Theory of Finance

FINA 865, Fall 2014

Wednesdays, 16:00-19:00; Room 110
(This version: August 26, 2014)

Instructor: SHINGO GOTO, Ph.D.

O¢ ce: 457D
Phone: 803-777-6644
Email: shingo.goto@moore.sc.edu, shingo.goto@gmail.com
O¢ ce Hours: Open door (appointments recommended)

COURSE OUTLINE

This is a doctoral course for Ph.D. students in …nance (and other related areas). This course
discusses several concepts of asset pricing, such as valuation by arbitrage, static and intertemporal
portfolio choice problems, continuous-time …nance, asset pricing under asymmetric information,
and recent research topics. Regular attendance, thorough preparation, and class participation are
expected of all students enrolled in the course. Expect to spend at least 30 hours per week for this
course.

Prerequisites
Although not an absolute necessity, some background in microeconomic theory, calculus, linear
algebra, probability theory, statistics, and econometrics is highly desirable.

Course Requirement and Grading

There will be a …nal exam, homework assignments (problem sets), and two in-class presentations.
Grading will be at the instructor’s discretion. It will be roughly based 1=2 on the …nal exam, 1=4
on in-class presentations, and 1=4 on homework and class participation.

In-class presentations: Each student will make lecture presentations to the class twice in October
and November. Each presentation should focus on explaining an asset pricing paper published in
a top …nance scholarly journal in the past 5 years (say from 2008 onwards). You will pick the
papers that interest you most. The papers do not need to be purely theoretical, but your in-
class presentation should explain the papers’theoretical motivations carefully. For each paper, you
should prepare a brief teaching note and share it with the class. The …nal exam will cover materials
from students’presentations and teaching notes.

The instructor will discuss the details of the in-class presentation in announce the details of
the in-class presentations on September 17 or 24.

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 Students must pick two papers (with consultation of the instructor) as early as they can, by
September 30 at the latest.

Course Materials:
Course materials will include academic papers, chapters from several di¤erent textbooks, and my
lecture notes. Each lecture will follow the lecture notes. Course materials, announcements, etc.
will be posted/shared online.

I recommend the following two books to complement the lectures.

Back, Kerry (2010), Asset Pricing and Portfolio Choice Theory, Oxford Univ. Press
Campbell, John Y., Andrew W. Lo, and A. Craig MacKinlay (1997), The Econometrics of Financial
Markets, Princeton Univ. Press

In addition to these recommended books, several good Ph.D. level textbooks are available, including:
Cochrane, John (2005), Asset Pricing (revised ed.), Princeton Univ. Press. (especially Chapters
1-6, 9, 17-18, and 20.)
Du¢ e, Darrell (1992), Dynamic Asset Pricing Theory, Princeton Univ. Press
Huang, Chi-fu, and Robert H. Litzenberger (1988), Foundations for Financial Economics, North-
Holland
Ingersoll, Jonathan E. (1987), Theory of Financial Decision Making, Rowman & Little…eld
LeRoy, Stephen F. and Jan Werner (2001), Principles of Financial Economics, Cambridge Univ.
Press
Pennachi, George (2007), Theory of Asset Pricing, Prentice Hall
Singleton, Kenneth J. (2006), Empirical Dynamic Asset Pricing: Model Speci…cation and Econo-
metric Assessment, Princeton Univ. Press

In addition to these textbooks and academic articles (posted online), the following books provide
very useful surveys of a few important topics of asset pricing. Most of these books are in my o¢ ce.
You can check them out from my o¢ ce.

Conventional Asset Pricing

Bossaerts, Peter L. (2002), The Paradox of Asset Pricing, Princeton Univ. Press
Campbell, John Y. and Luis M. Viceira (2002), Strategic Asset Allocation: Portfolio Choice for
Long-Term Investors, Oxford Univ. Press
Ross, Stephen A. (2005), Neoclassical Finance, Princeton Univ. Press

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Continuous Time Finance
Bjork, T. (1998), Arbitrage Theory in Continuous Time, Oxford Univ. Press (in Library)
Dixit, Avinash K. and Robert S. Pindyck (1994), Investment under Uncertainty, Princeton Univ.
Press
Kijima, Masaaki (2002), Stochastic Processes with Applications to Finance, Chapman & Hall
Malliaris, A.G. and W.A. Brock (1982), Stochastic Methods in Economics and Finance, North-
Holland
Musiela, Marek and Marek Rutkowski (1998), Martingale Methods in Financial Modelling, Springer
Merton, Robert C. (1994), Continuous-Time Finance, Blackwell
Neftci, Salih N. (2000), An Introduction to the Mathematics of Financial Derivatives (2nd ed.),
Academic Press
Shimko, David C. (1992), Finance in Continuous Time: A Primer, Kolb

Asymmetric Information, Market Microstructure, Liquidity, etc.

Brunnermeier, Markus K. (2001), Asset Pricing under Asymmetric Information: Bubbles, Crashes,
Technical Analysis, and Herding, Oxford Univ. Press
Harris, Larry (2003), Trading & Exchanges: Market Microstructure for Practitioners, Oxford Univ.
Press
O’Hara, Maureen (1995), Market Microstructure Theory, Blackwell (in Library)
Shin, Hyun Song (2010), Risk and Liquidity, Oxford Univ. Press

Portfolio Risk and Credit Risk

Connor, Gregory, Lisa R. Goldberg, and Robert A. Korajczyk (2010), Portfolio Risk Analysis,
Princeton Univ. Press
Du¢ e, Darrel and Kenneth J. Singleton (2003), Credit Risk –Pricing, Measurement, and Manage-
ment, Princeton Univ. Press
Meucci, Attilio (2007), Risk and Asset Allocation, Springer

Academic Integrity:

It is the responsibility of every student at the University of South Carolina Columbia to adhere
steadfastly to truthfulness and to avoid dishonesty, fraud, or deceit of any type in connection with
any academic program. Any student who violates this Honor Code or who knowingly assists another
to violate this Honor Code shall be subject to discipline. For more information about the academic
integrity issues, go to the following website: http : ==www:sc:edu=academicintegrity=

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Course Outline:

The course outline may change. The course outline and class schedule will be updated online.

1. Introduction

(a) No Arbitrage: The Fundamental Principle of Asset Pricing

(b) E¢ cient Markets Today

2. Static Asset Pricing under Symmetric Information

(a) Risk Aversion and Portfolio Choice

(b) Mean-Variance Analysis and the CAPM
(c) The Arbitrage Pricing Theory (APT)
(d) Fama-French Factor Model and the Conditional CAPM
(e) Recent Discussion of Asset Pricing Tests
(f) Appendix: Equilibrium, E¢ ciency, and Aggregation

3. Continuous Time Finance: A Primer

(a) Continuous Stochastic Processes (Ito Processes) and Valuation in Continuous Time
(b) Valuing Perpetual Assets in Continuous Time
(c) Basic Option Pricing Models

4. Dynamic Securities Markets: Discrete-Time Models and Continuous-Time Models

(a) Dynamic Securities Markets in Discrete Time

(b) The Martingale Approach in Continuous Time
(c) Dynamic Term Structure and Bond Pricing Models
(d) Pricing Defaultable Corporate Debts

5. Asset Pricing under Asymmetric Information

(a) Competitive Rational Expectations Models

(b) Dynamic REE Models of Trading Volume, etc.
(c) Strategic Trader Models
(d) Models of Trading Volume, Technical Analysis, Herding, Bubbles, etc.

6. Topics Chosen from:

Recent Developments in Consumption-Based Models

Recent Developments in Production/Investment-based Models
Return Predictability, Return Decomposition
Recent Discussion of Asset Pricing Tests
etc.