HARVARD UNIVERSITY: DEPARTMENT OF ECONOMICS

Economics 1723: Capital Markets

Professor Pedro Bordalo

Fall 2018 Littauer 323
Location: Harvard Hall 104 Office hours: Mo 3-4pm, Wed 3-3.30pm
Mon, Wed 1:30pm-2:45pm E-mail: [email protected]
[email protected]
______________________________________________________________________________

Course Overview

This course is an introduction to asset pricing, the study of financial assets and the “capital markets” in
which they are traded. Asset pricing is part of the larger field of financial economics. Other courses in
this area include Corporate Finance, Economics 1745; The Financial System and the Central Bank,
Economics 1759; and Behavioral Finance, Economics 1760.

The course will meet for lectures on Monday and Wednesday 1.30 to 2.45pm, and will meet in small
sections once a week at times to be arranged. The teaching fellows for the course are Jetlir Duraj
([email protected]), Paul Fontanier ([email protected]), Yang You ([email protected]),
and Lucas Lee ([email protected]). My assistant is Mary Lou Corradino
([email protected]).

All course materials will be posted on the course website at https://canvas.harvard.edu/courses/51393

Prerequisites

Economics 1723 is intended for undergraduates with significant mathematical background and an
appetite for technical economic analysis. Prerequisites include intermediate microeconomics at the level
of Economics 1010a (or preferably Economics 1011a – Intermediate microeconomics, advanced),
regression analysis and statistics at the level of Statistics 100, and a good knowledge of calculus. Some
assignments will require data analysis using Microsoft Excel. Some knowledge of linear algebra will be
useful.

Class Participation

In this course we use Learning Catalytics software to post questions in class, which are answered in real
time as an aid to discussion. To make time for these exercises, some of the more technical portions of
lectures will be posted in short modules and you will be asked to review these modules before class.

Class participation will receive course credit as follows. In each of three sections of the course, we will
measure participation (defined as posting an answer to a question, whether or not the answer is correct)
and will grade such participation as a “virtual assignment”. The three virtual assignments will be
considered equivalent to traditional written assignments (described below) for the assignment portion of
the course grade.

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Assignments

Course requirements include nine written homework (HM) assignments. The assignments will be
handed out in class, normally on Wednesdays, and will be due back at the start of class the following
Wednesday. Some assignments will be purely analytical while others will be numerical, requiring the
use of Excel to process financial data.
• No assignment will be accepted after 1.45pm on the due date.
• You are permitted to collaborate on the homework assignments. However, each person must
submit a separate write-up. If you choose to work within a group, each person is asked to list the
members of the group at the top of the submission.
• Assignments are graded on a check+, check, check- basis.
• Grades for the nine written assignments and three virtual assignments (described above under
class participation) will be treated equally. To give you some flexibility, the overall assignment
grade will be based on your best 8 out of these 12 assignments. In total, the assignments
account for 20% of the course grade.

The due dates should be as follows: HM1: 9/17, HM2: 9/26, HM3: 10/3, HM4: 10/24, HM5: 10/31,
HM6: 11/7, HM7: 11/21, HM8: 11/28, HM9: 12/3 (but we may announce a change)

Exams

The course has two midterm exams and a final exam. The first midterm exam will be in class on Wed,
10/10/18, and the second midterm will be in class on Wed, 11/7/18. There will be a final exam, which
will be held during the final exam week (date TBC). The assignments account for 20% of the course
grade, each midterm exam accounts for 20% of the grade, and the final exam accounts for the remaining
40% of the grade.
• MISSED EXAMS: If you are excused from a midterm exam, the course grades on subsequent
exams will be increased proportionally to make up for the missing exam. Thus, if you are
excused from the first midterm exam the grade weights will increase to 26.67% for the second
midterm exam and 53.33% for the final exam. If you are excused from the second midterm
exam, the grade weight will increase to 60% for the final exam. To be excused from a midterm
exam, you must contact me before the exam date or submit a medical excuse; this policy does
NOT allow you simply to skip a midterm exam. The usual university policies apply to a missed
final exam, which is handled by the registrar’s office.
• REGRADE POLICY: After an exam is graded and returned to you, you will have the option to
request a regrade for a short period following each exam. However, please be aware that we
reserve the right to regrade the entirety of your exam. Further, to ensure that graded exams are
not tampered with between the time when they are returned to students and submitted for a
regrade we will photocopy a random selection of the graded exams.
• PASS/FAIL POLICY: I will allow a limited number of students to take the course pass/fail.
Pass/fail students must fulfil all course requirements including participation, written
assignments, and exams. To apply for this status, please send an email to me stating the reason
for the request.
• Exams are closed book, closed notes. You can bring your own cheat sheet to the exams: a one-
sided cheat sheet for Midterm 1, and a 2-sided cheat sheet for Midterm 2 and for the final exam.

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Textbook and Readings

The textbook for the course is Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 11th ed. 2017,
McGraw-Hill Irwin. This book is very thorough and a valuable reference on the details of US financial
markets and institutions. You’ll be fine with an earlier edition (the 10th edition has the same chapter
numbers).

An optional reference is Jeremy J. Siegel, Stocks for the Long Run, 5th ed. 2014, McGraw-Hill Irwin,
which contains a wealth of accessible information about the history of stock and other asset prices.

A number of journal articles are assigned readings and will be made available through the website. Most
of these articles (particularly those from the Journal of Economic Perspectives) are accessible
introductions to a topic. For students who are interested in journal articles written at a professional level,
the syllabus includes some more advanced references, marked with square brackets, but these are not
required readings. You are only responsible for understanding the results from these articles that are
discussed in lectures or sections.

The textbook, the recommended books, and most of the assigned articles are less analytical than the
lectures. The technical content of the course is summarized in the lecture notes and other class notes,
which will be handed out during the semester.

Sections

The course will meet in small sections once a week at times to be arranged. Sections have three main
functions. First, they will occasionally cover background material necessary to understand the lectures,
including statistics and linear algebra. Second, they will provide a review of the material covered in
recent lectures. Third, they will present solutions to practice problems that are similar to those that will
appear in assignments and exams.

Laptops

Students are encouraged to print out the lecture slides, a consolidated version with space for notes is
available on the course website. Laptops are not encouraged during class, as they tend to hamper
learning. See https://www.nytimes.com/2017/11/22/business/laptops-not-during-lecture-or-meeting.html
and the references therein.

Calculators

For Midterms and final exam, you'll need a calculator (phones are not allowed). It is a distinct advantage
to have a graphing calculator (sometimes also called an engineering calculator) or a financial calculator,
but not an absolute requirement. If you plan to take other finance classes, you will get good use out of a
financial calculator anyways. Standard financial calculators include the HP 10B-II and the TI BA-II
Plus (they cost about $30). You are expected to learn how to operate the calculator on your own.

Canvas and Piazza

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The course web page is: https://canvas.harvard.edu/courses/51393.

This term we will be using Piazza for class discussion. You’ll access it via the Canvas course web page.
The system is catered to getting you help fast and efficiently from classmates, the TAs, and myself.
Rather than emailing questions to the teaching staff, I encourage you to post your questions on Piazza. If
you have any problems or feedback for the developers, email [email protected]. If you do wish to send
an email, please include Ec1723 in the subject line of all e-mails regarding the course.

We hope to make Ec1723 a great learning experience for everyone and look forward to teaching you
this semester!

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 Economics 1723: Capital Markets

Course Outline
____________________________________________________________________________

1. Introduction (September 5 – September 17)

Fundamental ideas of finance: arbitrage, optimality, and equilibrium

Financial markets and instruments
Event trees, state prices, and complete markets
Rates of returns
Present value and internal rate of return
Risk aversion and risk premia
Arbitrage in practice
Application: Negative stub values

2. Risk and return (September 19 – October 3)

a. Optimization: Mean-variance analysis and portfolio choice

The mean-variance efficient frontier

The mutual fund theorem
The beta representation theorem
Application: How does Harvard invest its endowment? Do households diversify?

b. Equilibrium: The Capital Asset Pricing Model

Derivation of the CAPM

The security market line
The size, value, and momentum anomalies
Application: Why is the reward for beta so low?

c. Risk Arbitrage: The Arbitrage Pricing Theory and multifactor models

Derivation of the Arbitrage pricing theory

Multifactor models
Application: The disappearing January effect

c. Advanced topics in portfolio choice (covered later in the course)

Hedging nontraded assets

Portfolio choice for long-term investors
Application: Stocks for the long run?

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3. Present value relations and efficient markets (October 10 – November 7)

a. Efficient markets, random walk hypothesis, and performance evaluation

The idea of market efficiency

Performance evaluation
Reaction to information and the Law of Iterated Expectations
Applications: Do active mutual fund managers justify their fees? Post-earnings announcement drift;
prediction markets

b. Equity valuation

The dividend discount model and the Gordon model

Earnings and equity valuation
Uncertainty, short sale constraints, and equity valuation
Applications: The Fed model; the technology and the housing bubbles

c. The term structure of interest rates

Fixed-income securities
The term structure of interest rates
The expectations hypothesis of the term structure
Application: Inflation-indexed bonds

d. Market microstructure and liquidity

Stale prices and serial correlation

Measuring liquidity
Application: Market manipulation

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4. Derivative securities and risk management (November 12 – December 5)

a. Forwards, futures, and swaps

The difference between forwards and futures

Swaps

b. Options

Characteristics of options
Put-call parity
The binomial model and the Black-Scholes model
Contingent claims analysis
Overpricing of index options

c. Risk management and crises

Options and risk management

Risk measurement difficulties
Structured finance
Leverage and amplification mechanisms
Applications: The LTCM crisis; the credit crisis of 2007-2009

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 Economics 1723: Capital Markets

Assigned Readings

___________________________________________________________________________________

Course textbook

Zvi Bodie, Alex Kane, and Alan J. Marcus (“BKM”), Investments, 11th ed. 2017, McGraw-Hill Irwin
(available at the Harvard Coop). You’re also fine with the 10th edition.

Recommended books

I also recommend buying also the Solution manual for Investments. If you find a concept difficult, you
can do a few BKM exercises related to it, and verify your answer in the solution manual. You need to
buy it online. 1

Jeremy J. Siegel, Stocks for the Long Run, 5th ed. 2014, McGraw-Hill Irwin (available at the Coop).
A wealth of accessible information about the price history of stocks and other assets.

In addition, the last page of this document lists some suggestions for further reading.

1. Introduction

BKM Chapters 1 (skim), 2 (sections 1-4) and 3 (sections 2-9).

BKM Chapters 5 (sections 2-9) and 6 (section 1 and Appendix A).
Siegel Chapters 1 and 3.
Lamont, Owen A. and Richard H. Thaler, 2003, “Anomalies: The Law of One Price in Financial
Markets,” Journal of Economic Perspectives 17(4), 191-202.
[Mitchell, Mark, Todd Pulvino, and Erik Stafford, 2002, “Limited Arbitrage in Equity Markets,”
Journal of Finance 57, 551-584.]

1 To do that: 1. Go to https://create.mheducation.com/shop/ 2. Search for and select book by ISBN:

9781307185775. 3. Add the book to your cart and pay using a credit card.

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2. Risk and return

a. Optimization: Mean-variance analysis

BKM Chapters 6, 7, and 8.

Harvard Business School Case 9-211-004, “Harvard Management Company (2010).”
[Calvet, Laurent, John Y. Campbell, and Paolo Sodini, 2007, “Down or Out? Assessing the Welfare
Costs of Household Investment Mistakes”, Journal of Political Economy 115, 707-747.]

b. Equilibrium: The Capital Asset Pricing Model

BKM Chapters 9 and 13.

Siegel Chapter 9.
Baker, Malcolm and Jeffrey Wurgler, 2015, “Do Strict Capital Requirements Raise the Cost of
Capital? Bank Regulation, Capital Structure, and the Low Risk Anomaly”, American Economic Review
Papers & Proceedings 105, 315-320.
Fama, Eugene F. and Kenneth R. French, 2004, “The Capital Asset Pricing Model: Theory and
Evidence,” Journal of Economic Perspectives 18(3), 25-46.

c. Arbitrage: The Arbitrage Pricing Theory and multifactor models

BKM Chapter 10.

Frazzini, Andrea, David Kabiller, and Lasse H. Pedersen, 2013, “Buffett’s Alpha”, unpublished paper,
AQR Capital Management.

d. Advanced topics in portfolio choice

Siegel Chapter 2.
Campbell, John Y. and Luis M. Viceira, 2005, “The Term Structure of the Risk-Return Tradeoff,”
Financial Analysts Journal 61, January/February, 34-44.

3. Present value relations and efficient markets

a. Efficient markets and the random walk hypothesis

BKM Chapters 11 and 12.

Siegel Chapter 21.
Wolfers, Justin and Eric Zitzewitz, 2004, “Prediction Markets,” Journal of Economic Perspectives
18(2), 107-126.
[Wermers, Russ, 2000, “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking
Talent, Style, Transactions Costs, and Expenses,” Journal of Finance 55, 1655-1695.]

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b. Equity valuation

BKM Chapter 18.

Siegel Chapters 7 and 8.
Asness, Clifford S. Andrea Frazzini, and Lasse H. Pedersen, 2014, “Quality Minus Junk”, unpublished
paper, AQR Capital Management.
Campbell, John Y. and Robert J. Shiller, 2005, “Valuation Ratios and the Long-Run Stock Market
Outlook: An Update,” in Nicholas Barberis and Richard Thaler eds. Advances in Behavioral Finance
Vol. II, Princeton University Press.

c. The term structure of interest rates

BKM Chapters 14, 15, and 5 (section 1).

Siegel Chapter 14.
Campbell, John Y., 1995, “Some Lessons from the Yield Curve,” Journal of Economic Perspectives
9(3), 129-152.
Council of Economic Advisers, 2015, “Long-Term Interest Rates: A Survey”, unpublished report.

d. Market microstructure and liquidity

BKM Chapter 3.
Asness, Clifford, Robert Krail, and John Liew, 2001, “Do Hedge Funds Hedge?” Journal of Portfolio
Management, 28(1), 6-19.
[Carhart, Mark, Ron Kaniel, David Musto, and Adam Reed, 2002, “Leaning for the Tape: Evidence of
Gaming Behavior in Equity Mutual Funds,” Journal of Finance, 57, 661-693.]

4. Derivative securities and risk management

a. Forwards, futures, and swaps

BKM Chapters 22 and 23.

Siegel Chapter 18.

b. Options

BKM Chapters 20 and 21.

Siegel Chapter 19.
[Coval, Joshua D. and Tyler Shumway, 2001, “Expected Option Returns,” Journal of Finance 56,
983-1009.]

c. Risk management and crises

Course notes.

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 Suggested Further Reading

Richard Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial
Innovation, 2007, Wiley. A readable discussion of modern financial vulnerability.

[Hard] John H. Cochrane, Asset Pricing, revised ed., 2005, Princeton University Press. A PhD- level
textbook on asset pricing theory.

[Hard] John Y. Campbell Financial Decisions and Markets: A Course in Asset Pricing, Oxford
University Press, 2017. A modern PhD- level textbook on asset pricing theory.

[Hard math] John C. Hull, Options, Futures, and Other Derivatives, 6th ed. 2005, Prentice-Hall. The
leading modern text on derivatives, with a practical orientation.

Antti Ilmanen, Expected Returns: An Investor’s Guide to Harvesting Market Rewards, 2011, Wiley.
A comprehensive guide to empirical patterns in asset markets.

Charles Kindelberger. Manias, Panics, and Crashes: A History of Financial Crises, Seventh Edition. A
vivid set of stories about bubbles and crashes.

Burton Malkiel, A Random Walk Down Wall Street, any ed., Norton (available at the Coop).
A classic and fun read about efficient markets.

Michael Lewis, The Big Short: Inside The Doomsday Machine, 2010, Norton. An entertaining
description of investors who took negative positions on the housing market in the run-up to the crisis.

Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management, 2000,
Random House. An intelligent journalistic account of the 1998 financial crisis.

Sebastian Mallaby, More Money Than God: Hedge Funds and the Making of a New Elite, 2010,
Penguin Press. An insightful analysis of the successes and failures of hedge funds.

Lasse Pedersen, 2015, Efficiently Inefficient: How Smart Money Invests and Market Prices are
Determined, Princeton University Press. Relates academic finance to investing strategies.

Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly,
2009, Princeton University Press. The recent crisis viewed from an international and historical
perspective.

Robert J. Shiller, Irrational Exuberance, 2005, 2nd ed., Broadway Books. This book, originally
published in early 2000, correctly predicted the end of the technology bubble.

Andrei Shleifer, Inefficient Markets: An Introduction to Behavioral Finance, 2000, Oxford University
Press. An accessible graduate-level presentation of behavioral finance.

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