Finance Concepts and Math

Catalog description

This course introduces the key concepts and analytical tools for financial analysis. Mastering these tools is important for making financial decisions and essential for understanding the material in later courses. We will develop two primary approaches to valuation—discounted cash flow valuation and no-arbitrage pricing—and apply these techniques to value fixed income securities, equities, and options. One critical component of discounted cash flow analysis is the determination of the appropriate discount rate. The search for a model of discount rates will naturally take us to a study of risk and return in the context of portfolio choice. The outcome of this journey will be an intuitive derivation of one of the most powerful and famous models in finance—the Capital Asset Pricing Model (CAPM)—and its more recent extensions. Along the way, the course will highlight the role of diversification and the associated classification of risk. The second valuation approach, no-arbitrage pricing, is the primary technique for valuing derivative securities. We’ll see how the law of one price can be applied to value options in a simple binomial setting and how the intuition from this setting allows us to understand the well-known and widely used Black-Scholes option pricing formula. Finally, we will discuss the role of banks and money market funds in the provision of safe and liquid assets. Safe and liquid assets, such as deposits, provide special services that allow them to fetch a higher price than implied by CAPM. Liquid assets, however, are still exposed to interest rate risk, and banks are exposed to the risk of runs, which must be understood and managed.