UNIVERSITY COLLEGE LONDON
DEPARTMENT OF ECONOMICS
Economics BSc (Econ)
Second Year – Term 2
ECONOMICS OF
FINANCE
ECON0048
Rodrigo Antón García
London, 2022
,
, Contents
Topic 1 – Basic Concepts in Finance, Arbitrage and the Money Market.
o Topic 1.1 – What are Capital Markets and What are they for? 1
o Topic 1.2 – Institutional and Functional Perspectives on Capital Markets. 3
o Topic 1.3 – Basic Concepts of Finance. 7
o Topic 1.4 – Arbitrage in Theory. 9
o Topic 1.5 – The Money Market. 10
Topic 2 – Measuring Return, Arbitrage in Theory and in Practice.
o Topic 2.1 – Measuring Return. 12
o Topic 2.2 – Arbitrage Theory. 13
o Topic 2.3 – Buying on Margin (Leverage) and Short Selling. 14
o Topic 2.4 – Arbitrage in Practice. 18
Topic 3 – The Bond and Equity Markets, Complete Markets, Modelling Risk
Aversion.
o Topic 3.1 – Arbitrage in Practice (Continued). 24
o Topic 3.2 – The Bond Market. 25
o Topic 3.3 – The Equity Market. 29
o Topic 3.4 – Indexes. 30
o Topic 3.5 – Are Markets Complete? 31
o Topic 3.6 – Risk and Risk Aversion. 34
Topic 4 – History of Asset Returns, Optimal Portfolio Choice, the Stochastic
Discount Factor.
o Topic 4.1 – Probability and Sample Means. 37
o Topic 4.2 – Arithmetic and Geometric Average Returns. 38
o Topic 4.3 – A Statistical View of Financial History. 43
o Topic 4.4 – Optimality and Equilibrium. 45
o Topic 4.5 – The Stochastic Factor. 49
o Topic 4.6 – Absolute Risk Aversion and the Insurance Premium. 50
o Topic 4.7 – Relative Risk Aversion and Portfolio Choice. 53
,Topic 5 – Optimal Portfolio Choice Under Mean-Variance Preferences.
o Topic 5.1 – One Risky Asset and One Risk-Free Asset. 58
o Topic 5.2 – Optimal Portfolio: One Risky and One Risk-Free Asset. 61
o Topic 5.3 – How Does the Horizon Matter? 63
o Topic 5.4 – Diversification, Fixed Weights. 64
o Topic 5.5 – Optimal Portfolio: Two Risky Assets. 69
o Topic 5.6 – Optimal Portfolio: Many Risky Assets. 75
o Topic 5.7 – Optimal Portfolio: Many Risky Assets and One Risk-Free Asset.
76
Topic 6 – Mutual Fund Theorem, Beta Representation Theorem, CAPM, Empirical
Research on CAPM.
o Topic 6.1 – The Mutual Fund Theorem and the Asset Allocation Puzzle. 80
o Topic 6.2 – Beta Representation Theorem. 83
o Topic 6.3 – The Capital Asset Pricing Model. 83
o Topic 6.4 – Alpha, Beta, and the Capital Asset Pricing Model (CAPM). 88
o Topic 6.5 – Empirical Research on the CAPM. 90
o Topic 6.6 – The Low Reward for Beta. 92
o Topic 6.7 – The Size and Value Effects. 95
o Topic 6.8 – Other Anomalies. 98
o Topic 6.9 – Alternative Reactions. 99
Topic 7 – Arbitrage Pricing Theory (APT), Factor models, SDF and CAPM, Market
Efficiency.
o Topic 7.1 – Arbitrage Pricing Theory (APT). 101
o Topic 7.2 – Multifactor Models. 105
o Topic 7.3 – Connecting CAPM and the SDF Approach. 108
,Topic 8 – Efficient Market Hypothesis: Fund Managers Performance, Returns and
New Information. Valuation of Stocks by Dividend Stream.
o Topic 8.1 – Market Efficiency. 114
o Topic 8.2 – Serial Correlation in Stock Returns. 115
o Topic 8.3 – Do Mutual Fund Managers Beat the Market? 117
o Topic 8.4 – The Implausibility of the Strong Form of Market Efficiency. 120
o Topic 8.5 – Returns and Prices: The Law of Iterated Expectations. 121
o Topic 8.6 – Event Studies. 123
o Topic 8.7 – The Dividend Discount Model. 125
o Topic 8.8 – The Gordon Growth Model. 126
Topic 9 – Stock Market Volatility, Investors' Beliefs, Labour Income.
o Topic 9.1 – Gordon Growth Model and the US Stock Market. 128
o Topic 9.2 – Investor’s Beliefs. 132
o Topic 9.3 – Disagreement About Return Beliefs. 135
o Topic 9.4 – Labour Income and Consumption Commitments. 138
Topic 10 – Yields, Returns, Duration and Risk in Bond Markets.
o Topic 10.1 – Fixed-Income Basics. 141
o Topic 10.2 – Bond Yields, Prices and Returns. 143
o Topic 10.3 – Average Maturity, Debt Crisis. 145
o Topic 10.4 – Duration. 149
o Topic 10.5 – Term Structure of Interest Rates, Forward Rates. 150
o Topic 10.6 – Risk in Bond Markets. 153
o Topic 10.7 – Nominal and Real Interest Rates. 155
o Topic 10.8 – Inflation-Linked Bonds. 156
,
,Economics of Finance – ECON0048 Rodrigo Antón García
ECON0048: ECONOMICS OF FINANCE – TERM 2
Topic 1 – Basic Concepts in Finance, Arbitrage and the Money Market.
o Topic 1.1 – What are Capital Markets and What are they for?
Financial Assets: claims to future resources: promises to pay a certain future amount.
Claims to the income generated by real assets.
You can think of a financial asset as a piece of paper that promises to pay something in
the future. A piece of paper that has been issued by someone and the issuer promises
to pay something in the future. Of course, nowadays there are no pieces of paper,
everything is done electronically, but the commitment is the same.
The key thing is that these financial assets are sold in competitive markets. Each asset
differs in terms of when, who and how much it pays. Financial assets are different from,
Real Assets (investments) which if put in place today, deliver an output of resources later
(e.g., a tree, a factory, a house). These determine the productive capacity of an economy.
Since financial assets are represented by assets and liabilities, my asset is your liability
and vice versa, these are cancelled out and so do not determine productive capacity.
Therefore, real investments produce real things whereas financial assets do not produce
anything, they are just pieces of paper that they promised to exchange that promise to
pay something in the future.
Capital Markets are environments in which financial assets are traded.
• Classifying Financial Assets.
- Equities (Stocks) are claims to a share of the profit (actually, since the firm may
decide to reinvest the profit, what you get are the distributed profits, called dividends) of
a corporation forever (if you hold on to the share). Shares also give voting rights.
- Fixed-income (Debt) Securities include bonds, bills, etc., which promise a fixed
stream of income or a stream of income determined by a specific formula. An important
key issue is default, that is, promised payments sometimes do not take place.
- Insurance Contracts are claims to a payment if something (usually something bad)
happens. You only get paid if this specific event happens.
For example, consider fire insurance. A piece of paper that you can buy whereby an
insurance company holds on the contract that if your house is caught on fire the company
will pay you the value of the house, otherwise, if no fire occurs, it pays nothing. You get
paid zero or if an uncertain event happens, then you get paid.
You can also buy insurance against default. So, you can buy insurance in case some
government some government default.
1
, Economics of Finance – ECON0048 Rodrigo Antón García
- Derivative Securities make payments that depend on the prices of other financial
assets. This includes futures, swaps, options (call and put), CDS, etc.
For example, stock-call-options give you the right to buy a stock in the future at a price
that has been agreed today (and then immediately sell the stock for a profit if the price
has gone up). So generally, a stock-call-option pays the difference in case a prize goes
up and zero if the price went down.
As we can see the payoff of a stock-call-option depends on the price of the stock, another
financial asset, because you get different amounts depending stocks’ price.
The main difference between financial assets is the uncertainty (in theory equities are
highly uncertain and bonds are fixed, if no default) and the timing of payoffs.
• What are Capital Markets for?
- Consumption timing. It allows to shift the timing of consumption (or spending) so
it need not coincide with the timing of the receival of income: Borrow or Lend.
- Allocation of risk. It allows investors with the greatest taste for risk to bear that
risk, while less risk-tolerant individuals can, to a greater extent, stay on the sidelines. It
shifts risk across people, sharing the risk of uncertain outcomes: insurance, stocks.
- Allocate resources to the most productive real investments (e.g., by separating
the ownership, the funding and the management of companies).
Main purpose: Allocate resources and risks efficiently across economic agents.
In principle, if ‘people in capital markets’ are going after the highest profit, then, if they
are well-informed, the best investments are the ones that will be that will be funded, and
the bad investments will not (eliminating zombie firms), driving up efficiency.
Therefore, a well-functioning capital market with allocate resources to good investments.
Of course, there is the risk of moral hazard, systemic risk and asymmetric information…
2
DEPARTMENT OF ECONOMICS
Economics BSc (Econ)
Second Year – Term 2
ECONOMICS OF
FINANCE
ECON0048
Rodrigo Antón García
London, 2022
,
, Contents
Topic 1 – Basic Concepts in Finance, Arbitrage and the Money Market.
o Topic 1.1 – What are Capital Markets and What are they for? 1
o Topic 1.2 – Institutional and Functional Perspectives on Capital Markets. 3
o Topic 1.3 – Basic Concepts of Finance. 7
o Topic 1.4 – Arbitrage in Theory. 9
o Topic 1.5 – The Money Market. 10
Topic 2 – Measuring Return, Arbitrage in Theory and in Practice.
o Topic 2.1 – Measuring Return. 12
o Topic 2.2 – Arbitrage Theory. 13
o Topic 2.3 – Buying on Margin (Leverage) and Short Selling. 14
o Topic 2.4 – Arbitrage in Practice. 18
Topic 3 – The Bond and Equity Markets, Complete Markets, Modelling Risk
Aversion.
o Topic 3.1 – Arbitrage in Practice (Continued). 24
o Topic 3.2 – The Bond Market. 25
o Topic 3.3 – The Equity Market. 29
o Topic 3.4 – Indexes. 30
o Topic 3.5 – Are Markets Complete? 31
o Topic 3.6 – Risk and Risk Aversion. 34
Topic 4 – History of Asset Returns, Optimal Portfolio Choice, the Stochastic
Discount Factor.
o Topic 4.1 – Probability and Sample Means. 37
o Topic 4.2 – Arithmetic and Geometric Average Returns. 38
o Topic 4.3 – A Statistical View of Financial History. 43
o Topic 4.4 – Optimality and Equilibrium. 45
o Topic 4.5 – The Stochastic Factor. 49
o Topic 4.6 – Absolute Risk Aversion and the Insurance Premium. 50
o Topic 4.7 – Relative Risk Aversion and Portfolio Choice. 53
,Topic 5 – Optimal Portfolio Choice Under Mean-Variance Preferences.
o Topic 5.1 – One Risky Asset and One Risk-Free Asset. 58
o Topic 5.2 – Optimal Portfolio: One Risky and One Risk-Free Asset. 61
o Topic 5.3 – How Does the Horizon Matter? 63
o Topic 5.4 – Diversification, Fixed Weights. 64
o Topic 5.5 – Optimal Portfolio: Two Risky Assets. 69
o Topic 5.6 – Optimal Portfolio: Many Risky Assets. 75
o Topic 5.7 – Optimal Portfolio: Many Risky Assets and One Risk-Free Asset.
76
Topic 6 – Mutual Fund Theorem, Beta Representation Theorem, CAPM, Empirical
Research on CAPM.
o Topic 6.1 – The Mutual Fund Theorem and the Asset Allocation Puzzle. 80
o Topic 6.2 – Beta Representation Theorem. 83
o Topic 6.3 – The Capital Asset Pricing Model. 83
o Topic 6.4 – Alpha, Beta, and the Capital Asset Pricing Model (CAPM). 88
o Topic 6.5 – Empirical Research on the CAPM. 90
o Topic 6.6 – The Low Reward for Beta. 92
o Topic 6.7 – The Size and Value Effects. 95
o Topic 6.8 – Other Anomalies. 98
o Topic 6.9 – Alternative Reactions. 99
Topic 7 – Arbitrage Pricing Theory (APT), Factor models, SDF and CAPM, Market
Efficiency.
o Topic 7.1 – Arbitrage Pricing Theory (APT). 101
o Topic 7.2 – Multifactor Models. 105
o Topic 7.3 – Connecting CAPM and the SDF Approach. 108
,Topic 8 – Efficient Market Hypothesis: Fund Managers Performance, Returns and
New Information. Valuation of Stocks by Dividend Stream.
o Topic 8.1 – Market Efficiency. 114
o Topic 8.2 – Serial Correlation in Stock Returns. 115
o Topic 8.3 – Do Mutual Fund Managers Beat the Market? 117
o Topic 8.4 – The Implausibility of the Strong Form of Market Efficiency. 120
o Topic 8.5 – Returns and Prices: The Law of Iterated Expectations. 121
o Topic 8.6 – Event Studies. 123
o Topic 8.7 – The Dividend Discount Model. 125
o Topic 8.8 – The Gordon Growth Model. 126
Topic 9 – Stock Market Volatility, Investors' Beliefs, Labour Income.
o Topic 9.1 – Gordon Growth Model and the US Stock Market. 128
o Topic 9.2 – Investor’s Beliefs. 132
o Topic 9.3 – Disagreement About Return Beliefs. 135
o Topic 9.4 – Labour Income and Consumption Commitments. 138
Topic 10 – Yields, Returns, Duration and Risk in Bond Markets.
o Topic 10.1 – Fixed-Income Basics. 141
o Topic 10.2 – Bond Yields, Prices and Returns. 143
o Topic 10.3 – Average Maturity, Debt Crisis. 145
o Topic 10.4 – Duration. 149
o Topic 10.5 – Term Structure of Interest Rates, Forward Rates. 150
o Topic 10.6 – Risk in Bond Markets. 153
o Topic 10.7 – Nominal and Real Interest Rates. 155
o Topic 10.8 – Inflation-Linked Bonds. 156
,
,Economics of Finance – ECON0048 Rodrigo Antón García
ECON0048: ECONOMICS OF FINANCE – TERM 2
Topic 1 – Basic Concepts in Finance, Arbitrage and the Money Market.
o Topic 1.1 – What are Capital Markets and What are they for?
Financial Assets: claims to future resources: promises to pay a certain future amount.
Claims to the income generated by real assets.
You can think of a financial asset as a piece of paper that promises to pay something in
the future. A piece of paper that has been issued by someone and the issuer promises
to pay something in the future. Of course, nowadays there are no pieces of paper,
everything is done electronically, but the commitment is the same.
The key thing is that these financial assets are sold in competitive markets. Each asset
differs in terms of when, who and how much it pays. Financial assets are different from,
Real Assets (investments) which if put in place today, deliver an output of resources later
(e.g., a tree, a factory, a house). These determine the productive capacity of an economy.
Since financial assets are represented by assets and liabilities, my asset is your liability
and vice versa, these are cancelled out and so do not determine productive capacity.
Therefore, real investments produce real things whereas financial assets do not produce
anything, they are just pieces of paper that they promised to exchange that promise to
pay something in the future.
Capital Markets are environments in which financial assets are traded.
• Classifying Financial Assets.
- Equities (Stocks) are claims to a share of the profit (actually, since the firm may
decide to reinvest the profit, what you get are the distributed profits, called dividends) of
a corporation forever (if you hold on to the share). Shares also give voting rights.
- Fixed-income (Debt) Securities include bonds, bills, etc., which promise a fixed
stream of income or a stream of income determined by a specific formula. An important
key issue is default, that is, promised payments sometimes do not take place.
- Insurance Contracts are claims to a payment if something (usually something bad)
happens. You only get paid if this specific event happens.
For example, consider fire insurance. A piece of paper that you can buy whereby an
insurance company holds on the contract that if your house is caught on fire the company
will pay you the value of the house, otherwise, if no fire occurs, it pays nothing. You get
paid zero or if an uncertain event happens, then you get paid.
You can also buy insurance against default. So, you can buy insurance in case some
government some government default.
1
, Economics of Finance – ECON0048 Rodrigo Antón García
- Derivative Securities make payments that depend on the prices of other financial
assets. This includes futures, swaps, options (call and put), CDS, etc.
For example, stock-call-options give you the right to buy a stock in the future at a price
that has been agreed today (and then immediately sell the stock for a profit if the price
has gone up). So generally, a stock-call-option pays the difference in case a prize goes
up and zero if the price went down.
As we can see the payoff of a stock-call-option depends on the price of the stock, another
financial asset, because you get different amounts depending stocks’ price.
The main difference between financial assets is the uncertainty (in theory equities are
highly uncertain and bonds are fixed, if no default) and the timing of payoffs.
• What are Capital Markets for?
- Consumption timing. It allows to shift the timing of consumption (or spending) so
it need not coincide with the timing of the receival of income: Borrow or Lend.
- Allocation of risk. It allows investors with the greatest taste for risk to bear that
risk, while less risk-tolerant individuals can, to a greater extent, stay on the sidelines. It
shifts risk across people, sharing the risk of uncertain outcomes: insurance, stocks.
- Allocate resources to the most productive real investments (e.g., by separating
the ownership, the funding and the management of companies).
Main purpose: Allocate resources and risks efficiently across economic agents.
In principle, if ‘people in capital markets’ are going after the highest profit, then, if they
are well-informed, the best investments are the ones that will be that will be funded, and
the bad investments will not (eliminating zombie firms), driving up efficiency.
Therefore, a well-functioning capital market with allocate resources to good investments.
Of course, there is the risk of moral hazard, systemic risk and asymmetric information…
2
