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Financial Economics

Financial Economics

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Lecture Notes in Financial Economics
c
°
by Antonio MeleThe London School of Economics and Political ScienceJanuary 2009
 
Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
I Foundations 11
1 The classic capital asset pricing model 12
1.1 Portfolio selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121.1.1 The wealth constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121.1.2 Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131.1.3 Choice without a safe asset . . . . . . . . . . . . . . . . . . . . . . . . . 141.1.4 The market portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161.2 The CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181.3 The APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201.3.1 A
rst derivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201.3.2 Empirical evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211.3.3 The asymptotic APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211.4 Appendix 1: Some analytical details for portfolio choice . . . . . . . . . . . . . . 221.4.1 The primal program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221.4.2 The dual program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231.5 Appendix 2: The market portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . 251.5.1 The tangent portfolio is the market portfolio . . . . . . . . . . . . . . . . 251.5.2 Tangency condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251.6 Appendix 3: An alternative derivation of the SML . . . . . . . . . . . . . . . . . 271.7 Appendix 4: Broader de
nitions of risk - Rothschild and Stiglitz theory . . . . . 28References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
2 The CAPM in general equilibrium 31
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
 
Contentsc
°
by A. Mele2.2 The static general equilibrium in a nutshell . . . . . . . . . . . . . . . . . . . . . 312.2.1 WalrasLaw . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322.2.2 Competitive equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . 322.2.3 Optimality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332.3 Time and uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362.4 Financial assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362.5 Arbitrage and optimality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372.5.1 How to price a
nancial asset? . . . . . . . . . . . . . . . . . . . . . . . . 372.5.2 The Land of Cockaigne . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392.6 Equivalent martingale measures and equilibrium . . . . . . . . . . . . . . . . . . 432.6.1 The rational expectations assumption . . . . . . . . . . . . . . . . . . . . 432.6.2 Stochastic discount factors . . . . . . . . . . . . . . . . . . . . . . . . . . 442.6.3 Optimality and equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . 452.7 Consumption-CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482.7.1 The beta relation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482.7.2 The risk premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482.7.3 CCAPM & CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492.8 In
nite horizon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492.9 Further topics on incomplete markets . . . . . . . . . . . . . . . . . . . . . . . . 502.9.1 Nominal assets and real indeterminacy of the equilibrium . . . . . . . . . 502.9.2 Nonneutrality of money . . . . . . . . . . . . . . . . . . . . . . . . . . . 512.10 Appendix 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522.11 Appendix 2: Proofs of selected results . . . . . . . . . . . . . . . . . . . . . . . . 532.12 Appendix 3: The multicommodity case . . . . . . . . . . . . . . . . . . . . . . . 56References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3 In
nite horizon economies 59
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593.2 Recursive formulations of intertemporal plans . . . . . . . . . . . . . . . . . . . 593.3 The Lucasmodel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603.3.1 Asset pricing and marginalism . . . . . . . . . . . . . . . . . . . . . . . . 603.3.2 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613.3.3 Rational expectations equilibria . . . . . . . . . . . . . . . . . . . . . . . 623.3.4 Arrow-Debreu state prices . . . . . . . . . . . . . . . . . . . . . . . . . . 643.3.5 CCAPM & CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653.4 Production: foundational issues . . . . . . . . . . . . . . . . . . . . . . . . . . . 653.4.1 Decentralized economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653.4.2 Centralized economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 673.4.3 Deterministic dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683.4.4 Stochastic economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 713.5 Production based asset pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 773.5.1 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 773.5.2 Consumers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 802

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