London School of Economics Michaelmas Term 2012

Department of Finance Michela Verardo

FM300 Corporate Finance, Investments, and Financial Markets

Section A Investments and Elements of International Finance

Course Description
This section of the course examines the empirical evidence on the behavior of stock prices from an investments perspective. After reviewing the essentials of portfolio theory and asset pricing, we will examine empirical tests of asset pricing models and their practical applications in determining expected returns. The course then focuses on market efficiency and return predictability. We will learn how to conduct an event study, how to create a portfolio strategy based on investment anomalies, and how to interpret the evidence in the light of rational and behavioral theories. We will then examine the main models and methods of performance evaluation and attribution. After a brief overview of the main issues concerning the management of bond portfolios, the last part of the course introduces elements of international finance. Particular emphasis is given to issues related to international portfolio management and hedging strategies.

Readings The required textbook for this section of the course is: Zvi Bodie, Alex Kane, and Alan Marcus, Investments and portfolio management, McGraw-Hill, 9th ed. (Please note: any other edition is fine).

The journal articles listed in the course outline are optional readings and they are posted on Moodle. They can help you deepen your knowledge of specific issues you may be interested in. More suggestions will be given in each lecture.

Course Outline

1. The Capital Asset Pricing Model: brief review and empirical applications Brief review of portfolio theory and the CAPM Basic rules of statistics and regression analysis Estimating betas and expected returns Applications of the CAPM Readings: BKM Chapters 7, 8, 9, 13.1

2. Empirical tests of the CAPM and multifactor models Empirical tests of the CAPM Brief overview of multifactor models and empirical tests The Fama-French model Readings: BKM Chapters 10, 13.2, 13.3 Optional readings: Fama, Eugene, and Kenneth French, 1992, The cross-section of expected stock returns, Journal of Finance 47, pp. 427-265. Fama, Eugene, and Kenneth French, 1993, Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33, pp. 3-56.

3. Market efficiency: Empirical tests and evidence The three forms of market efficiency Are markets efficient? Tests of market efficiency and empirical evidence Technical analysis Event studies Readings: BKM Chapters 11.1 11.4, 12.2 Optional readings: Fama, E., 1991, Efficient capital markets: II, Journal of Finance 46, 15751617.

4. Investment anomalies and return predictability Investment anomalies: size, value, momentum, post-earnings announcement drift Issues on data-mining The equity premium puzzle Readings: BKM Chapter 11.4, 13.5 Optional readings: Schwert, W., 2003, Anomalies and market efficiency, Handbook of the Economics and Finance, Ch. 15, 937-972. Jegadeesh, N. and Titman S., 2001, Profitability of momentum strategies: An evaluation of alternative explanations, Journal of Finance 56, 699-720. La Porta, R., J. Lakonishok, A. Shleifer, and R. Vishny, 1997, Good news for value stocks: further evidence on market efficiency, Journal of Finance 52, 859-874. Siegel, J., 1999, The shrinking equity premium, Journal of Portfolio Management, 10-17

5. Behavioral Finance and limits to arbitrage Behavioral biases Investment anomalies: underreaction and overreaction The disposition effect Costly arbitrage and short-sale constraints Readings: BKM Chapter 12 Optional readings: Shleifer, A., and R. Vishny, 1997, The limits of arbitrage, Journal of Finance 52, 35-55. Shleifer, A., 2000, Inefficient markets: An introduction to behavioral finance, Clarendon Lectures in Economics, Oxford University Press, New York. Barber, B. and T. Odean, 2000, Trading is hazardous to your wealth: the common stock investment performance of individual investors, Journal of Finance 55, 773-806. T. Odean, 1998, Are investors reluctant to realize their losses?, Journal of Finance 53, 1775-1798.

6. Fixed-income portfolio management Interest rate risk Duration and convexity Passive bond management, immunization, management Readings: BKM Chapters 14, 15, 16

active

bond

7. Active portfolio management and performance evaluation Measures of performance Market timing Stock picking The Treynor-Black model Performance attribution procedures Readings: BKM Chapters 24, 27.1, 27.2 Optional readings: Sharpe, W., 1992, Asset allocation: Management style and performance measurement, Journal of Portfolio Management, Winter, 7-19. Carhart, M., 1997, On persistence in mutual fund performance, Journal of Finance 52, 57-82

8. Elements of International Finance International financial markets: Spot and forward exchange markets, Interest rate parity Exchange rate determination: Purchasing Power Parity, Forecasting exchange rates, International risk management Readings: lecture notes. Optional readings: Raman Uppal and Piet Sercu, International Financial Markets and the Firm, South-Western College Publishing, 1995. Adler, M., and B. Dumas, 1984, Exposure to currency risk: Definition and measurement, Financial Management.

9. International asset allocation Exchange rate risk The world equity portfolio Benefits from international diversification The home equity bias Readings: BKM Chapter 25 Optional readings: Michaud, R., G. Bergstrom, R. Frashure, and B. Wolahan, 1996, Twenty years of international equity investing, Journal of Portfolio Management 23 Eun, C., and B. Resnick, 1988, Exchange rate uncertainty, forward contracts, and international portfolio selection, Journal of Finance 43, 197215. French, K., and J. Poterba, 1991, Investor diversification and international equity markets, American Economic Review 81, 222-226.