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
