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

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 • 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

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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

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 • 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