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CM2 Study Notes

This document provides an overview of the key topics covered in a financial economics revision course, including the efficient markets hypothesis, utility theory, measures of investment risk, portfolio theory, asset pricing models, stochastic calculus, option pricing models, and the term structure of interest rates. It outlines the key assumptions, concepts, and models within each topic area. The document is intended to help students revise and test their understanding of the essential aspects of financial economics.

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2K views

CM2 Study Notes

This document provides an overview of the key topics covered in a financial economics revision course, including the efficient markets hypothesis, utility theory, measures of investment risk, portfolio theory, asset pricing models, stochastic calculus, option pricing models, and the term structure of interest rates. It outlines the key assumptions, concepts, and models within each topic area. The document is intended to help students revise and test their understanding of the essential aspects of financial economics.

Uploaded by

jason
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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CT8 Financial economics revision notes

Amit Lad and Ewan Lawson


@ActuaryLad
http://actuarylad.tumblr.com/

April 2013

1 The Efficient Markets Hypothesis

• What are the three forms of EMH?


• What are the consequences of eficient/inefficient markets?
• What have past tests of the EMH shown?
• What info is there about informational efficiency in the market?
• How does the market tend to over-react to which events?
• How does the market tend to under-react to which events?

2 Utility theory and stochastic dominance

• Expected utility theorem


• Limitations of utility theory (3 points)
• How does utility function show risk aversion and non-satiation?
• First order stochastic dominance
• Second order stochastic dominance

3 Measures of investment risk

• Define semi-variance
• Define shortfall probability
• Define Value at Risk
• Define Expected shortfall
• Define TVaR

4 Portfolio theory

• Assumptions of MPT
• Define efficient frontier and optimal portfolio

1
• Solving things using the Lagrangian
• Benefits of diversification

5 Models of asset returns

• Define a multifactor model (3 types and examples of factors)


• Single factor as a special case of multifactor

6 Asset pricing models

• CAPM assumptions
• Separation theorem
• Capital market line
• Market price of risk
• Security market line
• Arbitrage pricing theory (including difficulties and problems)

7 Brownian motion and martingales

• 5 defining properties of SBM


• 7 extra properties of SBM (3 key ones)
• Definition of martingale (2 points)

8 Stochastic calculus and Ito processes

• Distribution of Ito integrals


• Deriving Ito’s lemma using Taylors formula
• Solve SDE for Ornstein-Uhlenbeck

9 Stochastic models of security prices

• Definition of continuous-time lognormal model including drift and velocity


• How does this differ from geometric BM?
• Stregnths and weaknesses (6 points)
• Cross sectional and longitudinal properties
• High level Wilkie model
• Stregnths and weaknesses of wilkie model
• AR(1) processes

2
10 Introduction to the valuation of derivative securities

• Law of one price


• intrinsic and time value of derivatives
• Price of a forward contract
• Bounds on options
• Deriving put call parity

11 The Greeks

• Six Greeks
• How they affect options prices
• Delta hedging

12 The binomial model

• Assumptions of binomial model (4)


• Condition for no arbitrage
• Constructing replicating portfolios
• Constructing risk neutral measures
• Finding th price of a derivative
• State price deflator

13 The Black-Scholes option pricing formula

• 6 assumptions behin black scholes model


• Derivations of black-scholes pDE
• Find delta hedge shares using Garman-Kohlhagen
• Probability of exercising an option

14 The 5-step method in discrete time

• Define previsible
• Define self-financing
• Define replicating portfolio
• Define complete investment market
• Cameron-Martin-Girsanov theorem
• Martingale representation theorem

3
• The 5-step approach in discrete time

15 The 5-step method in continuous time

• The 5-step approach in cts time


• Delta hedging in martingale approach
• State price deflators

16 The term structure of interest rates

• Desirable characteristics of a term structure model


• Notation and relationship between them
• General on-factor model for short rate
• State price deflators (again?!)
• Examples of one-factor models (critique them)

17 Credit risk

• Three types of credit risk models


• Merton model
• Two-state model
• Jarrow-Lando-Turnbull model

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