Financial Economics Lecture1 Foundations, Approaches, and Key Concepts in Asset Pricing

I. Introduction to Financial Economics

A. Definition and Scope

• Financial Economics: The branch of economics focuses on assigning financial assets efficiently.
• Core task: Understanding and determining the pricing of financial assets.

B. Key Concepts

1. Assets: Claims on future economic benefits.

2. Two critical dimensions in financial behavior:

   1. Intertemporal nature of decisions
   2. **Uncertainty (risk) **associated with future outcomes

II. Overview of Financial Markets

A. Basic Structure

Funds Suppliers (Asset Buyers) → Investment → Funds Demanders (Asset Sellers)  
                                ← Return ←  

B. Key Focus

• Central question: Determining asset prices
• Pricing mechanism: Driven by supply and demand, which are derived from human behavior
• Challenges: Human behavior is dynamic and uncertain

C. Corporate Finance

• Special case: When asset sellers are corporations

III. Approaches in Financial Economics

A. Equilibrium Pricing

• Method: Build a model incorporating human preferences and constraints to deduce behavior and determine supply and demand.
• Advantage: Can determine asset prices from fundamental principles.
• Disadvantage: Relies on assumptions that may be inaccurate or oversimplified.

B. No-Arbitrage Pricing

• Method: Deduce asset prices based on known prices of other assets.

C. Financial Frictions Analysis

• Focus areas: Information asymmetry, period mismatch

D. Behavioral Finance

• Approach: Incorporates “irrational” factors to better understand the behavior of market participants.

IV. Market Efficiency and Behavioral Finance

• Question of market efficiency remains central to financial economics.
• Behavioral finance helps explain deviations from traditional rational models.

V. Assets and Rate of Return

A. Basic Model: Single-Period Binary Tree

• Current price: P

• Future payoffs:

  • Xu (probability q)
  • Xd (probability 1-q)

B. Key Questions

1. Given Xu and Xd, how to determine P?

2. What determines Xu and Xd? (Beyond the scope of financial economics)

   1. Industry factors
   2. Business strategies
   3. Competitive landscape
   4. Management aspirations
   5. Macroeconomic conditions
   6. Geopolitical factors

C. Return Calculations

• Upside return: ru = (Xu/P) - 1
• Downside return: rd = (Xd/P) - 1
• Expected return: E(r) = q*ru + (1-q)*rd = E(x)/P - 1

D. Price-Return Relationship

• Inverse relationship between price (P) and expected return E(r)
• Higher asset price → Lower expected return
• Lower asset price → Higher expected return

E. Risk-Return Trade-off

• “Good” assets typically have higher prices but lower expected returns
• “Bad” (riskier) assets typically have lower prices but higher expected returns
• Market equilibrium tends to balance risk and return across assets

VI. Equilibrium Pricing (Absolute Pricing)

A. Concept

• Price is determined by the interaction of supply, demand, and behavior (under uncertainty/risk)
• Aims to price assets from fundamental principles

B. Expected Utility Theory

• Addresses limitations of simple expected value calculations

• Example: St. Petersburg paradox (where E = ∞)

  • Demonstrates why expected value alone is insufficient for decision-making

C. Risk and Asset Pricing: An Example

1. Steel Company:

   1. Current price: Ps
   2. Future dividends: 50% chance of 25,15

2. Pharmaceutical Company:

   1. Current price: Pp
   2. Future dividends: 50% chance of 40,0

Despite pharmaceutical companies having higher variance (risk), Pp should typically be higher than Ps. This counterintuitive result stems from the potential for higher returns, not just the risk involved.

D. Performance Evaluation: Beyond Simple Metrics

Consider two portfolio managers:

• Manager A: Average return rA = 10%, standard deviation σA

• Manager B: Average return rB = 8%, standard deviation σB

• If σA < σB, can we conclude A is better than B?

  • Not necessarily. Must consider risk-adjusted returns and investor preferences.

VII. No-Arbitrage Pricing (Relative Pricing)

A. Concept

• Based on the Law of One Price (LOOP)
• Riskless profit opportunities violate LOOP

B. Examples

1. Fast Food Combo:

   1. If Hamburg = 1 and Coke=1, then (Hamburg, Coke) combo should = $2
   2. Any deviation creates arbitrage opportunity

2. Investment Box:

   1. Box transforms 1 into 1.02 (2% return)

   2. Bank deposit rate = 3%

   3. Box value?

      • Not zero, despite lower return than bank
      • Option value exists if interest rates fall below 2% in future

C. Replication and Hedging

• Core of no-arbitrage pricing: Replicating cash flows
• Enables hedging strategies
• Fundamental to modern financial innovations

VIII. Financial Frictions

A. Maturity Mismatch

• Lenders prefer liquidity (short-term)
• Borrowers need stability (long-term)
• Example: Construction projects require stable, long-term funding

B. Role of Financial Intermediaries

• Banks transform short-term deposits into long-term loans
• Crucial for economic stability and growth

IX. Market Efficiency and Behavioral Finance

A. Efficient Market Hypothesis (EMH)

• Fama’s theory: Markets rapidly incorporate all available information
• Implies no persistent arbitrage opportunities

B. Challenges to EMH

• Shiller’s counterarguments

• Behavioral Finance insights:

  • Irrationality: e.g., overconfidence bias
  • Limited arbitrage: Practical limits to exploiting mispricings

C. Martingale Concept

• Mathematical foundation for fair games and efficient markets

Key Takeaways from Lecture 1

1. Financial Economics focuses on the efficient allocation of financial assets and understanding asset pricing.
2. The field employs various approaches: equilibrium pricing, no-arbitrage pricing, and consideration of financial frictions.
3. Understanding risk, return, and their relationship is crucial in asset valuation.
4. Market efficiency and behavioral factors play significant roles in financial markets.
5. Both absolute (equilibrium) and relative (no-arbitrage) pricing methods are essential tools in financial economics.
6. Financial frictions, such as maturity mismatches, highlight the importance of financial intermediaries.