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Lecture 1
Stephen H. Shore
Fall 2022
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• iCollege Tour/Content
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Course Assignments
• Go to iCollege Monday after 4:30pm to find
assignments for the week. (Practice problems,
videos, class instructions, etc.)
• Do these assignments in advance of Thursday What Are Capital Markets
4:30pm-7:00pm class. and What Are They For?
• Come to class, engage with the material, and
interrupt me! (1/12 class participation grade)
• 3 problem sets (1/12 each homework grade)
• 2 midterms, 1/6 each midterm grades
• Final exam, 1/3 of the grade
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Sketch of the Financial System
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Our Perspective
• In this course, we will emphasize functions of the
financial system
• This functional approach is a great strength of
the academic field of finance
Basic Concepts of Finance
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Portfolio Construction Example
• We can form a portfolio by buying wi shares of States:
asset i, i=1…N. If we stack the number of Farm: [3 2 1] (j= rain, small drought, large drought)
shares into a N-by-1 vector w, then
– the payoff on the portfolio is W=w’X Assets:
((1xN)x(NxS)=1xS, payoff in each of S state) • [3 2 1] (i=1 whole farm, p1=2)
and
• [2 2 1] (i=2, first 2 dollars produced, p2=1.75)
– the price of the portfolio is w’p. (1xN)x(Nx1)=1
• [1 1 1] (i=3 first dollar produced, p3=1)
• The portfolio is just a new asset that we have
constructed using the old ones.
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1
3 2 1 2 -1
2 2 1 1.75 0
1 1 1 1
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Comprehension Questions
• Consider a portfolio of 1 unit of asset 1
and -1 units of asset 2.
Complete Markets and Arrow
• What is the cost of buying this portfolio of
securities? Debreu Securities
• What are the payoffs of this portfolio in
the three states?
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Complete Markets Complete Markets
• Suppose we can construct a portfolio that pays
• Markets are complete if S securities exist with
$1 in state j and $0 in all other states. This linearly independent payoffs.
asset is called an Arrow-Debreu security for • In this case the matrix X that we start with is S-
state j. by-S and has full rank. Thus its inverse exists.
• We write its price as qj and call it the state price • To construct S Arrow-Debreu securities, define
for state j. an S-by-S matrix of portfolio weights X-1.
• The payoff on the set of portfolios is X-1X=I.
• If there are S Arrow-Debreu securities, one for
• The cost of the set of portfolios is X-1p=q.
each state, then the payoff matrix X = I, the
• To construct any other vector of payoffs x, buy
identity matrix. x’X-1 shares of the securities at cost
• In this case we say that markets are complete. x’X-1p=x’q.
• We write the set of state prices in a vector q.
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0 1 -1 0
1 -1
-1 -1 2 -1
-1 2
2 0 -1 2
0 -1
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0.25
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Incomplete markets Complete Markets
Imagine asset 1 didn’t exist and someone tried to • The Law of One Price is most helpful when
introduce it; what do we know about its price? markets are complete
We know all A-D securities must have non-negative • Then any asset can be priced by breaking it into
prices primitive state-contingent payoffs, and adding up
p= q = W’p = the prices of each piece
p1 q1=p1-1.75>0
1.75 q2=-p1+2*1.75 -1 >0
1 q3=-1.75+2=0.25
p1>=1.75 or q1<0; p1<=2.5 or q2<0
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Coin Toss Example Coin Toss Example
2 ¼
• For each coin toss, suppose there are two
H½ assets:
H½ T½ – one “head” asset that costs $0.50 and pays $1 if the
½
toss is a head, $0 otherwise
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H½ – one “tail” asset that costs $0.50 and pays $1 if the
T½
toss is a tail, $0 otherwise
T½
0
• To get $1 only if there are two heads, invest
¼
$0.25 at the first toss in half a unit of the head
asset. If the first toss is a head, reinvest your
winnings in one unit of the head asset.
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tree.
• It is common to value options by modelling
uncertainty with two-branch (binomial) or three-
branch (trinomial) event trees.
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Arbitrage Arbitrage
An arbitrage opportunity is an investment strategy Financial theory assumes there are no arbitrage
that opportunities
• never requires a cash outflow now or in the • Any opportunities that may arise are exploited so
future quickly that we never observe them
• This theory should not be taken literally, but as a
• generates a cash inflow either benchmark that helps us to identify, profit from,
– in one or more states in the future but not now (type 1 and rapidly eliminate arbitrage opportunities
arbitrage opportunity), or
– now and possibly in one or more states in the future
too (type 2 arbitrage opportunity)
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Expected Utility Expected Values?
• Up to now, we only required that agents • Why not choose the portfolio with the
are not satiated, that is, they like more to highest expected value?
less - the implication is the absence of • Portfolio w (Nx1 shares in N assets) has
arbitrage opportunities, and the payoff w’X (1xN)x(NxS)=(1xS) payoffs in
consequences discussed. each of S states.
• How do agents choose among risky • Let pi be the Sx1 vector of probabilities of
(uncertain) alternatives? each of S states pi(j)
• Decision theory under risk: expected utility • Expected payoff is w’Xpi (1xS)x(Sx1)=1x1
theory – Sum over all states j of pi(j)*payoff(j)
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St Petersburg Paradox
• A casino offers a game of chance for a single player in
which a fair coin is tossed at each stage. The pot starts
at 2 dollars and is doubled every time a tail appears. The
first time a head appears, the game ends and the player
wins whatever is in the pot. Thus the lottery pays 2n if the
first head appears at the n-th toss (and pays zero before
a head occurs and after that).
• What is the expected value of this gamble X, known as
the “St. Petersburg lottery"?
• EX =0.5*2+0.25*4+0.125*8+…=inf
• How much would you pay for this gamble?
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