MRM 8600 – Financial Economics, Fall 2003
Department of Risk Management and Insurance
Georgia State University

Richard D. Phillips
Bruce A. Palmer Professor of Risk Management and Insurance
Office: 1124 BA (35 Broad Street)
Telephone: (404) 651-3397, Fax: (404) 651-1897
E-Mail: rphillips@gsu.edu
Class Hours: Monday, 4:30PM -7:00PM in 107 Aderhold
Office Hours: Thursday 2:00PM – 4:00PM, and by appointment

I. Prerequisites:

None.  CSP 1,2,7.   Students are also expected to have satisfied the mathematical and statistical foundation requirements for the Mathematical Risk Management specialization.  GSU equivalent coursework is Math 2211, Math 2212, and Math 2215 for the mathematical requirement and AS 4120, AS 4130, or Math 4751, Math 4752 for the statistics requirement.

II. Catalog Description:

This course provides a rigorous introduction to financial economics.  The course is comprised of three main components.   The first is the development of the microeconomic theory approach to the valuation of financial assets.  The second component covers equity markets and their derivatives and develops techniques for constructing optimal portfolios for a variety of objectives. The third component covers interest rate dependent assets, including bond markets, instruments, and portfolio management techniques specific to such markets. 

III. Detailed Description:

This course covers essential aspects of investment management from a theoretically rigorous perspective.   It starts with a review of static equilibrium theory and develops the application of this theory for asset returns and for investment strategies.   Students then learn dynamic extensions of the theory.   This is followed by the study of computational models for constructing optimal strategies in realistic models with a variety of objectives: maximizing utility functions, maximizing goal probabilities, maximizing sustainable withdrawals, minimizing default probabilities.    The course then introduces arbitrage-free pricing methods, leading to the incorporation of derivative securities into the portfolio management problem. 

The second half of the course covers fixed income securities and their derivatives.  It provides and overview of the markets and instruments, and develops discrete-time models of term-structure movements.  These are calibrated to market data to provide pricing and hedging tools.   These securities are then added to the general framework computational developed in the first part of the course.

IV. Student Learning Outcomes:

Upon completion of this course, students will be able to:

·         Determine equilibrium allocations in a portfolio of assets given price and risk preferences.

·         Determine equilibrium prices of financial assets and insurance liabilities based upon the principles of general equilibrium and no-arbitrage.

·         Identify statistical properties of equity returns and interest rates.

·         Construct empirically calibrated models of asset price dynamics.

·         Make recommendations regarding appropriate investment and risk management strategies using both static and dynamic frameworks.

·         Calculate optimal portfolio choices in these models for a variety of investment objectives.

·         Identify and price various fixed-income securities

·         Construct spot-rate and forward-rate yield curves using publicly available data.

·         Build dynamic term structure models using single and multi-factor models. 

·         Price simple interest-rate sensitive securities in discrete time settings.

IV. Method of Instruction:

Classroom Procedures. The course material is presented in lecture form followed by questions and discussion. Computer assignments and projects stress the application of techniques to data and play a significant role in the teaching process. Students may complete the assignments and projects in teams of no more than two students per team.

Examinations. Formal examinations will consist of two one-hour sessions given during the semester, followed by the final examination. Students who miss examinations are required to notify the instructor before the scheduled start time.  Failure to abide by this requirement may earn the student a zero. Exams will be closed book and closed notes. Make-up exams are offered only under extraordinary circumstances.

Grading criteria. The final grade in the course is based on 15% per one-hour examination, 30% for homeworks, and 40% for the final comprehensive examination. The class scores may be transformed to obtain a reasonable mean and standard deviation. The final examination is scheduled for Thursday, December 18 @ 5:00pm.

Problem Solving. Students will be assigned several problem sets and small projects. Success in the course will be dependent on the student working all of these problems by the date in which they are due. Failure to turn in assignments at the beginning of the class period in which they are due will result in you receiving a penalty of 50 percent. Any assignments not turned in within twenty-four hours of the assigned due date will be given a grade of zero. No make-up work will be accepted. Assignment grades will be based on a ‘not adequate', ‘pass', or ‘high pass' basis. These grades will be converted to a numerical score at the end of the class. High passes received a score of 100, pass scores a 85, and not adequate a score of 70. Students will receive a score of high pass when he/she has demonstrated an understanding of the mathematical techniques and they are able to utilize the results of the analysis to make informed decisions. Cleanliness counts! Sloppy or illegible homework will result in a reduced homework score. A score of "pass" will be assigned when the student has demonstrated that he or she understands the majority of the topic of discussion and has made only minor errors. A score of "not-adequate" will be assigned when the student has not demonstrated a thorough understanding of the material.

Attendance Policy. It is strongly suggested that students not miss class. Historically, students with more than two or three absences perform poorly on quizzes and examinations, and will have extreme difficulty in completing the course successfully.

V. Texts:

There is one required text for the first half of this course. 

·         [HL] Huang, C. and Litzenberger, R., Foundations for Financial Economics; New Jersey, Prentice Hall, 1988.

In addition, I will distribute online readings from an additional text and from a set of lecture notes I have developed with a co-author.  The additional published materials will come from: 

·         [EG] Eeckhoudt, Louis, and Christian Gollier, Risk:  Evaluation, Management and Sharing; New York, Harvester Wheatsheaf, 1999.

Students are required to purchase the following text for the second half of the course:

·         [SS] Sundaresan, Suresh M., Fixed Income Markets and Their Derivatives; South-Western College Publishing, 2001.

Please check WebCT often for new notes and announcements.  Note, the exam material and problems will be largely based upon the lectures notes provided online.

VI. Additional Information

• Dropping the Course: The last date to withdraw from this class without receiving automatically receiving a grade of WF is October 17, 2003. Prior to that date, assignment of a W or WF will be determined by the grades the student achieved on all homework and exam scores the student received prior to the date of his or her withdrawal.
• Food in Class: Please refrain from bringing food into class or eat in class unless you are prepared to share your goodies with everyone in class. Drinks such as coffee and soft drinks are the only exception to this rule.
• Lateness is not an endearing quality.
• Cell phones and pagers - you know the drill!
• Any student who feels he or she may need an accommodation for any sort of disability should make an appointment to meet me for the purpose of discussing your needs.

VII. Course Outline:

Class Week	Topic	Text Reference
8/28	Introduction to the course.  Representation of uncertainty. Preferences and risk aversion.   Expected utility theory.	EG 3 Lecture Notes
9/4	Utility theory continued.  Common utility functions.  Conditions for utility maximization. Portfolio Selection.	HL 1 Lecture Notes
9/11	Arbitrage pricing theory.  Applications to portfolio construction.  Pricing of equity futures and options.	EG 14 Lecture Notes
9/18	Statistical properties of equity returns.  Modern portfolio theory.  Relation to utility theory.  Derivation of the CAPM.  Implications for portfolio selection.	HL  3 EG 15
9/25	General equilibrium and endogenous price determination.	HL 4 Lecture Notes
10/2	Examination 1
10/9	The dynamic investment problem.  Formulation of stochastic dynamic programs.   Utility maximizing dynamic investment strategies.	HL 7,8 Lecture Notes
10/16	Simulation exercise:  price determination in markets.
10/23	Overview of fixed income markets.  Price/yield calculations.  Yield curve construction.  Theories of the term structure.	SS 1,2 (background) SS 4-6
10/30	Classical bond portfolio management techniques: immunization, dedication.   Active strategies.  Risk-return measurement.	SS 4, 12
11/6	Examination 2.  Arbitrage-free models of the term structure.  Binomial model of interest rates.	SS 17 Lecture Notes
11/13	Implementation of one-factor models:  Ho and Lee, and BDT.	SS 17 Lecture Notes
11/20	Heath, Jarrow and Morton 1 factor model.  Interest rate risk: principal component analysis.  Multi-factor models.	Lecture Notes
11/27	Thanksgiving – No class.
12/4	Heath, Jarrow and Morton 2 factor model.. Caps, floors, swaptions.  Asset backed securities.  Structured products.  Pricing and hedging.  Effective duration measures.	Lecture Notes SS 9, 16
12/11	Review and catch-up	s

VIII. Notes:

1. The course syllabus provides a general plan for the course; deviations may be necessary.

2. The student has the responsibility to be cognizant of the University's Policy on Academic Honesty. Students unfamiliar with the specifics of this policy can find more information online in the student handbook at http://www.gsu.edu/~wwwcam/code/academicconduct/index.html.