The Economics of Financial Markets

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ISBN: 9780521848275 | 052184827X
Cover: Hardcover
Copyright: 7/11/2005

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The Economics of Financial Markets presents a concise overview of capital markets, suitable for advanced undergraduates and for beginning graduate students in financial economics. Following a brief overview of financial markets--their microstructure and the randomness of stock market prices--this textbook explores how the economics of uncertainty can be applied to financial decision-making. Emphasis is placed on the economic principles underlying all financial markets, focusing on markets for equities, bonds, futures and options contracts.

List of figures

Preface

xvii

1 Asset markets and asset prices

(32)

1.1 Capital markets

(3)

1.2 Asset price determination: an introduction

(4)

1.3 The role of expectations

(2)

1.4 Performance risk, margins and short-selling

(4)

1.5 Arbitrage

(5)

1.6 The role of time

(2)

1.7 Asset market efficiency

(1)

1.8 Summary

(1)

Appendix 1.1: Averages and indexes of stock prices

(4)

Appendix 1.2: Real rates of return

(1)

Appendix 1.3: Continuous compounding and the force of interest

(3)

References

(1)

2 Asset market microstructure

(23)

2.1 Financial markets: functions and participants

(2)

2.2 Trading mechanisms

(5)

2.3 Industrial organization of financial markets

(4)

2.4 Trading and asset prices in a call market

(3)

2.5 Bid-ask spreads: inventory-based models

(1)

2.6 Bid-ask spreads: information-based models

(3)

2.7 Summary

(2)

References

(2)

3 Predictability of prices and market efficiency

(27)

3.1 Using the past to predict the future

(7)

3.2 Informational efficiency

(6)

3.3 Patterns of information

(2)

3.4 Asset market anomalies

(3)

3.5 Event studies

(2)

3.6 Summary

(2)

Appendix 3.1: The law of iterated expectations and martingales

(2)

References

(2)

4 Decision making under uncertainty

(31)

4.1 The state-preference approach

(5)

4.2 The expected utility hypothesis

(8)

4.3 Behavioural alternatives to the EUH

(3)

4.4 The mean-variance model

101

(4)

4.5 Summary

105

(2)

Appendix 4.1: Useful notation

107

(1)

Appendix 4.2: Derivation of the FVR

108

(1)

Appendix 4.3: Implications of complete asset markets

109

(1)

Appendix 4.4: Quadratic von Neumann-Morgenstern utility

110

(1)

Appendix 4.5: The FVR in the mean-variance model

111

(1)

References

112

(2)

5 Portfolio selection: the mean-variance model

114

(29)

5.1 Mean-variance analysis: concepts and notation

115

(3)

5.2 Portfolio frontier: two risky assets

118

(3)

5.3 Portfolio frontier: many risky assets and no risk-free asset

121

(4)

5.4 Portfolio frontier: many risky assets with a risk-free asset

125

(6)

5.5 Optimal portfolio selection in the mean-variance model

131

(2)

5.6 Summary

133

(1)

Appendix 5.1: Numerical example: two risky assets

134

(1)

Appendix 5.2: Variance minimization: risky assets only

135

(4)

Appendix 5.3: Variance minimization with a risk-free asset

139

(1)

Appendix 5.4: Derivation of Δσρ=βjρσρΔαj

140

(1)

Appendix 5.5: The optimal portfolio with a single risky asset

141

(1)

References

142

(1)

6 The capital asset pricing model

143

(23)

6.1 Assumptions of the CAPM

144

(1)

6.2 Asset market equilibrium

145

(4)

6.3 The characteristic line and the market model

149

(2)

6.4 The security market line

151

(3)

6.5 Risk premia and diversification

154

(3)

6.6 Extensions

157

(2)

6.7 Summary

159

(1)

Appendix 6.1: The CAPM in terms of asset prices

160

(2)

Appendix 6.2: Linear dependence of epsilonj in the CAPM

162

(1)

Appendix 6.3: The CAPM when all assets are risky

162

(3)

References

165

(1)

7 Arbitrage

166

(17)

7.1 Arbitrage in theory and practice

166

(2)

7.2 Arbitrage in an uncertain world

168

(5)

7.3 State prices and the risk-neutral valuation relationship

173

(3)

7.4 Summary

176

(1)

Appendix 7.1: Implications of the arbitrage principle

177

(5)

References

182

(1)

8 Factor models and the arbitrage pricing theory

183

(17)

8.1 Factor models

184

(3)

8.2 APT

187

(3)

8.3 Predictions of the APT

190

(4)

8.4 Summary

194

(1)

Appendix 8.1: The APT in a multifactor model

195

(2)

Appendix 8.2: The APT in an exact single-factor model

197

(2)

References

199

(1)

9 Empirical appraisal of the CAPM and APT

200

(22)

9.1 The CAPM

201

(1)

9.2 Tests of the CAPM: time series

202

(4)

9.3 Tests of the CAPM: cross-sections

206

(8)

9.4 Sharpe ratios and Roll's criticism

214

(1)

9.5 Multiple-factor models and the APT

215

(4)

9.6 Summary

219

(1)

Appendix 9.1: The Black CAPM in terms of excess returns

220

(1)

References

221

(1)

10 Present value relationships and price variability

222

(28)

10.1 Net present value

223

(5)

10.2 Asset price volatility

228

(7)

10.3 Behavioural finance, noise trading and models of dividend growth

235

(2)

10.4 Extreme asset price fluctuations

237

(6)

10.5 Summary

243

(2)

Appendix 10.1: Present values in continuous time

245

(1)

Appendix 10.2: Infinitely lived assets: constant growth

246

(1)

Appendix 10.3: The RNVR with multiple time periods

246

(2)

References

248

(2)

11 Intertemporal choice and the equity premium puzzle

250

(31)

11.1 Consumption and investment in a two-period world with certainty

251

(3)

11.2 Uncertainty, multiple assets and long time horizons

254

(4)

11.3 Lifetime portfolio selection

258

(4)

11.4 The equity premium puzzle and the risk-free rate puzzle

262

(7)

11.5 Intertemporal capital asset pricing models

269

(4)

11.6 Summary

273

(1)

Appendix 11.1: Intertemporal consumption and portfolio selection

274

(2)

Appendix 11.2: Simplifying the FVR

276

(2)

Appendix 11.3: The consumption CAPM

278

(2)

References

280

(1)

12 Bond markets and fixed-interest securities

281

(25)

12.1 What defines a bond?

282

(4)

12.2 Zero-coupon bonds

286

(5)

12.3 Coupon-paying bonds

291

(4)

12.4 Bond valuation

295

(2)

12.5 Risks in bond portfolios

297

(1)

12.6 Immunization of bond portfolios

298

(2)

12.7 Summary

300

(2)

Appendix 12.1: Some algebra of bond yields

302

(3)

References

305

(1)

13 Term structure of interest rates

306

(30)

13.1 Yield curves

307

(3)

13.2 Index-linked bonds

310

(3)

13.3 Implicit forward rates

313

(4)

13.4 The expectations hypothesis of the term structure

317

(5)

13.5 Allowing for risk preferences in the term structure

322

(4)

13.6 Arbitrage and the term structure

326

(2)

13.7 Summary

328

(1)

Appendix 13.1: The expectations hypothesis with explicit uncertainty

329

(2)

Appendix 13.2: Risk aversion and bond portfolios

331

(3)

References

334

(2)

14 Futures markets I: fundamentals

336

(27)

14.1 Forward contracts and futures contracts

337

(5)

14.2 The operation of futures markets

342

(7)

14.3 Arbitrage between spot and forward prices

349

(5)

14.4 Arbitrage in foreign exchange markets

354

(1)

14.5 Repo markets

355

(2)

14.6 Summary and conclusion

357

(2)

Appendix 14.1: Forward and futures prices

359

(1)

Appendix 14.2: Revaluation of a forward contract

360

(2)

References

362

(1)

15 Futures markets II: speculation and hedging

363

(30)

15.1 Speculation

363

(2)

15.2 Hedging strategies

365

(9)

15.3 Optimal hedging

374

(4)

15.4 Theories of futures prices

378

(5)

15.5 Manipulation of futures markets

383

(3)

15.6 Summary

386

(1)

Appendix 15.1: Futures investment as portfolio selection

387

(3)

Appendix 15.2: Derivation of h

390

(2)

References

392

(1)

16 Futures markets III: applications

393

(24)

16.1 Weather futures

393

(4)

16.2 Financial futures contracts

397

(3)

16.3 Short-term interest rate futures

400

(4)

16.4 Long-term interest rate, or bond, futures

404

(2)

16.5 Stock index futures

406

(6)

16.6 The fall of Barings Bank

412

(2)

16.7 Summary

414

(2)

References

416

(1)

17 Swap contracts and swap markets

417

(21)

17.1 Swap agreements: the fundamentals

417

(6)

17.2 Why do swaps occur?

423

(6)

17.3 Risks associated with swaps

429

(1)

17.4 Valuation of swaps

429

(2)

17.5 Metallgesellschaft: a case study

431

(4)

17.6 Summary

435

(2)

References

437

(1)

18 Options markets I: fundamentals

438

(29)

18.1 Call options and put options

439

(7)

18.2 Varieties of options

446

(2)

18.3 Option-like assets

448

(1)

18.4 Upper and lower bounds for option prices

449

(5)

18.5 Put-call parity for European options

454

(3)

18.6 The Modigliani-Miller theorem

457

(2)

18.7 Summary

459

(1)

Appendix 18.1: Lower bound for a European call option premium

460

(1)

Appendix 18.2: Lower bound for a European put option premium

461

(1)

Appendix 18.3: Put-call parity for European options

462

(1)

Appendix 18.4: The Modigliani-Miller theorem: a proof

463

(3)

References

466

(1)

19 Options markets II: price determination

467

(27)

19.1 The fundamentals of option price models

468

(3)

19.2 A two-state option-pricing model

471

(9)

19.3 The Black-Scholes model

480

(6)

19.4 Contingent claims analysis

486

(4)

19.5 Summary

490

(2)

References

492

(2)

20 Options markets III: applications

494

(25)

20.1 Stock index options

495

(1)

20.2 Options on futures contracts

496

(4)

20.3 Interest rate options

500

(4)

20.4 Options and portfolio risks

504

(3)

20.5 Portfolio insurance

507

(5)

20.6 Combinations and spreads

512

(2)

20.7 Summary

514

(1)

Appendix 20.1: Put-call parity for European options on futures

515

(3)

References

518

(1)

Subject index

519

(7)

Author index

526

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The Economics of Financial Markets

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Author Biography

Table of Contents

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The Economics of Financial Markets

Summary

Author Biography

Table of Contents

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