L1. Intermediate Financial Theory: Intro

TOC

1. Milestones in Modern Finance 1.1 Origin of Modern Finance 1.2 First Revolution on Wall Street 1.3 Second Revolution on Wall Street 1.4 Frontiers 2. Why Need Finance 2.1 Micro view: time, risk and information 2.2 Macro View: Economic Growth 2.3 Elements of Financial Innovation 2.4 Overview of Theoretical Asset Pricing & Empirical Finance

1. Milestones in Modern Finance

1.1 Origin of Modern Finance

One controversial issue: Are stock prices predictable?

Charles Dow: “The price-waves, like those of the sea, do not recede at once from the top. The force which moves them checks the inflow gradually and time elapses before it can be told with certainty whether the tide has been seen or not.”

Cowles: Whether stock prices are predictable is doubtful.

Bachelier: “The theory of speculation”, “The dynamic of the exchange will never be an exact science” ⇒ Stochastic process.

1.2 First Revolution on Wall Street

While Keynes emphasizes the importance of concentration, Markovitz proposed portfolio selection theory. Then the Separation Theorem is proposed by Tobin. And finally, Treynor-Sharpe-Lintner-Mossin proposed CAPM.

1.3 Second Revolution on Wall Street

In 1958, Modigliani & Miller proposed “Change in capital structure and dividend policy have no impact on the overall valuation of a corporation” (MM theory).

In 1973, Black, Scholes and Merton proposed Black-Sholes Option Pricing.

In 1976, Arbitrage Pricing Theory (APT) is proposed.

1.4 Frontiers

Behavioral Finance

In 1979, Kahneman & Tversky proposed “When it comes to money and investing, we’re not always as rational as we think we are.”

Two “legs” of behavioral finance: Irrationality, limits to arbitrage.

FinTech

The fintech startups are designed to be a threat to traditional banks, e.g. Crowdfunding, P2P, Cryptocurrencies.

2. Why Need Finance

Financial system is a set of institutions and markets permitting the exchange of funds.

2.1 Micro view: time, risk and information

Desynchronization: Time Dimension

Financial system disassociate consumption and income across time:

Life-cycle patterns of income and consumption are not identical

Arbitrage over time: accept a small income for a period of time in exchange for the prospect of high returns in the future

Asset holing permits the desynchronization.

Desynchronization: Risk Dimension

Financial market can reduce or eliminate risk using diversification, insurance and hedge.

Desynchronization: Information

One example of information revelation:

Assume there are one risky asset and two investors:

Investor I receives signals

Investor II receives signals

The state-probability matrix is

Prior probability for state Up is , thus the fair price for is

Now assume investor I receives signal A, investor II receives signal :

If this is public information:

fair price =

If this is private information:

For investor I:

fair price = , which means he will buy the stock when P < 4 and sell the stock when P > 4

For investor II:

fair price = , which means he will buy the stock when P < 5.3 and sell the stock when P > 5.3

For other information pairs, we can get fair price pairs similarly.

Trading transactions will lead to information revelation. If investor I receive signal A, he will buy the stock when P < 4 and sell the stock when P > 4. If investor I receives signal B, he will buy the stock when P < 5.3 and sell the stock when P > 5.3.

Thus, the investor II can infer the infomation of the investor I from his transaction and so can investor I. Then both fair prices of them is the fair price when full information price is obtained, i.e. 6.

2.2 Macro View: Economic Growth

Financial system is to channel funds from savers to investors. The positive association between saving and growth rate depends on a Ceteris paribus clause.

Issues of Chinese Economic Policies