FINANCIAL ECONOMICS



Course Description

This course introduces students to the economics of finance. Some of the basic models used to benchmark valuation of assets and derivatives are studied in detail; these include the CAPM, and the Binomial Option Pricing models. The course ends with a brief introduction to corporate finance.

Course Outline

1. Investment Theory and Portfolio Analysis

a. Deterministic cash-flow streams
Basic theory of interest; discounting and present value; internal rate of return; evaluation criteria; fixed-income securities; bond prices and yields; interest rate sensitivity and duration; immunisation; the term structure of interest rates; yield curves; spot rates and forward rates.
b. Single-period random cash flows
Random asset returns; portfolios of assets; portfolio mean and variance; feasible
combinations of mean and variance; mean-variance portfolio analysis: the Markowitz model and the two-fund theorem; risk-free assets and the one-fund theorem.
c. CAPM
The capital market line; the capital asset pricing model; the beta of an asset and of a
portfolio; security market line; use of the CAPM model in investment analysis and as a pricing formula.

2. Options and Derivatives
Introduction to derivatives and options; forward and futures contracts; options; other
derivatives; forward and future prices; stock index futures; interest rate futures; the use of futures for hedging; duration-based hedging strategies; option markets; call and put options; factors affecting option prices; put-call parity; option trading strategies: spreads; straddles; strips and straps; strangles; the principle of arbitrage; discrete processes and the binomial tree model; risk-neutral valuation.

3. Corporate Finance
Patterns of corporate financing: common stock; debt; preferences; convertibles; Capital
structure and the cost of capital; corporate debt and dividend policy; the Modigliani- Miller theorem.


THIS SECTION COMPRISES STUDY MATERIAL OF FINANCIAL ECONOMICS.


THIS SECTION COMPRISES PREVIOUS YEAR QUESTION PAPERS OF FINANCIAL ECONOMICS.



Readings:

1. David G. Luenberger, Investment Science, Oxford University Press, USA, 1997.

2. Hull, John C., Options, Futures and Other Derivatives, Pearson Education, 6th
edition, 2005.

3. Thomas E. Copeland, J. Fred Weston and Kuldeep Shastri, Financial Theory and
Corporate Policy, Prentice Hall, 4th edition, 2003.

4. Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, McGraw-Hill, 7th edition, 2002.

5. Stephen A. Ross, Randolph W. Westerfield and Bradford D. Jordan,
Fundamentals of Corporate Finance. McGraw-Hill, 7th edition, 2005.

6. Burton G. Malkiel, A Random Walk Down Wall Street, W.W. Norton & Company, 2003.

7. William Sharpe, Gordon Alexander and Jeffery Bailey, Investments, Prentice Hall of India, 6th edition, 2003.


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