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Intermediate Financial Theory, 3rd Edition

Book Description

The space between basic MBA-level textbooks and highly technical Ph.D. presentations is filled by Intermediate Financial Theory.  Targeting readers with backgrounds in economics, the Third Edition includes new material on the asset pricing implications of behavioral finance perspectives, recent developments in portfolio choice, derivatives-risk neutral pricing research, and implications of the 2008 financial crisis.  Each chapter concludes with questions, and for the first time a freely-accessible website includes presents complementary and supplementary material for every chapter.  Known for its rigor and intuition, Intermediate Financial Theory is perfect for those who need basic training in financial theory and those looking for a user-friendly introduction to advanced theory.

  • Covers both the main concepts of standard finance and its principal new ideas
  • 65% new and revised material captures current applications and technologies
  • Includes new and expanded pedagogical supplements

Table of Contents

  1. Cover image
  2. Title page
  3. Copyright
  4. Preface
  5. Epigraph
  6. Dedication
  7. Part I: Introduction
    1. Chapter 1. On the Role of Financial Markets and Institutions
      1. 1.1 Finance: The Time Dimension
      2. 1.2 Desynchronization: The Risk Dimension
      3. 1.3 The Screening and Monitoring Functions of the Financial System
      4. 1.4 The Financial System and Economic Growth
      5. 1.5 Financial Markets and Social Welfare
      6. 1.6 Financial Intermediation and the Business Cycle
      7. 1.7 Financial Crises
      8. 1.8 Conclusion
      9. References
      10. Complementary Readings
      11. Appendix: Introduction to General Equilibrium Theory
    2. Chapter 2. The Challenges of Asset Pricing: A Road Map
      1. 2.1 The Main Question of Financial Theory
      2. 2.2 Discounting Risky Cash Flows: Various Lines of Attack
      3. 2.3 Two Main Perspectives: Equilibrium versus Arbitrage
      4. 2.4 Decomposing Risk Premia
      5. 2.5 Models and Stylized Facts
      6. 2.6 Asset Pricing Is Not All of Finance!
      7. 2.7 Banks
      8. 2.8 Conclusions
      9. References
  8. Part II: The Demand for Financial Assets
    1. Chapter 3. Making Choices in Risky Situations
      1. 3.1 Introduction
      2. 3.2 Choosing Among Risky Prospects: Preliminaries
      3. 3.3 A Prerequisite: Choice Theory Under Certainty
      4. 3.4 Choice Theory Under Uncertainty: An Introduction
      5. 3.5 The Expected Utility Theorem
      6. 3.6 How Restrictive Is Expected Utility Theory? The Allais Paradox
      7. 3.7 Behavioral Finance
      8. 3.8 Conclusions
      9. References
    2. Chapter 4. Measuring Risk and Risk Aversion
      1. 4.1 Introduction
      2. 4.2 Measuring Risk Aversion
      3. 4.3 Interpreting the Measures of Risk Aversion
      4. 4.4 Risk Premium and Certainty Equivalence
      5. 4.5 Assessing the Degree of Relative Risk Aversion
      6. 4.6 The Concept of Stochastic Dominance
      7. 4.7 Mean Preserving Spreads
      8. 4.8 An Unsettling Observation About Expected Utility
      9. 4.9 Applications: Leverage and Risk
      10. 4.10 Conclusions
      11. References
      12. Appendix: Proof of Theorem 4.2
    3. Chapter 5. Risk Aversion and Investment Decisions, Part 1
      1. 5.1 Introduction
      2. 5.2 Risk Aversion and Portfolio Allocation: Risk-Free Versus Risky Assets
      3. 5.3 Portfolio Composition, Risk Aversion, and Wealth
      4. 5.4 Special Case of Risk-Neutral Investors
      5. 5.5 Risk Aversion and Risky Portfolio Composition
      6. 5.6 Risk Aversion and Savings Behavior
      7. 5.7 Generalizing the VNM-Expected Utility Representation
      8. 5.8 Conclusions
      9. References
    4. Chapter 6. Risk Aversion and Investment Decisions, Part II: Modern Portfolio Theory
      1. 6.1 Introduction
      2. 6.2 More About Utility Functions and Return Distributions
      3. 6.3 Refining the Normality-of-Returns Assumption
      4. 6.4 Description of the Opportunity Set in the Mean–Variance Space: The Gains from Diversification and the Efficient Frontier
      5. 6.5 The Optimal Portfolio: A Separation Theorem
      6. 6.6 Stochastic Dominance and Diversification
      7. 6.7 Conclusions
      8. References
      9. Appendix 6.1: Indifference Curves Under Quadratic Utility or Normally Distributed Returns
      10. Appendix 6.2: The Shape of the Efficient Frontier; Two Assets; Alternative Hypotheses
      11. Appendix 6.3: Constructing the Efficient Frontier
    5. Chapter 7. Risk Aversion and Investment Decisions, Part III: Challenges to Implementation
      1. 7.1 Introduction
      2. 7.2 The Consequences of Parameter Uncertainty
      3. 7.3 Trends and Cycles in Stock Market Return Data
      4. 7.4 Equally Weighted Portfolios
      5. 7.5 Are Stocks Less Risky for Long Investment Horizons?
      6. 7.6 Conclusions
      7. References
      8. Appendix 7.1
  9. Part III: Equilibrium Pricing
    1. Chapter 8. The Capital Asset Pricing Model
      1. 8.1 Introduction
      2. 8.2 The Traditional Approach to the CAPM
      3. 8.3 Valuing Risky Cash Flows with the CAPM
      4. 8.4 The Mathematics of the Portfolio Frontier: Many Risky Assets and No Risk-Free Asset
      5. 8.5 Characterizing Efficient Portfolios (No Risk-Free Assets)
      6. 8.6 Background for Deriving the Zero-Beta CAPM: Notion of a Zero-Covariance Portfolio
      7. 8.7 The Zero-Beta CAPM
      8. 8.8 The Standard CAPM
      9. 8.9 An Empirical Assessment of the CAPM
      10. 8.10 Conclusions
      11. References
      12. Appendix 8.1: Proof of the CAPM Relationship
      13. Appendix 8.2: The Mathematics of the Portfolio Frontier: An Example
      14. Appendix 8.3: Diagrammatic Representation of the Fama–MacBeth Two-Step Procedure
    2. Chapter 9. Arrow–Debreu Pricing, Part I
      1. 9.1 Introduction
      2. 9.2 Setting: An Arrow–Debreu Economy
      3. 9.3 Competitive Equilibrium and Pareto Optimality Illustrated
      4. 9.4 Pareto Optimality and Risk Sharing
      5. 9.5 Implementing PO Allocations: On the Possibility of Market Failure
      6. 9.6 Risk-Neutral Valuations
      7. 9.7 Conclusions
      8. References
    3. Chapter 10. The Consumption Capital Asset Pricing Model
      1. 10.1 Introduction
      2. 10.2 The Representative Agent Hypothesis and its Notion of Equilibrium
      3. 10.3 An Exchange (Endowment) Economy
      4. 10.4 Pricing Arrow–Debreu State-Contingent Claims with the CCAPM
      5. 10.5 Testing the CCAPM: The Equity Premium Puzzle
      6. 10.6 Testing the CCAPM: Hansen–Jagannathan Bounds
      7. 10.7 The SDF in Greater Generality
      8. 10.8 Some Extensions
      9. 10.9 Conclusions
      10. References
      11. Appendix 10.1 Solving the CCAPM with Growth
      12. Appendix 10.2 Some Properties of the Lognormal Distribution
  10. Part IV: Arbitrage Pricing
    1. Chapter 11. Arrow–Debreu Pricing, Part II
      1. 11.1 Introduction
      2. 11.2 Market Completeness and Complex Securities
      3. 11.3 Constructing State-Contingent Claims Prices in a Risk-Free World: Deriving the Term Structure
      4. 11.4 The Value Additivity Theorem
      5. 11.5 Using Options to Complete the Market: An Abstract Setting
      6. 11.6 Synthesizing State-Contingent Claims: A First Approximation
      7. 11.7 Recovering Arrow–Debreu Prices from Options Prices: A Generalization
      8. 11.8 Arrow–Debreu Pricing in a Multiperiod Setting
      9. 11.9 Conclusions
      10. References
      11. Appendix 11.1: Forward Prices and Forward Rates
    2. Chapter 12. The Martingale Measure: Part I
      1. 12.1 Introduction
      2. 12.2 The Setting and the Intuition
      3. 12.3 Notation, Definitions, and Basic Results
      4. 12.4 Uniqueness
      5. 12.5 Incompleteness
      6. 12.6 Equilibrium and No Arbitrage Opportunities
      7. 12.7 Application: Maximizing the Expected Utility of Terminal Wealth
      8. 12.8 Conclusions
      9. References
      10. Appendix 12.1 Finding the Stock and Bond Economy That Is Directly Analogous to the Arrow–Debreu Economy in Which Only State Claims Are Traded
      11. Appendix 12.2 Proof of the Second Part of Proposition 12.6
    3. Chapter 13. The Martingale Measure: Part II
      1. 13.1 Introduction
      2. 13.2 Discrete Time Infinite Horizon Economies: A CCAPM Setting
      3. 13.3 Risk-Neutral Pricing in the CCAPM
      4. 13.4 The Binomial Model of Derivatives Valuation
      5. 13.5 Continuous Time: An Introduction to the Black–Scholes Formula
      6. 13.6 Dybvig’s Evaluation of Dynamic Trading Strategies
      7. 13.7 Conclusions
      8. References
      9. Appendix 13.1: Risk-Neutral Valuation When Discounting at the Term Structure of Multiperiod Discount Bond
    4. Chapter 14. The Arbitrage Pricing Theory
      1. 14.1 Introduction
      2. 14.2 Factor Models: A First Illustration
      3. 14.3 A Second Illustration: Multifactor Models, and the CAPM
      4. 14.4 The APT: A Formal Statement
      5. 14.5 Macroeconomic Factor Models
      6. 14.6 Models with Factor-Mimicking Portfolios
      7. 14.7 Advantage of the APT for Stock or Portfolio Selection
      8. 14.8 Conclusions
      9. References
      10. Appendix A.14.1: A Graphical Interpretation of the APT
      11. Appendix 14.2: Capital Budgeting
    5. Chapter 15. An Intuitive Overview of Continuous Time Finance
      1. 15.1 Introduction
      2. 15.2 Random Walks and Brownian Motion
      3. 15.3 More General Continuous Time Processes
      4. 15.4 A Continuous Time Model of Stock Price Behavior
      5. 15.5 Simulation and European Call Pricing
      6. 15.6 Solving Stochastic Differential Equations: A First Approach
      7. 15.7 A Second Approach: Martingale Methods
      8. 15.8 Applications
      9. 15.9 Final Comments
      10. References
    6. Chapter 16. Portfolio Management in the Long Run
      1. 16.1 Introduction
      2. 16.2 The Myopic Solution
      3. 16.3 Variations in the Risk-Free Rate
      4. 16.4 The Long-Run Behavior of Stock Returns
      5. 16.5 Background Risk: The Implications of Labor Income for Portfolio Choice
      6. 16.6 An Important Caveat
      7. 16.7 Another Background Risk: Real Estate
      8. 16.8 Conclusions
      9. References
    7. Chapter 17. Financial Structure and Firm Valuation in Incomplete Markets
      1. 17.1 Introduction
      2. 17.2 Financial Structure and Firm Valuation
      3. 17.3 Arrow–Debreu and Modigliani–Miller
      4. 17.4 On the Role of Short Selling
      5. 17.5 Financing and Growth
      6. 17.6 Conclusions
      7. References
      8. Appendix Details of the Solution of the Contingent Claims Trade Case of Section 17.5
    8. Chapter 18. Financial Equilibrium with Differential Information
      1. 18.1 Introduction
      2. 18.2 On the Possibility of an Upward-Sloping Demand Curve
      3. 18.3 An Illustration of the Concept of REE: Homogeneous Information
      4. 18.4 Fully Revealing REE: An Example
      5. 18.5 The Efficient Market Hypothesis
      6. References
      7. Appendix Bayesian Updating with the Normal Distribution
  11. Index
  12. List of Frequently Used Symbols and Notation
    1. Roman Alphabet
    2. Greek Alphabet
    3. Numerals and Other Terms