API 141 Finance SYLLABUS September 11, 2007
Akash Deep
API 141 Finance Syllabus Akash Deep September 11, 2007
John F. Kennedy School of Government, Harvard University API-141, Fall 2007 Finance Faculty: Office: Telephone: Email: Office Hours: Lectures: Review Sessions: Faculty assistant: Office: Telephone: Teaching Fellow: Akash Deep Littauer 213 617 495 1340 akash_deep@harvard.edu Thursday afternoons (sign-up outside L-213) Tuesday and Thursday, 10:10 to 11:30 AM in Wiener Auditorium Friday, 10:10 to 11:30 AM in Wiener Auditorium Camiliakumari Wankaner Littauer 201 617 495 5994 Anthony Stinton
COURSE DESCRIPTION This introductory course provides a general survey of finance and investments. It emphasizes an intuitive, logically rigorous understanding of the theory and practice of financial markets, illustrating the concepts through examples and cases drawn from the public, private, and nonprofit sectors. Topics covered include: present value analysis and discounting, diversification, the tradeoff between risk and return, market efficiency, pricing of stocks and bonds, the capital asset pricing model, the arbitrage pricing theory, term structure of interest rates, the principle of arbitrage, pricing of derivative securities (forwards, futures, and options), the use of derivatives for hedging, and risk management. AUDIENCE The course is intended for students who are interested in learning the basic tools and techniques of finance and how they are employed for the valuation of complex securities. While an intuitive appreciation of the principles will be the primary objective, mathematical tools will be employed to illustrate the implementation of these principles to practical cases. Any advanced mathematics that is used will be developed in lectures and review sessions. PREREQUISITE It is assumed that students will be familiar with introductory concepts in economics (e.g. API 101) and basic (high school level) mathematics. Students with concerns about their backgrounds are welcome to speak to the instructor. Familiarity with computer spreadsheets will be expected.
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API 141 Finance Syllabus Akash Deep September 11, 2007
REQUIREMENTS The course must be taken for credit. No auditors please. Attendance: An alert, inquisitive presence in each and every class is mandatory. Attendance in review sessions is strongly advised but not required. Readings and Assignments: Students will be expected to have completed the assigned readings before class and review them after class. Weekly problem sets will be assigned throughout the course to illustrate and reinforce the concepts presented in class. A written assignment will precede each case discussion. Exams: There will be an in-class, closed book and closed notes, midterm exam and an in-class, closed book and closed notes final exam. The tentative dates are mentioned below. No make-up exams will be held. Grading: Class Participation Midterm Exam Final Exam MATERIALS The textbook for the course, Essentials of Investments, 6th edition by Zvi Bodie, Alex Kane and Alan Marcus, McGraw-Hill Irwin, 2007, is available online and in bookstores such as the Harvard Coop. Other “Required Readings”, including cases, are available from the Course Materials Office as a course packet. Regular reading of The Wall Street Journal and The Financial Times is strongly recommended. OTHER RECOMMENDED (BUT NOT REQUIRED) FINANCE TEXTS The following are some good introductory finance texts that overlap in parts with the material covered in the recommended text for this class: Investments, 6th edition, William Sharpe, Gordon Alexander, and Jeffery Bailey, Prentice Hall, 1999. Corporate Finance, 7th edition, Stephen Ross, Jeffrey Jaffe, and Randolph Westerfield, 2005. Principles of Corporate Finance, 7th edition, Richard Brealey and Stewart Myers, The McGrawHill Companies, 2003. These are some additional intermediate to advanced texts devoted to asset pricing: Modern Portfolio Theory and Investment Analysis, 6th edition, Edwin Elton, Martin Gruber, Stephen Brown and William Goetzmann, John Wiley and Sons, Inc. 2003. Investment Science, David Luenberger, Oxford University Press, Inc. 1997. Options, Futures, and Other Derivatives, 6th edition, John C. Hull, Prentice Hall, 2005. 10% 30% 40% Written assignments 20%
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API 141 Finance Syllabus Akash Deep September 11, 2007
TOPICS AT A GLANCE Day Thu Tue Thu Tue Thu Tue Thu Tue Thu Tue Thu Tue Thu Tue Thu Tue Thu Tue Thu Tue Tue Thu Tue Thu Tue Wed Date Sep 13 Sep 18 Sep 20 Sep 25 Sep 27 Oct 2 Oct 4 Oct 9 Oct 11 Oct 16 Oct 18 Oct 23 Oct 25 Oct 30 Nov 1 Nov 6 Nov 8 Nov 13 Nov 15 Nov 20 Nov 27 Nov 29 Dec 4 Dec 6 Dec 11 Dec 12 Topic Introduction to finance and financial markets Present value and the opportunity cost of capital Valuing financial securities: Bonds Valuing financial securities: Equity Diversification, risk, and return measures Case: The State of South Carolina Choosing a portfolio The Capital Asset Pricing Model Municipal Bonds (Guest: Mr. Colin MacNaught, Standard & Poor’s) Case: Communications Satellite Corporation Efficient markets Arbitrage Arbitrage Pricing Theory Case: Long-Term Capital Management Midterm exam (in class) Risk management Forward and futures contracts Case: Dozier Industries Options Pricing of options Case: The Privatization of Rhone-Poulenc, 1993 Real options Case: Bidding for Antamina Review: the big picture TBD Final exam ( 9 AM to 12 noon) E F Assignment due
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API 141 Finance Syllabus Akash Deep September 11, 2007
INTRODUCTION TO FINANCE AND FINANCIAL MARKETS Required Readings Introduction to finance and financial markets Chapters 1 and 2, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. “The New Capitalism, How Unfettered finance is fast reshaping the global economy”, Martin Wolf, The Financial Times, June 19, 2007. Additional Readings Chapters 3 and 4, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. The Wall Street Journal Guide to Understanding Money and Investing, Kenneth Morris, Virginia Morris and Alan Siegel, Simon & Schuster Trade, 1999. A Random Walk Down Wall Street, 7th edition, Burton Malkiel, W. W. Norton & Company, Inc., 2000.
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API 141 Finance Syllabus Akash Deep September 11, 2007
VALUATION: PRICING STOCKS AND FIXED INCOME SECURITIES Required Readings Present value and the opportunity cost of capital Chapters 2 and 3, Principles of Corporate Finance, 7th edition, Richard Brealey and Stewart Myers, 2003, 12-50. Valuing financial securities: Bonds Chapter 9, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. “Some Question U.S. Bond Rating”, Aaron Lucchetti, The Wall Street Journal, December 7, 2004, p A1. Valuing financial securities: Equity Chapter 12 and Section 13.1, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007.
Additional Readings “Uses, Abuses, and Alternatives to the Net Present Value Rule”, S. Ross, Financial Management, Vol. 24, 96-102, 1995. “Market Myths”, G. Bennett Stewart, III, Journal of Applied Corporate Finance, Vol. 2, No. 3, Fall 1989, 6-23. “Do Stock Prices Reflect Fundamental Values?”, J. Randall Woolridge, Journal of Applied Corporate Finance, Spring 1995, 64-69. “Valuation Models for Default-risky Securities: An Overview”, Saikat Nandi, Federal Reserve Bank of Atlanta Economic Review, Fourth Quarter 1998
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API 141 Finance Syllabus Akash Deep September 11, 2007
PORTFOLIO SELECTION Required Readings Diversification, risk, and return measures Chapter 5 and Section 18.3, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. “Risk, Market Sensitivity, and Diversification”, William F. Sharpe, Financial Analysts Journal, JanFebruary, 1995, 84-88. Choosing a portfolio Chapter 6, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. “You, too, Can Short Stocks”, Business Week, March 22, 1999 “Long & Short: It’s a Tough Job, So Why Do They Do It? The Backward Business of Short Selling”, Jesse Eisinger, The Wall Street Journal, March 1, 2006, p C1. Case: The State of South Carolina HBS case # 9-201-061 South Carolina, State Treasurer's Office, 1998. Until last year the state pension fund, with over $17 billion in assets, was barred by the state constitution from investing in equities. After the constitution was amended, the state government has to decide how much to invest in equities, and what assets to choose. Additional Readings “Why Not Diversify Internationally rather than Domestically?”, Bruno H. Solnik, Financial Analysts Journal, Jan-Feb, 1995, 89-94. "Estimating Expected Return", Fisher Black, Financial Analysts Journal, Jan-Feb 1995, 168-171. "Why No One Can Tell Who's Winning", J. Michael Murphy, Financial Analysts Journal, May-Jun 1980, 49-57. "Portfolio Optimization in Practice", Phillipe Jorion, Financial Analysts Journal, January-February, 1992, 68-74. "Portfolio Theory versus Portfolio Practice", Richard Brealey, Journal of Portfolio Management, Summer 1990, 6-10. "The Persistence of Risk: Stocks versus Bonds over the Long Term", Martin Leibowitz and William Krasker, Financial Analysts Journal, November-December 1988, 40-47. “Global Stock Markets in the Twentieth Century”, Philippe Jorion and William Goetzman, Journal of Finance, 1999, Vol. 54, no. 3, 953-980.
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API 141 Finance Syllabus Akash Deep September 11, 2007
THE CAPITAL ASSET PRICING MODEL Required Readings The Capital Asset Pricing Model Sections 7.1-7.4, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. “Risk and Return” The Economist, February 2nd 1991, 72-73. “Does the Capital Asset Pricing Model Work?” David Mullins, Jr., Harvard Business Review, JanuaryFebruary, 1982, 105-113 Case: Communications Satellite Corporation HBS Case No. 276-195 In January 1975, the Federal Communications Commission (FCC) concluded an 11-year investigation of the appropriate regulation of Comsat. One of the most important of these was the determination of the fair rate of return on Comsat's capital. Both the qualitative assessment of risk and the use of analytical techniques had been suggested by eminent experts. Additional Readings "Prediction of Beta from Investment Fundamentals", Barr Rosenberg and James Guy, Financial Analysts Journal, Jan.-Feb., 1995. "The Capital Asset Pricing Model and the Market Model", Barr Rosenberg, Journal of Portfolio Management, Winter 1981. "Beta and Return", Fisher Black, Journal of Portfolio Management, Fall 1993. "Efficient? Chaotic? What's the New Finance?" Nancy Nichols, Harvard Business Review, March-April, 1993, 2-7. "Beta and Return", Fisher Black, Journal of Portfolio Management, Fall 1993, 8-17. "In Defense of Beta", S.P Kothari and Jay Shanken, Journal of Applied Corporate Finance, Spring 1995, 53-58. "Tale from the FAR Side", The Economist, November 16th 1996, 86.
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API 141 Finance Syllabus Akash Deep September 11, 2007
EFFICIENT MARKETS Required Readings Efficient markets Chapter 8, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. “Random Walks in Stock Market Prices”, Eugene F. Fama, Financial Analysts Journal, Jan-February, 1995, 75-80. “The Efficient Market Hypothesis and its Critics”, Burton G. Malkiel, Journal of Economic Perspectives, Winter 2003 17 (1) 59-82 “The Truth Investors Don’t Want to Hear on Index Funds and Market Soothsayers”, The Wall Street Journal, May 12, 1998, C1. “The Efficient Market Theory Thrives on Criticism”, Dwight Lee and James Verbrugge, Journal of Applied Corporate Finance, Vol. 9, No. 1, Fall 1996, 35-40. “Stock Characters: As Two Economists Debate Markets, the Tide Shifts", The Wall Street Journal, October 18, 2004, A1. Additional Readings "Implications of the Random Walk Hypothesis for Portfolio Management", Fisher Black, Financial Analysts Journal, March-April, 1971, 16-22. "The Theory of Stock Market Efficiency: Accomplishments and Limitations", Ray Ball, Journal of Applied Corporate Finance, Spring 1995, 4-17. "How Rational Investors Deal with Uncertainty (Or Reports of the Death of Efficient Markets are Greatly Exaggerated)", Keith Brown, W. Harlow, and Seha Tinic, Journal of Applied Corporate Finance, Fall 1989, 45-58. "I've Got the Horse Right Here: Sports Betting and Market Efficiency", Martin Fridson, Journal of Applied Corporate Finance, Summer 1993, 88-95. "The Impact of Macroeconomic News on Financial Markets", Louis Ederington and Jae Lee, Journal of Applied Corporate Finance, Spring 1996, 41-49. Manias, Panics & Crashes: A History of Financial Crises, 3rd edition, Charles Kindleberger, John Wiley & Sons, Inc., 1996. Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life, 2nd edition, Nassim Nicholas Taleb, Thomson South-Western, 2004.
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API 141 Finance Syllabus Akash Deep September 11, 2007
ARBITRAGE PRICING Required Readings Arbitrage "Death by the Numbers", David Kestenbaum, Science, February 26, 1999, 1244-1247. Arbitrage Pricing Theory “An Alternative View to Risk and Return”, Chapter 11, Corporate Finance, 7th edition, Stephen Ross, Jeffrey Jaffe, and Randolph Westerfield, 2005. “The Arbitrage Pricing Theory Approach to Strategic Portfolio Planning”, Richard Roll and Stephen Ross, Financial Analysts Journal, Jan-Feb, 1995, 122-131. Case: Long-Term Capital Management “Hedge Fund Existential” Richard Bookstaber, Financial Analysts Journal, September/October 2003, p 19. “How Salesmanship and Brainpower Failed to Save Long-Term Capital” Michael Siconolfi, Anita Raghvan, et. al., The Wall Street Journal, November 16, 1998, p A1. Smart people aren't supposed to get into this kind of a mess. With two Nobel prize winners among its partners, Long-Term Capital Management L.P. was considered too clever to get caught in a market downdraft. The Greenwich (Conn.) hedge fund nearly tripled the money of its wealthy investors between its inception in March, 1994, and the end of 1997. Its sophisticated arbitrage strategy was avowedly ''market-neutral'' -designed to make money whether prices were rising or falling. Indeed, until last spring its net asset value never fell more than 3% in a single month. Then came the guns of August. Long-Term Capital's rocket science exploded on the launchpad. Its portfolio's value fell 44%, giving it a year-to-date decline of 52%. That's a loss of almost $ 2 billion. (“Failed Wizards of Wall Street”, Business Week, September 28, 1998)
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API 141 Finance Syllabus Akash Deep September 11, 2007
Additional Readings “What Every CFO Should Know About Scientific Progress in Financial Economics…”, Richard Roll, Financial Management, 23 (2), Summer, 1994, 69 - 75. “Arbitrage”, Stephen Ross and Philip Dybvig, The New Palgrave, 1989, 57 - 71. “The Arbitrage Principle in Financial Economics”, Hal Varian, The Journal of Economic Perspectives, Autumn, 1987, 55-72. “How the Eggheads Cracked”, Michael Lewis, The New York Times, January 24, 1999, p 24, Column 5. “What moves Stock Prices?”, David Cutler, James Poterba, and Lawrence Summers, Journal of Portfolio Management, Spring 1989. "The Arbitrage Theory of Capital Asset Pricing" Journal of Economic Theory, December 1976, p 341360. “An Empirical Investigation of the Arbitrage Pricing Theory”, Richard Roll and Stephen Ross, Journal of Finance, December 1980, p 1073-1103. “A Primer on Arbitrage Pricing Theory” D. Bower, R. Bower, and D.E. Logue, The Midland Journal of Corporate Finance, Fall, 1984, Vol 2, No. 3, p 31-40. “Factor models, CAPMs, and the APT”, William Sharpe, Journal of Portfolio Management, Fall 1984, p 21-25.
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API 141 Finance Syllabus Akash Deep September 11, 2007
RISK MANAGEMENT Required Readings Risk Management “The Fantastic System of Side Bets” in Against the Gods: The Remarkable Story of Risk, Peter Bernstein, 1996, 304-328. “A Framework for Risk Management”, Kenneth Froot, David Scharfstein, and Jeremy Stein, Harvard Business Review, November-December 1994, 91 - 102. “Risk management for the masses”, The Economist, March 20, 2003. Forward and Futures Contracts Sections 16.1-16.4, and Section 18.2, Essentials of Investment, 6th edition, Bodie, Kane & Marcus, 2007. “Note on Hedging Foreign Currency Debt”, Akash Deep, 1999. “Financial WMD?”, The Economist, January 22, 2004. Case: Dozier Industries “Currency Derivatives Markets Landscape”, John W. Labuszewski, The Journal of Trading, Spring 2006. "Dozier Industries" in G. Feiger and B. Jacquillat, International Finance, Allyn and Bacon, 1982. A US company has just secured its first international sales contract in the UK. But the CFO of the company is concerned that if the value of the pound sterling depreciated, the viability of the project could be impaired. Additional Readings "Pricing Financial Futures Contracts: An Introduction", Kenneth French, Journal of Applied Corporate Finance, Winter 1989, 59-66. “Your Financial Future”, The Economist, May 14th 1994, 15 - 16. “Futures Trading”, H. Houthakker, The New Palgrave, 1989, 153 - 157. "The Currency Hedging Decision: A Search for Synthesis in Asset Allocation, Gary Gastineau, Financial Analysts Journal, May-Jun 1995. "Estimating Currency Hedge Ratios for International Portfolios", Grant Gardner, and Douglas Stone, Financial Analysts Journal, Nov-Dec 1995. "Derivative Assets Analysis", Mark Rubinstein, The Journal of Economic Perspectives, Autumn, 1987, 73-93.
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API 141 Finance Syllabus Akash Deep September 11, 2007
"Stock Index Futures and the Crash of '87", Merton Miller, Burton Malkiel, Myron Scholes, and John Hawke, Journal of Applied Corporate Finance, Winter 1989, 6-17. "The Case of the Missing Ten Pounds: In which Sherlock Holmes explains forward pricing, options theory and other financial arcana", John Price, Derivatives Strategy, October 1997. (also available online at http://www.sherlockinvesting.com/articles/tenpounds.htm) "Measuring Financial Risk", Clifford Smith Jr., Charles Smithson, and D. Sykes Wilford, Journal of Applied Corporate Finance, Winter 1989, Vol. 1, No. 4, 27-48. "Global Risk Management: Are We Missing the Point?", Richard Bookstaber, Journal of Portfolio Management, Spring 1997, 102-107. “A Multifractal Walk Down Wall Street”, Benoit Mandelbrot, Scientific American, February 1999, 70-73. “The Beauty in the Beast”, The Economist, May 14th 1994, 21 - 24. "Using Derivatives: What Senior Managers Must Know", Harvard Business Review, January-February, 1995, 3-10. "Risk as a History of Ideas", Peter Bernstein, Financial Analysts Journal, January-February, 1995, 7-11. "What is VAR?", David Shimko, Risk, July 1997. "The Benefits and Risks of Derivative Instruments: An Economic Perspective", Rajna Gibson and Heinz Zimmermann, Working Paper, http://Finance.Wat.ch/GenevaPapers/paper1.htm "Risk Management Guidelines for Derivatives", Basle Committee on Banking Supervision, 1994, http://www.bis.org/publ/bcbsc211.pdf "Does Government have a Future in Derivatives?" Ken Bull, Australian Business Law Review, August 1997, 246-257. "10 Myths About Financial Derivatives", Thomas Siems, Policy Analysis, September 1997.
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API 141 Finance Syllabus Akash Deep September 11, 2007
OPTION CONTRACTS Required Readings Options Chapter 14, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. “Of Butterflies and Condors”, The Economist, February 16, 1991, 58-59. Pricing of Options Chapter 15, Essentials of Investments, 6th edition, Bodie, Kane & Marcus, 2007. “A Calculus of Risk”, Gary Stix, Scientific American, May 1998, 92-97. “So many options”, The Economist, November 7, 2002. Case: The Privatization of Rhone-Poulenc, 1993 HBS Case # 295-049 In mid-1993, representatives of Rhone-Poulenc, a leading nationalized French firm, are working with the French government to plan the imminent privatization of the firm. One aspect of the privatization was to create incentives for employees to buy and hold shares in the firm. A partial privatization earlier in 1993 proved that workers were reluctant to hold equities, even after receiving discounts and subsidized financing. The key financial officers of the firm received a proposal from Bankers Trust that would offer employees a unique investment in the firm, which might increase employee participation in the share offering. This alternative would guarantee employees a minimum rate of return yet allow them to enjoy appreciation of the firm's shares. The financial officers have to decide whether to propose this employee stock ownership alternative to the French government and to Rhone-Poulenc's board for inclusion in the forthcoming privatization. Additional Readings “Replicating Options with Positions in Stock and Cash”, Mark Rubinstein and Hayne Leland, Financial Analysts Journal, Jan-Feb, 1995, 113-121. "Implied Volatility", Stewart Mayhew, Financial Analysts Journal, July-Aug 1995, 8-20. "Option Pricing Thoery: Is Risk-Free Hedging Feasible?", John Glister, Jr., Financial Management, Spring 1997, 91-105. "Fact and Fantasy in the Use of Options", Fischer Black, Financial Analysts Journal, Jul-Aug 1975, 3672. "How We Came up with the Option Formula", Fisher Black, Journal of Portfolio Management, Winter 1989.
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API 141 Finance Syllabus Akash Deep September 11, 2007
REAL OPTIONS Required Readings Real Options “The Options Approach to Investment”, Avinash Dixit and Robert Pindyck, Harvard Business Review, May-June 1995, 105 – 115. Case: Bidding for Antamina HBS Case # 297-054 In June 1996, executives of the multinational mining company RTZ-CRA are contemplating bidding to acquire the Antamina copper and zinc mine in Peru. The Antamina project is being offered for sale by auction as part of the privatization of Peru's state mining company. RTZ-CRA has to determine what the mine is worth, and to recommend whether and how RTZ-CRA should bid in the upcoming auction. The bidding rules put in place by the Peruvian government dictate that each company's bid contain two components: an up-front cash amount and the amount the bidder will invest to develop the property, if development is warranted after further exploration is completed. Additional Readings Investment under Uncertainty, Avinash Dixit and Robert Pindyck, Princeton University Press, 1994. Real Options: Managerial Flexibility and Strategy in Resource Allocation, Lenos Trigeorgis, MIT Press, 1996. Real Options in Capital Investment: Models, Strategies, and Applications, Lenos Trigeorgis (Editor), Greenwood Publishing Group, Incorporated, 1995. “Using APV: A Better Tool for Valuing Operations”, Harvard Business Review, May-June, 1997, 3-10. “What's It Worth? A General Manager's Guide to Valuation”, Timothy Luehrman, Harvard Business Review, May-June 1997, 132-142. “Today's Options for Tomorrow's Growth”, W. Carl Kester, Harvard Business Review, March-April 1984, 153-160. “The real power of real options”, Keith Leslie and Max Michaels, The McKinsey Quarterly, 1997, Number 3.
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