Download Investments, Mon. Feb. 4, `08

Finance 2: Investors and Markets
The plan for this Monday April 20, 2009:
• Practical info; text-book, APSIM,
lectures, tutorials, hand-ins, exam, …
• Scientific contents; the big picture and
Sharpe’s Chapter 1.
• Trading and equilibrium in a simple statepreference model; Sharpe’s Chapter 2.
Practical Matters, I
Text-book: W. Sharpe (200[6-7-8]),
”Investors and Markets”, Princeton.
Important tool: The APSIM-program which is
a (C++-based) Excel plug-in. Get that
working on your computer. (Installation
problem-free on my XP-laptop. C-driveacces; Excel security-level. Vista, Linux,
Mac … ?)
Practical Matters, II
The schedule is lectures 8-10 on Mondays
and Wednesdays, and tutorials (w/
Cathrine)13-15 on Wednesdays.
”Odd holidays” and other external factors
mean: look at the plan on the course
homepage.
Should we try to move tutorials?
Practical Matters, III: Evaluation
3 test elements:
• Hand-In #1. Posted soon. Deadline Monday May 11.
Groups of up to 3 are OK. Theme: Manual trading or DIY
APSIM
• 2-hour written exam on Wednesday June 3. ”Pop quiz” in
Sharpe. Individual; no cooperation.
• Hand-In #2: Posted early June. Deadline Friday June 26.
Probably freedom of choice. Cooperation is fine, but
answers must be individually composed.
Final grade (on the 7-scale) is a (~ equally) weighted
average of performance on the 3 elements.
Scientific Contents, I
You have
• had courses in microeconomics. Did you think
that the dicussion of general equlibrium was too
abstract?
• seen CAPM. Did you think that the equilibirum
considerations were partial at best?
• seen (binomial-model) option-pricing. Did you
ever wonder why there are markets for options?
Scientific Contents, II
Well, that is what we going to fix.
The more dull version is that we study portfolio
choice, asset prices and equilibrium in statepreference models.
One period, finite #outcomes makes the math
(although not necessarily the algebra) simple.
Our approach: Experimental; or ”simulation” as
Sharpe says.(”Numerical”, ”empirical” could be
used too.)
Scientific Contents, III: Sharpe
Ch. 2: Trade-to-equilibrium in a simple
model.
Ch. 3 (Preferences) and 4 (Prices) is
”standard text-book stuff”, but with twists.
We uncover details of the trading process.
Ch. 5 (Positions): Standard texts mention
”wealth and utility heterogeneity” but
usually don’t do anything about it.
Scientific Contents, IV: Sharpe
Ch. 6 (Predictions): What if people differ in
their the assesments of probabilities?
Theory is tricky, experiments are easy.
Ch. 7 (Protection): Introducing option-like
structures and finding both buyers and
sellers.(Meaningful financial engineering.)
Ch. 8 (Advice): Uncovering people’s
preferences.
Scientific Contents, V: Post-Sharpe
We’ll finish Sharpe ~ June 1.
Then we could
• look more closely at option pricing
aspects; ”marginal” vs. ”full equilibrium” in
incomplete models
• investigate multi-period investments;
dynamic programming, ”myopia” and the
Kelly criterion
Sharpe’s Chapter 2
Agents are equipped with initial portfolios
and then they trade via a market maker.
Equilibrium (”ligevægt”) is when no further
trades can be made.
Sharpe’s Chapter 2
The procedure (see Fig. 2.6):
• Agents submit reservation prices
• Market maker post a trading price as the average of
these
• Agents submit buy/sell quantities
• Buy and sell orders are matched as best possible
• Repeat over securities, rounds ’till equilibrium is reached
Alternative – less colorful – version is: this is a numerical
procedure for solving first order conditions for
equilibrium.
Sharpe’s Chapter 2
Market Risk-Reward Theorem (MRRT)
Only market risk is rewarded with a higher
expected return.
You are not rewarded for taking risk that could be
diversified away. A very sobering principle.
If you think ”market risk” is vague: fair enough …
CAPM is one case where MRRT holds. (Here, the
expected return relation is linear; it needn’t be)