ECON 4515: Finance Theory I

ECON 4515, Finance Theory I, is a core course in many economics and finance programs, typically offered at the advanced undergraduate or introductory graduate level. It provides a rigorous foundation in the theoretical underpinnings of modern finance, focusing on the core models and concepts used to analyze investment decisions, asset pricing, and corporate finance.

The course generally begins with a review of fundamental concepts in probability and statistics, particularly those relevant to financial modeling. This includes topics like random variables, probability distributions, expected value, variance, covariance, and correlation. Understanding these statistical tools is crucial for quantifying risk and return, which are central themes in finance.

A significant portion of the course is dedicated to portfolio theory, particularly the Markowitz mean-variance model. This model explores how investors can construct optimal portfolios by balancing risk and return. Students learn how to calculate the efficient frontier, which represents the set of portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given expected return. The concept of diversification and its benefits are thoroughly examined. The Capital Asset Pricing Model (CAPM) is then introduced as a framework for determining the expected return on an asset, based on its systematic risk (beta) and the market risk premium. Students learn to apply CAPM to evaluate investment opportunities and understand the relationship between risk and expected return in equilibrium.

Further topics often include arbitrage pricing theory (APT), which provides an alternative to CAPM for asset pricing. APT allows for multiple factors to influence asset returns, offering a more flexible framework than CAPM. Understanding the assumptions and limitations of both CAPM and APT is crucial for applying them correctly in real-world scenarios. Another key area covered is option pricing theory, focusing on the Black-Scholes-Merton model. Students learn how to derive the Black-Scholes formula, understand its assumptions, and apply it to price European options. The model serves as a cornerstone for understanding derivatives pricing and risk management.

The course also delves into market efficiency and behavioral finance. Market efficiency explores the degree to which asset prices reflect all available information. Different forms of market efficiency (weak, semi-strong, and strong) are discussed, along with the implications for investment strategies. Behavioral finance challenges the assumption of rational investors by incorporating psychological biases and heuristics into financial models. Students learn how these biases can affect investment decisions and market outcomes.

Throughout the course, a strong emphasis is placed on mathematical rigor and analytical problem-solving. Students are expected to master the theoretical models and apply them to practical examples and case studies. Problem sets, exams, and potentially projects typically involve quantitative analysis, requiring students to use mathematical tools and software to analyze financial data and make investment recommendations. A strong understanding of calculus, linear algebra, and statistics is generally required.