Lectures: Wednesday, 1:10 PM to 4:00 PM in Commerce-508
Review Sessions: TBA
(Syllabus Reference: Harvard API 141 Finance Syllabus of Professor Akash Deep)
This introductory (but fast-paced) course provides a general survey of finance and investments. It emphasizes an intuitive, logically rigorous understanding of the theory and practice of financial markets, illustrating the concepts through examples and cases drawn from the public, private, and non-profit sectors. Topics covered include: present value analysis and discounting, diversification, the tradeoff between risk and return, market efficiency, pricing of stocks and bonds, the capital asset pricing model, term structure of interest rates, the principle of arbitrage, pricing of derivative securities (forwards, futures, and options), the use of derivatives for hedging, risk management,
and the regulation of financial markets.
The course is intended for students who are interested in learning the basic tools and techniques of finance and how they are employed for the valuation of complex securities. While an intuitive appreciation of the principles will be the primary objective, mathematical tools will be employed to illustrate the implementation of these principles to practical cases. Any advanced mathematics that is used will be developed in lectures and review sessions.
It is assumed that students will be familiar with introductory concepts in economics and basic (high school level) mathematics. Students with concerns about their backgrounds
are welcome to speak to the instructor. Basic computer spreadsheet skills will be expected, and required to complete some of the assignments.
The course must be taken for credit. No auditors please.
Attendance: An alert, inquisitive presence in each and every class is mandatory. Attendance in review sessions is strongly advised but not required.
Readings and Assignments: Students will be expected to have completed the assigned readings before class and review them after class. Weekly problem sets will be assigned throughout the course to illustrate and reinforce the concepts presented in class as well as in preparation of the case discussions to follow.
Exam: There will be an in-class, closed book and closed notes final exam on December 12, 2008 at 9 AM. No make-up exams will be held.
Grading: Class Participation 10%
Written assignments 25%
Final Exam 65%
The textbook for the course, Essentials of Investments, 7th edition by Zvi Bodie, Alex Kane and Alan Marcus, McGraw-Hill Irwin, 2008, is available online and in bookstores. Other “Required Readings”, including cases, are available from the Course Materials Office as a course packet. Regular reading of financial news in publications such as
The Wall Street Journal, The Financial Times or the Business pages of The International Herald Tribune is strongly recommended.
OTHER RECOMMENDED (BUT NOT REQUIRED) FINANCE TEXTS
The following are some good introductory finance texts that overlap in parts with the material covered in the recommended text for this class:
Investments, 6th edition, William Sharpe, Gordon Alexander, and Jeffery Bailey, Prentice Hall, 1999.
Corporate Finance, 7th edition, Stephen Ross, Jeffrey Jaffe, and Randolph Westerfield, 2005.
Principles of Corporate Finance, 7th edition, Richard Brealey and Stewart Myers, The McGraw-Hill Companies, 2003.
These are some additional intermediate to advanced texts devoted to asset pricing:
Modern Portfolio Theory and Investment Analysis, 6th edition, Edwin Elton, Martin Gruber, Stephen Brown and William Goetzmann, John Wiley and Sons, Inc. 2003.
Investment Science, David Luenberger, Oxford University Press, Inc. 1997.
Options, Futures, and Other Derivatives, 6th edition, John C. Hull, Prentice Hall, 2005.
TOPICS AT A GLANCE
No. Day / Date Topic Assignment due date
1 Introduction to finance and financial markets
2 Present value and the opportunity cost of capital
"Portfolio Theory versus Portfolio Practice", Richard Brealey, Journal of Portfolio Management, Summer 1990, 6-10.
"The Persistence of Risk: Stocks versus Bonds over the Long Term", Martin Leibowitz and William Krasker, Financial Analysts Journal, November-December 1988, 40-47.
“Global Stock Markets in the Twentieth Century”, Philippe Jorion and William Goetzman, Journal of Finance, 1999, Vol. 54, no. 3, 953-980.
THE CAPITAL ASSET PRICING MODEL Required Readings
The Capital Asset Pricing Model
Sections 7.1-7.4, Essentials of Investments, 7th edition, Bodie, Kane & Marcus, 2008.
“Risk and Return” The Economist, February 2nd 1991, 72-73.
“Does the Capital Asset Pricing Model Work?” David Mullins, Jr., Harvard Business Review, January-February, 1982, 105-113
Case: Communications Satellite Corporation
HBS Case No. 276-195
In January 1975, the Federal Communications Commission (FCC) concluded an 11-year
investigation of the appropriate regulation of Comsat. One of the most important of these
was the determination of the fair rate of return on Comsat's capital. Both the qualitative
assessment of risk and the use of analytical techniques had been suggested by eminent
Additional Readings "Prediction of Beta from Investment Fundamentals", Barr Rosenberg and James Guy, Financial Analysts Journal, Jan.-Feb., 1995.
"The Capital Asset Pricing Model and the Market Model", Barr Rosenberg, Journal of Portfolio
Management, Winter 1981.
"Beta and Return", Fisher Black, Journal of Portfolio Management, Fall 1993.
"Efficient? Chaotic? What's the New Finance?" Nancy Nichols, Harvard Business Review, March-April, 1993, 2-7.
"Beta and Return", Fisher Black, Journal of Portfolio Management, Fall 1993, 8-17.
"In Defense of Beta", S.P Kothari and Jay Shanken, Journal of Applied Corporate Finance, Spring 1995, 53-58.
"Tale from the FAR Side", The Economist, November 16th 1996, 86.
EFFICIENT MARKETS Required Readings
Chapter 8, Essentials of Investments, 7th edition, Bodie, Kane & Marcus, 2008.
“Random Walks in Stock Market Prices”, Eugene F. Fama, Financial Analysts Journal, Jan-February, 1995, 75-80.
“The Efficient Market Hypothesis and its Critics”, Burton G. Malkiel, Journal of Economic Perspectives, Winter 2003 17 (1) 59-82
“The Truth Investors Don’t Want to Hear on Index Funds and Market Soothsayers”, The Wall Street Journal, May 12, 1998, C1.
“The Efficient Market Theory Thrives on Criticism”, Dwight Lee and James Verbrugge, Journal of Applied Corporate Finance, Vol. 9, No. 1, Fall 1996, 35-40.
“Stock Characters: As Two Economists Debate Markets, the Tide Shifts", The Wall Street Journal, October 18, 2004, A1.
"Implications of the Random Walk Hypothesis for Portfolio Management", Fisher Black, Financial Analysts Journal, March-April, 1971, 16-22.
"The Theory of Stock Market Efficiency: Accomplishments and Limitations", Ray Ball, Journal of Applied Corporate Finance, Spring 1995, 4-17.
"How Rational Investors Deal with Uncertainty (Or Reports of the Death of Efficient Markets are Greatly Exaggerated)", Keith Brown, W. Harlow, and Seha Tinic, Journal of Applied Corporate Finance, Fall 1989, 45-58.
"I've Got the Horse Right Here: Sports Betting and Market Efficiency", Martin Fridson, Journal of Applied Corporate Finance, Summer 1993, 88-95.
"The Impact of Macroeconomic News on Financial Markets", Louis Ederington and Jae Lee, Journal of Applied Corporate Finance, Spring 1996, 41-49.
Manias, Panics & Crashes: A History of Financial Crises, 3rd edition, Charles Kindleberger, John Wiley & Sons, Inc., 1996.
Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life, 2nd edition, Nassim Nicholas Taleb, Thomson South-Western, 2004.
ARBITRAGE PRICING Required Readings
"Death by the Numbers", David Kestenbaum, Science, February 26, 1999, 1244-1247.
Case: Long-Term Capital Management
“Hedge Fund Existential” Richard Bookstaber, Financial Analysts Journal, September/October
2003, p 19.
“How Salesmanship and Brainpower Failed to Save Long-Term Capital” Michael Siconolfi, Anita Raghvan, et. al., The Wall Street Journal, November 16, 1998, p A1.
Smart people aren't supposed to get into this kind of a mess. With two Nobel prize winners among its partners, Long-Term Capital Management L.P. was considered too clever to get caught in a market downdraft. The Greenwich (Conn.) hedge fund nearly tripled the money of its wealthy investors between its inception in March, 1994, and the end of 1997. Its sophisticated arbitrage strategy was avowedly ''market-neutral'' -- designed to make money whether prices were rising or falling. Indeed, until last spring its net asset value never fell more than 3% in a single month. Then came the guns of August. Long-Term Capital's rocket science exploded on the launchpad. Its portfolio's value fell 44%, giving it a year-to-date decline of 52%. That's a loss of almost $ 2 billion. (“Failed Wizards of Wall Street”, Business Week, September 28, 1998)
“What Every CFO Should Know About Scientific Progress in Financial Economics…”, Richard Roll, Financial Management, 23 (2), Summer, 1994, 69 - 75.
“Arbitrage”, Stephen Ross and Philip Dybvig, The New Palgrave, 1989, 57 - 71.
“The Arbitrage Principle in Financial Economics”, Hal Varian, The Journal of Economic Perspectives, Autumn, 1987, 55-72.
“How the Eggheads Cracked”, Michael Lewis, The New York Times, January 24, 1999, p 24, Column 5.
RISK MANAGEMENT Required Readings
“The Fantastic System of Side Bets” in Against the Gods: The Remarkable Story of Risk, Peter Bernstein, 1996, 304-328.
“A Framework for Risk Management”, Kenneth Froot, David Scharfstein, and Jeremy Stein, Harvard Business Review, November-December 1994, 91 - 102.
“Risk management for the masses”, The Economist, March 20, 2003.
Forward and Futures Contracts
Sections 17.1-17.4, and Section 18.2, Essentials of Investment, 7th edition, Bodie, Kane & Marcus, 2008.
“Note on Hedging Foreign Currency Debt”, Akash Deep, 1999.
“Financial WMD?”, The Economist, January 22, 2004.
Case: Dozier Industries
“Currency Derivatives Markets Landscape”, John W. Labuszewski, The Journal of Trading, Spring 2006.
"Dozier Industries" in G. Feiger and B. Jacquillat, International Finance, Allyn and Bacon, 1982.
A US company has just secured its first international sales contract in the UK. But the CFO of the company is concerned that if the value of the pound sterling depreciated, the viability of the project could be impaired.
"Pricing Financial Futures Contracts: An Introduction", Kenneth French, Journal of Applied Corporate Finance, Winter 1989, 59-66.
“Your Financial Future”, The Economist, May 14th 1994, 15 - 16.
“Futures Trading”, H. Houthakker, The New Palgrave, 1989, 153 - 157.
"The Currency Hedging Decision: A Search for Synthesis in Asset Allocation, Gary Gastineau, Financial Analysts Journal, May-Jun 1995.
"Estimating Currency Hedge Ratios for International Portfolios", Grant Gardner, and Douglas Stone, Financial Analysts Journal, Nov-Dec 1995.
"Derivative Assets Analysis", Mark Rubinstein, The Journal of Economic Perspectives, Autumn, 1987, 73-93.
"Stock Index Futures and the Crash of '87", Merton Miller, Burton Malkiel, Myron Scholes, and John Hawke, Journal of Applied Corporate Finance, Winter 1989, 6-17.
"The Case of the Missing Ten Pounds: In which Sherlock Holmes explains forward pricing, options theory and other financial arcana", John Price, Derivatives Strategy, October 1997. (also available online at http://www.sherlockinvesting.com/articles/tenpounds.htm)
"Measuring Financial Risk", Clifford Smith Jr., Charles Smithson, and D. Sykes Wilford, Journal of Applied Corporate Finance, Winter 1989, Vol. 1, No. 4, 27-48.
"Global Risk Management: Are We Missing the Point?", Richard Bookstaber, Journal of Portfolio Management, Spring 1997, 102-107.
“A Multifractal Walk Down Wall Street”, Benoit Mandelbrot, Scientific American, February 1999, 70-73.
“The Beauty in the Beast”, The Economist, May 14th 1994, 21 - 24.
"Using Derivatives: What Senior Managers Must Know", Harvard Business Review, January-February, 1995, 3-10.
"Risk as a History of Ideas", Peter Bernstein, Financial Analysts Journal, January-February, 1995, 7-11.
"What is VAR?", David Shimko, Risk, July 1997.
"The Benefits and Risks of Derivative Instruments: An Economic Perspective", Rajna Gibson and Heinz Zimmermann, Working Paper, http://Finance.Wat.ch/GenevaPapers/paper1.htm
"Risk Management Guidelines for Derivatives", Basle Committee on Banking Supervision, 1994,
"Does Government have a Future in Derivatives?" Ken Bull, Australian Business Law Review, August 1997, 246-257.
"10 Myths About Financial Derivatives", Thomas Siems, Policy Analysis, September 1997.
OPTION CONTRACTS Required Readings
Chapter 15, Essentials of Investments, 7th edition, Bodie, Kane & Marcus, 2008.
“Of Butterflies and Condors”, The Economist, February 16, 1991, 58-59.
Pricing of Options
Chapter 16, Essentials of Investments, 7th edition, Bodie, Kane & Marcus, 2008.
“A Calculus of Risk”, Gary Stix, Scientific American, May 1998, 92-97.
“So many options”, The Economist, November 7, 2002.
HBS Case # 207-099
BASIX, an Indian microfinance corporation, must decide whether to continue to sell weather insurance to its clients. A brand-new financial product, weather insurance pays if measured rainfall during the growing season falls below a pre-specified limit. Mr. Sattaiah, managing director of the BASIX's bank, considers a revised insurance policy for the coming season, weighing the costs and potential risks of expanding the product against the potential benefits.
“Replicating Options with Positions in Stock and Cash”, Mark Rubinstein and Hayne Leland, Financial Analysts Journal, Jan-Feb, 1995, 113-121.
"Implied Volatility", Stewart Mayhew, Financial Analysts Journal, July-Aug 1995, 8-20.
"Option Pricing Thoery: Is Risk-Free Hedging Feasible?", John Glister, Jr., Financial Management, Spring 1997, 91-105.
"Fact and Fantasy in the Use of Options", Fischer Black, Financial Analysts Journal, Jul-Aug 1975, 36-72.
"How We Came up with the Option Formula", Fisher Black, Journal of Portfolio Management, Winter 1989.
REAL OPTIONS Required Readings
“The Options Approach to Investment”, Avinash Dixit and Robert Pindyck, Harvard Business Review, May-June 1995, 105 – 115.
Case: Bidding for Antamina
HBS Case # 297-054
In June 1996, executives of the multinational mining company RTZ-CRA are contemplating bidding to acquire the Antamina copper and zinc mine in Peru. The Antamina project is being offered for sale by auction as part of the privatization of Peru's state mining company. RTZ-CRA has to determine what the mine is worth, and to recommend whether and how RTZ-CRA should bid in the upcoming auction. The bidding rules put in place by the Peruvian government dictate that each company's bid contain two components: an up-front cash amount and the amount the bidder will invest to develop the property, if development is warranted after further exploration is completed.
Investment under Uncertainty, Avinash Dixit and Robert Pindyck, Princeton University Press, 1994.