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Asset pricing and financial markets FN2190

This course is aimed at students who wish to understand how financial markets work and how securities are priced.

Prerequisites/ Exclusions

If taken as part of a BSc degree, the following course(s) must be passed before this course may be attempted:

  • EC1002 Introduction to economics

Plus one from:

  • MT105a Mathematics 1
  • MT105b Mathematics 2
  • MT1174 Calculus
  • MT1186 Mathematical Methods.

This course may not be taken with:

  • AC3059 Financial management
  • FN3092 Corporate finance.

Topics covered

  • Present value calculations; discounting, compounding and the Net Present Value rule; quoted versus effective interest rates; annuities and perpetuities; Fisher separation.
  • Bond valuation: valuing coupon, and zero coupon, bonds via present value methods; the term structure of interest rates and bond valuation; yield to maturity; interest rate risk and Macaulay duration; spot and forward interest rates; modelling the term structure of interest rates.
  • Stock valuation: dividend discount models; the Gordon Growth model; earnings, payout ratios and stock prices; company valuation and the Present Value of Growth Opportunities.
  • Portfolio Theory and the Capital Asset Pricing model: investor preferences; the mathematics of security portfolios; investor portfolio selection; market equilibrium and the CAPM; empirical evaluation of the CAPM and competing models.
  • Efficient security markets: defining informational efficiency; why should markets be efficient?; problems with testing efficiency; evidence on the efficiency of stock markets; puzzles and anomalies.
  • Derivative pricing: the definition of a derivative contract; how to price derivatives using absence of arbitrage; forwards and futures contracts; pricing forwards on stocks, currencies and commodities; option contracts; practical uses of options contracts; bounds on option premia; option pricing via binomial models and Black-Scholes.

Learning outcomes

If you complete the course successfully, you should be able to:

  • Describe the important differences between stock, bond and derivative securities.
  • Explain how to price assets using both present value and absence of arbitrage methods.
  • Apply present value techniques to price stocks and bonds
  • Employ mathematical tools to compute risk and return for portfolios of securities.
  • Evaluate portfolio choice problems.
  • Present, explain and apply the Capital Asset Pricing model for computing expected stock returns.
  • Critically evaluate the evidence for informational efficiency of stock markets
  • Price derivative securities using absence of arbitrage.

Assessment

Unseen written exam (3 hrs).

Essential reading

  • Brealey, R, Myers, S. and F. Allen Principles of Corporate Finance. 11th edition. (McGraw Hill)