# 363-1000-00L Financial Economics

Semester | Spring Semester 2021 |

Lecturers | A. Bommier, C. Daminato |

Periodicity | yearly recurring course |

Language of instruction | English |

Abstract | This is a theoretical course on the economics of financial decision making, at the crossroads between Microeconomics and Finance. It discusses portfolio choice theory, risk sharing, market equilibrium and asset pricing. |

Objective | The objective is to make students familiar with the economics of financial decision making and develop their intuition regarding the determination of asset prices, the notions of optimal risk sharing. However this is not a practical formation for traders. Moreover, the lecture doesn't cover topics such as market irrationality or systemic risk. After completing this course: 1. Students will be familiar with the economics of financial decision making and develop their intuition regarding the determination of asset prices; 2. Students will understand the intuition of market equilibrium. They will be able to solve the market equilibrium in a simple model and derive the prices of assets. 3. Students will be familiar with the representation of attitudes towards risk. They will be able to explain how risk, wealth and agents’ preferences affect the demand for assets. 4. Students will understand the notion of risk diversification. 5. Students will understand the notion of optimal risk sharing. |

Content | The following topics will be discussed: 1. Introduction to financial assets: The first lecture provides an overview of most common financial assets. We will also discuss the formation of asset prices and the role of markets in the valuation of these assets. 2. Option valuation: this lecture focuses on options, which are a certain type of financial asset. You will learn about arbitrage, which is a key notion to understand the valuation of options. This lecture will give you the intuition of the mechanisms underlying the pricing of assets in more general settings. 3. Introduction to the economic analysis of asset markets: this chapter will familiarize you with the notion of market equilibrium and the role it plays concerning asset pricing. Relying on economic theory, we will consider the properties of the market equilibrium: In which cases does the equilibrium exist? Is it optimal? How does it depend on individual’s wealth and preferences? The concepts defined in this chapter are essential to understand the following parts of the course. 4. A simplified approach to asset markets: based on the notions introduced in the previous lectures, you will learn about the key concepts necessary to understand financial markets, such as market completeness and the no-arbitrage theorem. 5. Choice under uncertainty: this class covers fundamental concepts concerning agents’ decisions when facing risk. These models are crucial to understand how the demand for financial assets originates. 6. Demand for risk: Building up on the previous chapters, we will study portfolio choice in a simplified setting. We will discuss how asset demand varies with risk, agent’s preferences and wealth. 7. Asset prices in a simplified context: We will focus on the portfolio choices of an investor, in a particular setting called mean-variance analysis. The mean-variance analysis will be a first step to introduce the notion of risk diversification, which is essential in finance. 8. Risk sharing and insurance: in this lecture, you will understand that risk can be shared among different agents and how, under certain conditions, this sharing can be optimal. You will learn about the distinction between individual idiosyncratic risk and macroeconomic risk. 9. Risk sharing and asset prices in a market equilibrium: this course builds up on previous lessons and presents the consumption-based Capital Asset Pricing Model (CAPM). The focus will be on how consumption, assets and prices are determined in equilibrium. |

Literature | Main reading material: - "Investments", by Z. Bodie, A. Kane and A. Marcus, for the introductory part of the course (see chapters 20 and 21 in particular). - "Finance and the Economics of Uncertainty" by G. Demange and G. Laroque, Blackwell, 2006. - "The Economics of Risk and Time", by C. Gollier, MIT Press, 2001. Other readings: - "Intermediate Financial Theory" by J.-P. Danthine and J.B. Donaldson. - Ingersoll, J., E., Theory of Financial Decision Making, Rowman and Littlefield Publishers. - Leroy S and J. Werner, Principles of Financial Economics, Cambridge University Press, 2001 |

Prerequisites / Notice | Basic mathematical skills needed (calculus, linear algebra, convex analysis). Students must be able to solve simple optimization problems (e.g. Lagrangian methods). Some knowledge in microeconomics would help but is not compulsory. The bases will be covered in class. |