复旦大学：《投资学讲义》（英文版） Chapter 1 introduction

INVESTMENT or master and phd students Fan longzhen

INVESTMENT for Master and PH.D students Fan Longzhen

Course overview The focus of this course is on financial theory and empirical evidence that are useful for investment decisions. The topics include Financial theory: This include portfolio theory, CAPM, APT, discount factor model, they are important for decision-making in investments Empirical study approaches: GMM, Fama-Macbeth regression, time-series, cross-sections test of pricing model, ect Empirical evidence in the equity market. This includes patterns in cross section of stock returns. the time-series behavior of stock returns---time varying expected returns and stochastic volatility Market efficiency and active investments we start with the efficient market hypothesis, which is useful for modeling financial markets. Because efficient market theory is not a perfect description of the reality: some prices are almost certainly" wrong, active investment can have effective results. Topics in active investment include security analysis, active portfolio management, hedge funds, and risk management issues

Course overview • The focus of this course is on financial theory and empirical evidence that are useful for investment decisions. The topics include: • Financial theory: This include portfolio theory, CAPM, APT, discount factor model, they are important for decision-making in investments; • Empirical study approaches: GMM, Fama-Macbeth regression, time-series, cross-sections test of pricing model, ect. • Empirical evidence in the equity market. This includes patterns in cross￾section of stock returns, the time-series behavior of stock returns---time varying expected returns and stochastic volatility. • Market efficiency and active investments: we start with the efficient market hypothesis, which is useful for modeling financial markets. Because efficient market theory is not a perfect description of the reality: some prices are almost certainly ‘wrong’, active investment can have effective results. Topics in active investment include security analysis, active portfolio management, hedge funds, and risk management issues

Introduction Assets, real assets and financial assets Financial assets. divided by markets Money markets. currencies commercial papers; T-bills Capital markets: Government debt; Corporate debt; LOCKS, Derivatives: options, forward, and futures Investment stock market investment

Introduction • Assets: real assets and financial assets; • Financial assets:divided by markets • Money markets:currencies; • commercial papers; T-bills; • Capital markets: Government debt ; Corporate debt; • stocks; • Derivatives: options, forward, and futures; • Investment: stock market investment

Role of financial asset Allocating resources: transfer resources across time(money market); transfer resources across different states(derivatives) 2. Communication information Market reflect relevant information

Role of financial asset 1. Allocating resources: transfer resources across time(money market); transfer resources across different states (derivatives); 2. Communication information:Market reflect relevant information;

Example 1: Allocating resources across time Consider an individual who live for two dates now(t=0)and later(t=1); She is endowed with 100 new and 25 later Her happiness(utility depends on her consumption now and later: Co and Cl She prefer a smooth consumption path over time There is a borrowing/lending market with zero Interest rate

Example 1: Allocating resources across time • Consider an individual who live for two dates: now (t=0) and later (t=1); • She is endowed with 100 new and 25 later; • Her happiness (utility) depends on her consumption now and later: C 0 and C 1 ; • She prefer a smooth consumption path over time; • There is a borrowing/lending market with zero interest rate;

To be continued 1. Without the loan market she consume her endowments: C0=100. C=25 2. With the loan market she lend 37.5 now and receive 37.5 later. her consumption is Co=62.5 and c1=62. 5 the same over time she is now better off 3. At the endowment, she prefer I later over 1 now at the optimum, she is different between later and i now

To be continued 1. Without the loan market, she consume her endowments: C 0=100, C1=25. 2. With the loan market, she lend 37.5 now and receive 37.5 later, her consumption is C 0=62.5 and C 1=62.5, the same over time, she is now better off. 3. At the endowment, she prefer 1 later over 1 now; at the optimum, she is different between 1later and 1 now

Example 2 allocating resources across different states 1. Consider an individual, who lives for two dates: now(t=0)and later (t=1). Att=l, the economy can be in state a and state b 2. She is endowed with 100 in state a and 25 in state b 3. Her happiness (utility) depends on her consumption in the two possible state: Ca, and Cb 4. She prefer similar consumption level in the two states 5. There are a financial market where the price of a security that pays only if state a occurs is the same as that of a security that pays l only if state b occurs

Example 2 allocating resources across different states 1. Consider an individual, who lives for two dates: now (t=0) and later (t=1). At t=1, the economy can be in state a and state b; 2. She is endowed with 100 in state a and 25 in state b; 3. Her happiness (utility) depends on her consumption in the two possible state: C a, and C b, 4. She prefer similar consumption level in the two states; 5. There are a financial market where the price of a security that pays 1 only if state a occurs is the same as that of a security that pays 1 only if state b occurs;

To be continued 1. without the securities market she consumes her endowments: Ca=100. Cb=25 2. with the security market, she sell 37.5 unit of security a and buy 37. 5 units of security b. he er consumption is Ca =62.5. and cb=62.5. the same in the two states she is better off 3. At endowment, she prefer l in state b over 1 in state a 4. At the optimal consumption. she is indifferent between 1 in state a and 1 in state b

To be continued 1. Without the securities market, she consumes her endowments: C a=100, C b=25; 2. With the security market, she sell 37.5 unit of security a and buy 37.5 units of security b. Her consumption is C a=62.5, and C b=62.5, the same in the two states, she is better off; 3. At endowment, she prefer 1 in state b over 1 in state a; 4. At the optimal consumption, she is indifferent between 1 in state a and 1 in state b

First pricing principal: No free lunches- No arbitrage opportunities Definition: an arbitrage is an investment opportunity such that 1. It requires no positive investment today but yield positive payoff in the future 2. It yield positive payoff today without requiring positive payments in the future Absence of arbitrage establishes relations among securities prices Example: IBM Shares are traded on Nyse at 100, the current $e exchange rate is 2.0, what is the price of IBM shares traded on London stock exchange Key assumptions of arbitrage pricing More is better than less 2. No frictions, such as trading costs; short sales constraint

First pricing principal: No free lunches— No arbitrage opportunities Definition: an arbitrage is an investment opportunity such that 1. It requires no positive investment today but yield positive payoff in the future; 2. It yield positive payoff today without requiring positive payments in the future; Absence of arbitrage establishes relations among securities prices; Example: IBM shares are traded on NYSE at 100, the current $/€ exchange rate is 2.0, what is the price of IBM shares traded on London stock exchange. Key assumptions of arbitrage pricing: 1. More is better than less; 2. No frictions, such as trading costs; short sales constraint

Second pricing principal: supply equals demand -e-market in equilibrium Market equilibrium determines security prices in term of fundamentals Expectation of future cash flows Risk in the future cash flows tor's preference toward risk Example: CAPM price securities based on fundamentals price all securities key to understanding economic forces behind security prices

Second pricing principal: supply equals demand ---market in equilibrium Market equilibrium determines security prices in term of “fundamentals” • Expectation of future cash flows; • Risk in the future cash flows; • Investor’s preference toward risk. Example: CAPM • price securities based on fundamentals; • price all securities; • key to understanding economic forces behind security prices