat, Chapters 7, 8, 10
Coverage
- September 5: Mean-Variance I pdf Notes
- Measurement of risk and return under normality
- Multivariate normality-risk and return on a portfolio
- Efficient portfolio -- the mean variance frontier
- September 10: Mean-Variance II
- Minimum variance portfolio
- Zero-beta portfolio, Black's theorem and short sales
- Efficient set with a risk-free asset
- September 12: Towards CAPM
- Equivalence of mean-variance frontier and expected utility
- Optimal portfolio choice
- Derivation of the capital market line (CML)
State Preference Models
- Readings
- Copeland and Weston, Chapter 5
- Ingersoll, Chapter 2
- Hirshleifer, Chapter 9
- Debreu
- Coverage
- September 17: Basic State Preference Model
- September 19: Building on State Preference Models
September 24: No Class
Catch-up Day -- Quiz over Basic Concepts of Utility Maximization
Market Efficiency
Readings
- Copeland and Weston, Chapters 9, 10
- Ingersoll, Chapter 3
- Fama and Miller, Chapter 7
- Levy and Sarnat, Chapter 19
Coverage
- October 1: Basic Concepts of Market Efficiency
Asset Pricing
Capital Asset Pricing Model
- Readings
- Copeland and Weston, Chapter 7
- Ingersoll, Chapter 4
- Levy and Sarnat, Chapter 11
- Coverage
- October 3: The Basic Capital Asset Pricing Model
- Derive the Capital Asset Pricing Model through a discussion of the Capital Market Line (CML) and
the Security Market Line
- Develop the empirical model
- October 8: Switch Back to Market Efficiency
- Cover the concept of the joint test of the CAPM and the hypothesis of efficient markets
- Review empirical evidence supporting market efficiency
- October 10: Makeup, Empirical Setup, Quiz
- Review of market efficiency
- Empirical estimation of the CAPM (Generalized Least Squares)
- Quiz over market efficiency
- October 15: Uses of CAPM Betas
- Defining Risk Adjusted Discount Rates (RADRs) and Certainty Equivalents
- Use of RADRs and Certainty Equivalents in capital budgeting
- Concept of an event study
- Quiz over CAPM
October 17: Midterm Examination
Arbitrage Pricing Theorem
- Reading
- Coverage
- October 22: Overview of the Arbitrage Pricing Theorem
- The factor model of asset returns
- Intuitive basis for arbitrage equilibrium
- Mathematical manifestations of arbitrage equilibrium
- October 24: Review Midterm
- October 29: Linear Factor Models and Arbitrage
- Following Ingersoll, discuss the development of arbitrage equilibrium for two assets
- Start working the concepts behind multiple assets noting that this is the riskless arbitrage model
- October 31: Ross's Theorem
- Finish the multiple asset model.
- Provide the "proof" or a discussion involving risk. Highlight the more important parts of the proof
without too much mathematics.
- November 5: Risk Premiums and Discounts, Interpretations and Empirical Models
- Discussion of what the parameters estimated in the Arbitrage Pricing Model mean and how they can be used
- Estimation and testing of the Arbitrage Pricing Model
- November 7: Finish and Quiz
- Make up and review on the Arbitrage Pricing Theorem
- Quiz on the Arbitrage Pricing Theorem
Term Structure of Interest Rates
Readings
- Copeland and Weston, Chapter 3
- Ingersoll, Chapter 18
Coverage
- November 12: Theory of the Term Structure of the Interest Rate.
- A look at the current term structure
- What is in an interest rate?
- Theoretical decomposition of the term structure
- November 14: The Effect of the Term Structure on Capital Budgeting
- Agricultural example
- Quiz on term structure
Option Pricing Theory
Readings
- Copeland and Weston, Chapter 8
- Ingersoll, Chapter 14
- Levy and Sarnat, Chapters 16, 17
Coverage
- November 19: An Overview of Options
- What is an option?
- Terminology
- Develop the concept of derived and contingent assets
- November 21: Pricing Options I
- Two state and combinatorial pricing of options
- Introduction to Black-Scholes
- November 26: Pricing Options II
- Finish Black-Scholes
- Advanced topics in option pricing
- Quiz on options
Capital Structure Theory and Evidence
Readings
- Copeland and Weston, Chapters 12, 13
- Ingersoll, Chapter 19
Coverage
- December 3: Capital Structure for a Corporation
- Optimum capital structure for a sole proprietorship
- Corporation, arbitrage and the Modigliani-Miller theorem
- Implications for capital budgeting
- December 5: The Capital Structure Puzzle
- Survey of literature -- Meyers
- Empirical evidence -- Tittman and Wessels
Dividend Policy
Readings
- Copeland and Weston, Chapters 14, 15
Coverage
- December 10: Overview of Dividend Policy
- Review
Final
Saturday, December 14, 3:00 pm to 5:00 pm (T-R period 4), or
Friday, December 20, 7:30 am to 9:30 am (T-R period 3)
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