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Financial Economics

Book Description

Financial Economics has quickly established itself as a strong and growing market. Financial Economics by Frank Fabozzi, Ted Neave, and Gaofu Zhou presents an introduction to basic financial ideas through a strong grounding in microeconomic theory. This calculus based text explores the theoretical framework for analyzing the decisions by individuals and managers of firms, and area which is common to both the financial economics and microeconomics. It also explores the interplay of these decisions on the prices of financial assets.

Table of Contents

  1. Cover Page
  2. Title Page
  3. Copyright
  4. Contents
  5. PREFACE
  6. Acknowledgments
  7. ABOUT THE AUTHORS
  8. 1: INTRODUCTION
    1. 1.1 MICROECONOMIC THEORY: INDIVIDUALS, MANAGERS, AND MARKETS
    2. 1.2 FINANCIAL ECONOMIC THEORY: INDIVIDUALS, MANAGERS, AND MARKETS
    3. 1.3 ROAD MAP FOR THE BOOK
    4. QUESTIONS
    5. REFERENCES
  9. PART I: FINANCE IN A CERTAINTY WORLD WITH A PERFECT CAPITAL MARKET
    1. 2: CONSUMER FINANCIAL DECISIONS
      1. 2.1 THE CONSUMPTION-INVESTMENT PROBLEM
      2. 2.2 INITIAL WEALTH IS THE ONLY CONSTRAINT ON CONSUMER DECISIONS
      3. 2.3 THE MEANING OF THE MARKET RATE OF INTEREST
      4. 2.4 PRACTICAL IMPORTANCE OF CONSUMPTION-INVESTMENT THEORY
      5. KEY POINTS
      6. QUESTIONS
    2. 3: CREATING WEALTH BY INVESTING IN PRODUCTIVE OPPORTUNITIES
      1. 3.1 THE ENTREPRENEURIAL FIRM—PRODUCTION AND INVESTMENT DECISIONS
      2. 3.2 INVESTMENT DECISIONS MADE BY MANAGERS ON BEHALF OF OWNERS
      3. 3.3 EXAMPLE: AGING WINE
      4. 3.4 CONSEQUENCES FOR INVESTMENT AND FINANCING DECISIONS
      5. KEY POINTS
      6. QUESTIONS
      7. REFERENCES
    3. 4: HOW INVESTORS VALUE FIRMS
      1. 4.1 VALUE BASED IN A FIRM'S CAPACITY TO GENERATE INVESTOR RETURNS
      2. 4.2 WHAT GROWTH STOCKS ARE AND WHAT RETURNS THEY YIELD
      3. 4.3 MARKET VALUES AND DIFFERENT PLANNING HORIZONS
      4. QUESTIONS
      5. REFERENCES
    4. 5: FIRM FINANCING DECISIONS IN A PERFECT CAPITAL MARKET
      1. 5.1 DEBT VS. EQUITY
      2. 5.2 CAPITAL STRUCTURE AND FINANCIAL LEVERAGE
      3. 5.3 CAPITAL STRUCTURE AND TAXES
      4. 5.4 THE COST OF CAPITAL
      5. 5.5 CAPITAL STRUCTURE IN A PERFECT CAPITAL MARKET: THE IRRELEVANCE THEORY
      6. KEY POINTS
      7. QUESTIONS
      8. REFERENCES
    5. 6: FIRM INVESTMENT DECISIONS
      1. 6.1 INVESTMENT DECISIONS AND OWNERS’ WEALTH MAXIMIZATION
      2. 6.2 CLASSIFICATION OF INVESTMENT PROJECTS
      3. 6.3 A PROJECT'S INCREMENTAL CASH FLOWS
      4. 6.4 APPLYING THE MARKET VALUE RULE TO INDEPENDENT PROJECTS
      5. 6.5 COMMONLY USED ASSESSMENT CRITERIA IN A CERTAIN WORLD WITH A PERFECT CAPITAL MARKET
      6. 6.6 INVESTMENT CRITERIA IN PRACTICE
      7. KEY POINTS
      8. QUESTIONS
      9. REFERENCES
  10. PART II: FINANCIAL SYSTEM
    1. 7: FINANCIAL SYSTEMS, GOVERNANCE, AND ORGANIZATION
      1. 7.1 FINANCIAL SYSTEM FUNCTIONS
      2. 7.2 FINANCIAL SYSTEM GOVERNANCE
      3. 7.3 FINANCIAL SYSTEM ORGANIZATION
      4. KEY POINTS
      5. QUESTIONS
      6. REFERENCES
    2. 8: MARKET, INTERMEDIARY, AND INTERNAL GOVERNANCE
      1. 8.1 FINANCIAL MARKET GOVERNANCE
      2. 8.2 NON-MARKET GOVERNANCE: FINANCIAL INTERMEDIARIES
      3. 8.3 INTERNAL GOVERNANCE
      4. KEY POINTS
      5. QUESTIONS
      6. REFERENCES
  11. PART III: TOOLS FOR COPING WITH RISK
    1. 9: THE MICROECONOMIC FOUNDATION OF FINANCIAL ECONOMICS
      1. 9.1 PRESCRIPTIVE AND DESCRIPTIVE APPROACHES
      2. 9.2 ASSUMPTIONS UNDERLYING FINANCIAL ECONOMICS
      3. KEY POINTS
      4. QUESTIONS
      5. REFERENCES
    2. 10: CONTINGENT CLAIMS AND CONTINGENT STRATEGIES
      1. 10.1 STATES OF THE WORLD
      2. 10.2 CONTINGENT CLAIMS AND THEIR VALUE
      3. 10.3 INVESTOR'S UTILITY MAXIMIZATION IN CONTINGENT CLAIMS MARKETS
      4. 10.4 INCOMPLETE MARKETS FOR CONTINGENT CLAIMS
      5. 10.5 MODIGLIANI-MILLER REVISITED
      6. 10.6 FINANCIAL INSTRUMENTS AS CONTINGENT CLAIMS
      7. 10.7 CONTINGENT STRATEGIES
      8. KEY POINTS
      9. QUESTIONS
      10. REFERENCES
    3. 11: RISK AND RISK MANAGEMENT
      1. 11.1 RISK AND UNCERTAINTIES
      2. 11.2 DECISION CRITERIA
      3. 11.3 METHODS OF RISK TRANSFER
      4. 11.4 CHARACTERISTICS OF PROBABILITY DISTRIBUTIONS
      5. 11.5 EXPECTED UTILITY THEORY AND ARROW-PRATT RISK AVERSION
      6. KEY POINTS
      7. QUESTIONS
      8. REFERENCES
    4. 12: ON CHOOSING RISK MEASURES
      1. 12.1 USING RISK MEASURES
      2. 12.2 MEASURES OF RISKINESS
      3. 12.3 CONSISTENT RISK MEASURES AND STOCHASTIC ORDERINGS
      4. 12.4 VALUE AT RISK AND COHERENT RISK MEASURES
      5. KEY POINTS
      6. QUESTIONS
      7. REFERENCES
  12. PART IV: SELECTION AND PRICING OF RISKY ASSETS
    1. 13: MEAN-VARIANCE PORTFOLIO CHOICE
      1. 13.1 TWO RISKY ASSETS
      2. 13.2 MANY RISKY ASSETS
      3. 13.3 ADDING A RISK-FREE ASSET
      4. 13.4 MARKOWITZ PORTFOLIOS
      5. 13.5 PRACTICAL ISSUES
      6. 13.6 ADVANCED TOPICS
      7. KEY POINTS
      8. QUESTIONS
      9. REFERENCES
    2. 14: CAPITAL ASSET PRICING MODEL
      1. 14.1 CAPM ASSUMPTIONS
      2. 14.2 DERIVING THE CAPITAL MARKET
      3. 14.3 DERIVING THE CAPM
      4. 14.4 CAPM IN THE ABSENCE OF A RISK-FREE ASSET
      5. 14.5 IMPLICATIONS OF THE CAPM
      6. 14.6 AN ALTERNATIVE DERIVATION
      7. 14.7 ESTIMATING BETA RISK
      8. 14.8 APPLICATION OF CAPM IN INVESTMENT MANAGEMENT
      9. 14.9 TESTS OF THE CAPM
      10. KEY POINTS
      11. QUESTIONS
      12. APPENDIX 14.1: RUBINSTEIN'S PROOF OF THE CAPM
      13. REFERENCES
    3. 15: ARBITRAGE PRICING THEORY AND FACTOR MODELS
      1. 15.1 APT AND CAPM
      2. 15.2 APT IN A SPECIAL ONE-FACTOR MODEL
      3. 15.3 APT IN THE MULTIFACTOR MODEL
      4. 15.4 FACTOR MODELS
      5. 15.5 FACTOR MODEL ESTIMATION
      6. KEY POINTS
      7. QUESTIONS
      8. REFERENCES
    4. 16: GENERAL PRINCIPLES OF ASSET PRICING
      1. 16.1 ONE-PERIOD FINITE STATE ECONOMY
      2. 16.2 PORTFOLIOS AND MARKET COMPLETENESS
      3. 16.3 THE LAW OF ONE PRICE AND LINEAR PRICING
      4. 16.4 ARBITRAGE AND POSITIVE STATE PRICING
      5. 16.5 THE FUNDAMENTAL THEOREM OF ASSET PRICING
      6. 16.6 DISCOUNT FACTOR MODELS
      7. 16.7 EQUITY RISK PREMIUM PUZZLE
      8. KEY POINTS
      9. QUESTIONS
      10. REFERENCES
    5. 17: PRICING CORPORATE SECURITIES
      1. 17.1 PROFIT-SEEKING ELIMINATES ARBITRAGE OPPORTUNITIES
      2. 17.2 PRICING SECURITIES RELATIVE TO EACH OTHER
      3. 17.3 CALCULATING RISK-NEUTRAL PROBABILITY MEASURES
      4. 17.4 USING RISK-NEUTRAL PROBABILITIES FOR SECURITIES VALUATION
      5. 17.5 DEBT VERSUS EQUITY
      6. 17.6 APPLICATION: BOND VALUATION AND MARKET RISK
      7. KEY POINTS
      8. QUESTIONS
      9. REFERENCES
  13. PART V: DERIVATIVE INSTRUMENTS
    1. 18: PRICING DERIVATIVES BY ARBITRAGE: LINEAR PAYOFF DERIVATIVES
      1. 18.1 LINEAR VERSUS NONLINEAR PAYOFF DERIVATIVE INSTRUMENTS
      2. 18.2 FORWARD CONTRACTS
      3. 18.3 FUTURES PRICING
      4. 18.4 SWAPS
      5. KEY POINTS
      6. QUESTIONS
      7. REFERENCES
    2. 19: PRICING DERIVATIVES BY ARBITRAGE: NONLINEAR PAYOFF DERIVATIVES
      1. 19.1 BASIC CONCEPTS
      2. 19.2 SIMPLE USES OF OPTIONS
      3. 19.3 PUT-CALL PARITY
      4. 19.4 KEY IDEA FOR VALUATION
      5. 19.5 SINGLE-PERIODB IN OMIAL MODEL
      6. 19.6 BLACK-SCHOLES FORMULA
      7. 19.7 BINOMIAL MODEL
      8. 19.8 AMERICAN OPTIONS
      9. 19.9 ARBITRARY PAYOFFS AND GENERAL MODELS
      10. Appendix 19.1 Derivation of the Black-Scholes Formula
      11. KEYPOINTS
      12. QUESTIONS
      13. REFERENCES
  14. PART VI: CAPITAL MARKET IMPERFECTIONS AND THE LIMITS TO ARBITRAGE
    1. 20: CAPITAL MARKET IMPERFECTIONS AND FINANCIAL DECISION CRITERIA
      1. 20.1 TYPES OF CAPITAL MARKET IMPERFECTIONS
      2. 20.2 SOME EFFECTS OF CAPITAL MARKET IMPERFECTIONS
      3. 20.3 NEED FOR AN INTEGRATED APPROACH TO FINANCIAL DECISION MAKING
      4. 20.4 CHOOSING CRITERIA FOR FINANCIAL DECISIONS
      5. 20.5 MOTIVATING MANAGERS TO MEET OWNERS’ OBJECTIVES: AGENCY THEORY
      6. KEY POINTS
      7. QUESTIONS
      8. REFERENCES
    2. 21: IMPEDIMENTS TO ARBITRAGE
      1. 21.1 SECURITIES MARKETS AND LIQUIDITY
      2. 21.2 LIMITS TO ARBITRAGE
      3. 21.3 MARKET SEGMENTATION
      4. 21.4 INFORMATIONAL ASYMMETRIES AND CREDIT MARKET EQUILIBRIA
      5. 21.5 MARKET FAILURE
      6. 21.6 FINANCIAL SYSTEM EXTERNALITIES
      7. KEY POINTS
      8. QUESTIONS
      9. REFERENCES
  15. PART VII: CAPITAL STRUCTURE DECISIONS IN IMPERFECT CAPITAL MARKETS
    1. 22: WHEN CAPITAL STRUCTURE MATTERS
      1. 22.1 EFFECT OF CORPORATE TAXATION ON LEVERAGE
      2. 22.2 CAPITAL STRUCTURE AND FINANCIAL DISTRESS
      3. 22.3 FINANCIAL DISTRESS AND CAPITAL STRUCTURE
      4. 22.4 HETEROGENEOUS EXPECTATIONS
      5. 22.5 AGENCY EFFECTS
      6. 22.6 THEORY OF DIVIDEND PAYMENTS
      7. 22.7 IS THERE AN OPTIMAL CAPITAL STRUCTURE?
      8. 22.8 DYNAMIC MODELS
      9. KEY POINTS
      10. QUESTIONS
      11. REFERENCES
    2. 23: FINANCING DECISIONS IN PRACTICE
      1. 23.1 ESTIMATING THE COSTS OF DIFFERENT FUNDING SOURCES
      2. 23.2 TIMING THE ISSUANCE OF DEBT
      3. 23.3 CREDITORS, INVESTORS, AND CAPITAL STRUCTURE CHOICES
      4. 23.4 SIGNIFICANCE OF TECHNICAL INSOLVENCY
      5. 23.5 RESTRICTIVE COVENANTS AND AGENCY COSTS
      6. 23.6 DIVIDEND POLICY
      7. 23.7 REPURCHASING THE FIRM'S COMMON STOCK
      8. 23.8 PREEMPTIVE RIGHTS OFFERING
      9. 23.9 CONTINGENCY PLANNING AND CAPITAL STRUCTURE CHOICES
      10. KEY POINTS
      11. QUESTIONS
      12. REFERENCES
    3. 24: FINANCIAL CONTRACTING AND DEAL TERMS
      1. 24.1 COSTS OF DEALS
      2. 24.2 INFORMATIONAL CONDITIONS
      3. 24.3 MORAL HAZARD 9
      4. 24.4 COMPLETE CONTRACTS
      5. 24.5 INCOMPLETE CONTRACTS: INTRODUCTION
      6. 24.6 INCOMPLETE CONTRACTS: FURTHER COMMENTS
      7. 24.7 ISSUANCE OF MULTIPLE DEBT CLAIMS
      8. 24.8 SECURITIZATION
      9. KEY POINTS
      10. QUESTIONS
      11. REFERENCES
  16. PART VIII: INCORPORATING RISK IN CAPITAL BUDGETING DECISIONS
    1. 25: CAPITAL EXPENDITURE PLANS IN A RISKY WORLD
      1. 25.1 A MARKET VALUE CRITERION
      2. 25.2 COMPARING NEW AND EXISTING EARNINGS RISKS TO OBTAIN OPTIMAL CAPITAL EXPENDITURE PLANS
      3. 25.3 REQUIRED RATES OF RETURN: FIRM, DIVISION, AND PROJECT
      4. 25.4 DEPRECIATION TAX SHIELD IN A RISKY WORLD
      5. 25.5 SINGLE-PERIOD VERSUS MULTI-PERIOD INVESTMENT MODELS
      6. KEY POINTS
      7. QUESTIONS
      8. REFERENCES
    2. 26: EVALUATING PROJECT RISK IN CAPITAL BUDGETING
      1. 26.1 RISK-ADJUSTED DISCOUNT RATE
      2. 26.2 CERTAINTY-EQUIVALENT APPROACH AND ITS APPLICATION IN PRACTICE
      3. 26.3 MEASURING A PROJECT'S STAND-ALONE RISK
      4. 26.4 MEASURING A PROJECT'S MARKET RISK
      5. 26.5 CONTINGENCY PLANNING OF CAPITAL EXPENDITURES
      6. 26.6 REAL OPTIONS VALUATION
      7. KEY POINTS
      8. QUESTIONS
      9. REFERENCES
  17. SUBJECT INDEX
  18. AUTHOR INDEX
  19. WEB–APPENDIX A: DEAL TERMS
    1. A.1 COSTS OF DEALS
    2. A.2 INFORMATIONAL CONDITIONS
    3. REFERENCES
  20. WEB–APPENDIX B: CORPORATE DEBT FUNDING INSTRUMENTS
    1. B.1 CORPORATE BONDS
    2. B.2 MEDIUM-TERM NOTES
    3. B.3 COMMERCIAL PAPER
    4. B.4 BANK LOANS
  21. WEB–APPENDIX C: INVESTMENT BANKERS AND THE ISSUANCE OF SECURITIES
    1. C.1 PUBLIC ISSUANCE OF SECURITIES
    2. C.2 PRIVATE PLACEMENT OF SECURITIES
  22. WEB-APPENDIX D: CREDIT RISK
    1. D.1 DEFAULT RISK
    2. D.2 DOWNGRADE RISK
    3. D.3 CREDIT RISK TRANSFER MECHANISMS
    4. REFERENCES
  23. WEB-APPENDIX E *: FINANCIAL STATEMENTS
    1. E.1 ACCOUNTING PRINCIPLES
    2. E.2 THE BALANCE SHEET
    3. E.3 INCOME STATEMENT
    4. E.4 STATEMENT OF CASH FLOWS
    5. E.5 STATEMENT OF STOCKHOLDERS’ EQUITY
    6. E.6 FOOTNOTES TO FINANCIAL STATEMENTS
    7. REFERENCES
  24. WEB-APPENDIX F *: FINANCIAL RATIO ANALYSIS
    1. F.1 RETURN-ON-INVESTMENT RATIOS
    2. F.2 LIQUIDITY
    3. F.3 PROFITABILITY RATIOS
    4. F.4 ACTIVITY RATIOS
    5. F.5 FINANCIAL LEVERAGE RATIOS
    6. F.6 COMMON-SIZE ANALYSIS
    7. REFERENCES
  25. WEB-APPENDIX G *: ESTIMATING CASH FLOWS OF CAPITAL BUDGETING PROJECTS
    1. G.1 OPERATING CASH FLOWS
    2. G.2 INVESTMENT CASH FLOWS
    3. G.3 NET CASH FLOWS
  26. WEB–APPENDIX H: MERGER AND ACQUISITION STRATEGIES
    1. H.1 MERGERS AND ACQUISITIONS IN A PERFECT CAPITAL MARKET
    2. H.2 MERGERS AND ACQUISITIONS IN AN IMPERFECT CAPITAL MARKET
    3. REFERENCES
  27. WEB–APPENDIX I: CONGLOMERATES AS A MEANS OF OVERCOMING CAPITAL MARKET IMPERFECTIONS
    1. REFERENCE
  28. WEB–APPENDIX J: LEASE FINANCING
    1. J.1 LEASING FUNDAMENTALS
    2. J.2 COST OF LEASING
    3. J.3 RISK OF OBSOLESCENCE AND DISPOSAL OF EQUIPMENT
    4. J.4 VALUING A LEASE: THE LEASE OR BORROW-TO-BUY DECISION
    5. REFERENCES
  29. WEB–APPENDIX K: TAYLOR SERIES APPROXIMATION
  30. WEB-APPENDIX L: SOME ELEMENTARY CONCEPTS INVOLVING PROBABILITY
    1. L.1 PROPERTIES OF THE EXPECTED VALUE OF A RANDOM VARIABLE
    2. L.2 MEASURES OF DISPERSION FOR RANDOM VARIABLES
    3. L.3 CORRELATION AND COVARIANCE
  31. WEB–APPENDIX M: CONTINUOUS PROBABILITY DISTRIBUTIONS
    1. M.1 CONTINUOUS RANDOM VARIABLE
    2. M.2 PROBABILITY DISTRIBUTION FUNCTION, PROBABILITY DENSITY FUNCTION, AND CUMULATIVE DISTRIBUTION FUNCTION
    3. M.3 THE NORMAL DISTRIBUTION
    4. M.4 STUDENT'S t -DISTRIBUTION
    5. M.5 LOGNORMAL DISTRIBUTION
    6. M.6 STABLE DISTRIBUTIONS
    7. REFERENCES
  32. WEB–APPENDIX N: CONTINUOUS INTEREST RATES
  33. WEB-APPENDIX O *: FUNDAMENTALS OF MATRIX ALGEBRA
    1. O.1 VECTORS AND MATRICES DEFINED
    2. O.2 SQUARE MATRICES
    3. O.3 DETERMINANTS
    4. O.4 SYSTEMS OF LINEAR EQUATIONS
    5. O.5 LINEAR INDEPENDENCE AND RANK
    6. O.6 VECTOR AND MATRIX OPERATIONS
    7. O.7 EIGENVALUES AND EIGENVECTORS
  34. WEB–APPENDIX P: PRINCIPAL COMPONENT ANALYSIS IN FINANCE
  35. SUBJECT INDEX (WEB-APPENDIX A TO P)
  36. AUTHOR INDEX (WEB-APPENDIX A TO P)