Overview

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The course Asset Pricing I will provide students with the main theoretical and analytical tools to study and understand the economics of financial markets and portfolio choices. After learning the different structure that financial markets can take and the key functions that these perform, learners will analyze how financial markets affect saving and investment decisions in an economy with no uncertainty. Then, learners will be introduced to expected utility theory, which will provide them with the key analytical tools to study choices under uncertainty. These tools will then be used to model and analyze portfolio choices: first, learners will study the so-called canonical portfolio problem, that is, the problem of an investor who has to choose how to allocate their wealth between a safe and a risky asset; then, they will study portfolio choices that involve multiple risky assets. The analysis of portfolio choices will allow learners to characterize and determine investors’ optimal demand for risky assets, which will lay the foundation for the analysis of the Capital Asset Pricing Model, a milestone for asset pricing and financial economics. The analysis of the CAPM will finally teach learners how to characterize equilibrium returns and asset prices in financial markets, also understanding the key forces that govern these key variables.

Syllabus

Week 1 - Functions of financial markets

By the end of this week, you will learn the various structures financial markets can adopt and comprehend their primary functions. You'll also be able to assess how the establishment of financial markets influences households' choices regarding saving and borrowing, along with companies' decisions regarding investment, all within an economy devoid of uncertainty.

Week 2 - Choice under uncertainty

This week you will learn the theoretical principles that underlie individual choices under uncertainty, that is, in the presence of risk, in light of expected utility theory. Additionally, you will examine how to characterize agents' attitudes towards risk and the primary criteria for comparing risky prospects. These criteria include first- and second-order stochastic dominance, as well as the mean-variance criterion.

Week 3 - Contingent claim markets

By the end of this week you will understand how to analyze contingent claim markets and the risk neutral evaluation.

Week 4 - Canonical portfolio problem

By the end of this week you will learn the principles underlying investors' portfolio choice and to analyze, in particular, how stock market participation depends on individual preferences and stocks' fundamentals (expected return and riskiness).

Week 5 - Mean-Variance analysis

By the end of this week you will be able to identify the set of efficient portfolios in an economy with many risky assets and to analyze, in this economy, the portfolio choices of investors with mean-variance preferences, so as to characterize stocks' aggregate demand.

Week 6 - The Capital Asset Pricing Model (CAPM)

By the end of this week, you will learn the concept of equilibrium in financial markets. You'll apply this understanding to an economy featuring numerous risky assets and a riskless asset, all within a framework of risk-averse investors with mean-variance preferences. Additionally, you'll gain the ability to calculate equilibrium prices and expected excess returns. Furthermore, you'll recognize that these values are contingent upon the covariance risk of assets, which is quantified by asset betas.