Finance Microeconomics

Objective

This course aims to address the microeconomic foundations of the main tools and models of modern finance, in particular the methods developed for the valuation of financial assets (CAPM, no-arbitrage valuation, etc.), while also considering the problem of individual decision-making and optimal portfolio choice. After a review of the fundamentals of finance (No-Arbitrage, Law of One Price, Risk-Neutral Probabilities, the Mean-Variance decision criterion, and the CAPM model), emphasis will be placed on the undeniable contribution of microeconomic tools (competitive general equilibrium, von Neumann–Morgenstern utility functions, risk aversion) in understanding and justifying the main financial models.

The topics covered will enable students to better grasp the notions of arbitrage, the link between real-world probabilities and risk-neutral probabilities, the role of risk aversion in portfolio choices, the distinction between diversifiable and non-diversifiable risk, and the key role of covariance.

This course is intended for students wishing to gain a solid understanding of markets as well as a strong foundation in corporate and market finance.

Planning

General Introduction

Main topics covered:

• Individual decision-making.

• Market equilibrium and pricing models.

• The necessity of addressing the microeconomic foundations of modern finance.

1. Principle of Arbitrage

Main topics covered:

• No-Arbitrage Opportunities (NAO) conditions.

• Fundamental Theorem of Asset Pricing.

• Law of One Price (LOP).

• Complete markets and Arrow securities. State prices and interpretation of risk-neutral probabilities.

• Choice of numeraire and risk-neutral world.

• The case of incomplete markets.

2. Mean-Variance Criterion and the Construction of an Equilibrium Model (CAPM)

Main topics covered:

• Mean-Variance criterion.

• CAPM.

• The use and relevance of β.

3. Individual Decision-Making and Optimal Portfolios

Main topics covered:

• von Neumann–Morgenstern utility.

• Risk aversion. HARA utility functions. Mean-Variance criterion and utility functions.

• Stochastic Discount Factor (SDF) and representative agent in a consumption-based model.

• Revisiting the interpretation of risk-neutral probabilities.

• SDF and CAPM.

4. General Equilibrium with Financial Assets

Main topics covered:

• Arrow–Debreu model. Radner model.

• The contribution of microeconomic theory to understanding modern finance tools.

• Some empirical puzzles.

References

Lengwiler Y. (2004), Microfundations of financial Economics, Princeton Series in Finance.

LeRoy S. et Werner J. (2001), Principles of Financial Economics, Cambridge University Press.

Duffie D. (2001), Dynamic Asset Pricing Theory, Princeton University Press.