Master
2019/2020

## Theory of Finance

Type:
Compulsory course (Financial Markets and Institutions)

Area of studies:
Finance and Credit

Delivered by:
School of Finance

When:
1 year, 3 module

Mode of studies:
offline

Instructors:
Maria Shchepeleva

Master’s programme:
Financial Markets and Financial Institutions

Language:
English

ECTS credits:
3

### Course Syllabus

#### Abstract

a) Pre-requisites The course assumes a good knowledge of microeconomics (utility and equilibrium theories), a sound command of calculus, standard knowledge of the probability theory and mathematical statistics. b) Abstract This course introduces fundamental ideas in the theory of finance. It consists of three parts, including microeconomic foundations of finance, general ideas from corporate finance and asset pricing theory. The first section covers a number of topics, ranging from individual decision making under certainty and uncertainty to market equilibrium and the impact of information asymmetry on exchange outcomes. The second section revises some fundamental ideas from capital structure management such as Modigliani- 2 Miller theorem, the concept of WACC, the role of taxes and dividend policy in creating company’s value. The third section studies conventional models of asset pricing, e.g. the capital asset pricing model (CAPM) and its extensions, the arbitrage pricing theory (APT) and martingale pricing methods.

#### Learning Objectives

- This course is intended to give students a comprehensive understanding of the fundamental theoretical concepts in finance and describe various techniques for appropriate pricing of financial instruments

#### Expected Learning Outcomes

- Knowledge: At the end of the course students are expected to know: the classic issues of the Financial Theory (stochastic discount factor, risk-neutral valuation, (in)complete markets, asymmetric information, equilibrium and arbitrage pricing)
- Knowledge: At the end of the course students are expected to know: Fisher Separation Theorem
- Knowledge: At the end of the course students are expected to know: the fundamental notions of Corporate Finance (capital structure, WACC, Modigliani-Miller Theory on Capital Structure, tax shield, dividend puzzle)
- Knowledge: At the end of the course students are expected to know: the main assumptions of the modern portfolio theory, CAPM and APT
- Knowledge: At the end of the course students are expected to know: Efficient Market Hypothesis and models of financial equilibrium with differential information
- Skills: A student should be able to describe and explain the causes and consequences of financial crises
- Skills: A student should be able to describe and explain the causes and consequences of financial crises apply utility theory to analyze investment decisions under certainty and uncertainty
- Skills: A student should be able to describe and apply modern portfolio theory
- Skills: A student should be able to describe, apply and criticize single and multiple factor asset pricing models
- Competence: A student should be able to understand and discuss the logic of capital structure decisions
- Competence: A student should understand corporate payout decisions
- Competence: A student should understand the principles of Arrow-Debreu pricing and martingale pricing
- Competence: A student should read and understand journal articles that make use of the concepts and methods introduced in the course

#### Course Contents

- The role of financial markets in macroeconomics. Financial crises and macroprudential policy.Finance: time and risk dimension. Financial markets and economic growth. Index of financial development. Financial Crises: types, causes and consequences. Macroprudential Policy.
- Introduction to the Theory of Finance: evolution of the discipline and the classic issues in finance.A Historical Overview of the Theory of Finance. The Scope of the study of financial theory. The main issues in finance: stochastic discount factor, risk-neutral valuation, (in)complete markets, asymmetric information, equilibrium and arbitrage pricing
- What determines the demand for financial assets? Making choices in risky situations. Risk aversion and investment decisions.Choice theory under uncertainty. The Expected utility theorem. Measuring risk aversion (absolute risk aversion, relative risk aversion, risk neutral investors). Risk premium and certainty equivalence. The concept of stochastic dominance. Fisher Separation Theorem.
- Corporate financial decision making. Part 1.Capital structure and corporate value. Modigliani-Miller theorem on capital structure. Perfect capital Market. Weighted Average Cost of Capital (WACC). Pecking Order Theory of Investment Financing.
- Corporate financial decision making. Part 2.Financial structure and firm valuation in imperfect capital markets. Payout policy and corporate value.
- Modern Portfolio Theory.Description of the opportunity set in the mean–variance space: the gains from diversification and the efficient frontier of financial development. The Optimal portfolio: Separation Theorem. Stochastic dominance and diversification.
- The Capital Asset Pricing Model.The Traditional approach to the CAPM. Many risky assets and no risk-free asset. The Zero-Beta CAPM. An empirical assessment of the CAPM.
- Arrow-Debreu Pricing. The Consumption Capital Asset Pricing Model.An Arrow–Debreu Economy. Competitive equilibrium and pareto optimality illustrated. Risk-Neutral valuations. Pricing Arrow–Debreu state-contingent claims with the CCAPM. Market Completeness and complex securities. Constructing state-contingent claims prices in a risk-free world. The Value Additivity Theorem.
- Arbitrage Pricing. The Martingale Measure. The Arbitrage Pricing Theory.Martingale Measures: no-arbitrage opportunities. Risk-Neutral pricing. Multifactor Models. Arbitrage Pricing Theory.
- Efficient Market Hypothesis. Financial equilibrium with differential information.Differential Information. The Efficient Market Hypothesis. Fully/Partially Revealing Rational Expectations Equilibrium (REE).

#### Assessment Elements

- Cumulative mark
- Final examThe final test will be closed-book, in a written form, and will be arranged at the end of module 3.

#### Bibliography

#### Recommended Core Bibliography

- Danthine, J.-P., & Donaldson, J. B. (2014). Intermediate Financial Theory (Vol. 3rd ed). Burlington: Academic Press. Retrieved from http://search.ebscohost.com/login.aspx?direct=true&site=eds-live&db=edsebk&AN=485499

#### Recommended Additional Bibliography

- Cochrane, J. H. (2005). Asset Pricing (Vol. Rev. ed). Princeton, N.J.: Princeton University Press. Retrieved from http://search.ebscohost.com/login.aspx?direct=true&site=eds-live&db=edsebk&AN=329716