Financial Economics, Fall 2013 (FIN 501) Class: Tuesday and Thursday 11:00 AM - 12:20 PM in 240 Wohlers Professor: Tatyana Deryugina Email: deryugin@illinois.edu Office Hours: Friday 2:00pm-4:00pm in 4029 BIF or by appointment Teaching Assistant: Kedir Turi Email: knturi@illinois.edu Course Web Page: https://compass2g.illinois.edu/ Note: This is a required course for students in the MSF program. A limited number of graduate students from other programs may be admitted with consent of the instructor. Non-MSF students should contact me as soon as possible. Course Description Microeconomics is the intellectual foundation for the field of finance. This course is designed to give you a strong understanding of the theory and logic of microeconomics. We will discuss the standard models of how consumers and producers behave, and the implications of these models for resource allocation and market efficiency. We will also discuss the basic tools of microeconomics, including optimization, comparative statics and equilibrium. Applications to finance will be highlighted throughout the course, and special attention will be paid to how the tools of economics can be applied to problems in finance and business more generally. The course is divided into four parts. The first part, Markets, focuses on the fundamentals of markets and why, under ideal circumstances, markets allocate resources efficiently. We will also focus on applications of this material to finance, with particular emphasis on the economics of time and risk. The second part, Market Failures considers departures from ideal circumstances and how such departures can lead to inefficiencies. Such inefficiencies are often the targets of financial innovations (e.g. new securities) that aim to reduce the magnitude of the market failure and have the dual benefit of reducing inefficiency and improving profit. We will also look at situations to which the theory of competitive markets is less applicable. 1
The third part considers game theory and strategy, which applies to situations where there are a small number of actors. Finally, part four of the course, Macroeconomics, will provide an overview of some key concepts in macroeconomics economic growth, economic fluctuations, monetary policy, international linkages. Recent economic turbulence and financial instability have reinforced the importance of basic understanding of these topics to the study of finance. Prerequisites: If you are in the MSF program, this is not relevant. The course tries to be largely self-contained. However, a certain comfort with mathematical reasoning and familiarity with calculus will be helpful. Early in the semester there will be a review session dedicated to refreshing important mathematical concepts. In general, I will use calculus from time to time, (partial derivatives in particular) and I will use math when I think it helps make the ideas clearer. However, although this material can be presented in a highly mathematical way, it is not my intention that this be a course in mathematical economics. If you feel you lack some of the background needed to succeed in this course, you should contact me as soon as possible. Textbooks Microeconomics part of the course: Nicholson and Snyder, "Intermediate Microeconomics and its Applications", 11th edition (referred to below as IM ). OR Nicholson and Snyder, "Microeconomic Theory: Basic Principles and Extensions", 11th edition (referred to below as MT ). Macroeconomics part of the course: Mankiw, Macroeconomics, 8th edition (referred to below as MA ). You will not be assigned problems from the textbooks, nor will I ask you about material that was not covered in lectures. Copies of the lecture slides are made available on Compass. Therefore, any good micro and macro text should work for this course. The textbooks mentioned above are meant to provide some structure to the course. Microeconomic Theory (MT) is a calculus based text. Students who are not as comfortable with calculus might consult Intermediate Microeconomics by the same authors. Microeconomic Theory (MT) and Intermediate Microeconomics (IM) cover the same material at two different levels and work well together as a team. The IM book is written using a lower level of mathematics than we will use in this course. It is, however, generally well written and provides good intuitive explanations of material. The MT text, on the other hand, presents some ideas at a somewhat higher level of mathematics than you will need in this course. 2
Course Requirements 1. Assignments. There will be 8 problem sets assigned during the semester. I will drop the problem set with the lowest grade from the final grade calculations. Problem sets are due (a) in class at the beginning of class on the due date or (b) in my mailbox by 9 am on the due date. No late assignments will be accepted for any reason. To save paper, I will not hand out paper copies of the problem sets in class. The problem sets will be made available on Compass. You are strongly encouraged to work on the assignments as a group. However, you must write up your answers independently and turn in separate work. Photocopies or multiple printouts of essentially the same computer file do not qualify as separate work. While numerical results may look identical for individuals in the same study group, each person must write his answer and accompanying explanations separately. That is, you should provide your answers in your own words. If presentation and written explanations are too similar to those of others, then they will receive no credit. Please include the names of the members of your study group on your assignment when you hand it in. 2. One mid-term examination. The mid-term examination will be a closed-book, closednotes exam and will take place during class time. 3. Participation. The participation grade depends on class attendance and active class participation via discussion, questions, and contributions of examples from current events. The supplemental readings will form the basis of regular discussions of applications of the theory. Therefore in order to receive a high participation grade, it is essential to read the assigned articles before class. Please bring the articles with you to class. 4. Final Exam. The final exam will be a closed-book, closed-notes exam and will be taken during the scheduled final exam period. No makeup exams will be given. If you miss the midterm for any reason, the final will count for 60% of your grade. 3
Grading Problem sets (graded on a V/V-/V+ basis) 20% of the grade Participation 20% of the grade Midterm exam 25% of the grade Cumulative final exam 35% of the grade The following are upper bounds for the class grade cutoffs: 98%: A+ 93%: A 90%: A- 88%: B+ 83%: B 80%: B- 78%: C+ 73%: C 70%: C- 68%: D+ 63%: D 60%: D- Students who earn the percentages shown will receive at least the corresponding letter grade. However, the cutoffs may be adjusted downward based on the final distribution of points. Re-grading If you believe a mistake in grading has been made, I will re-grade your ENTIRE assignment. Your grade may go up OR down as a result. Lecture notes Slides from the lecture will be available on the course website the evening following the class. Academic Integrity Exerts from the Student Code: The University has the responsibility for maintaining academic integrity so as to protect the quality of education and research on our campus and to protect those who depend upon our integrity. It is the responsibility of the student to refrain from infractions of academic integrity, from conduct that may lead to suspicion of such infractions, and from conduct that aids others in such infractions. Students have been given notice of this rule by virtue of its publication. Regardless of whether a student has actually read this rule, a student is charged with knowledge of it. Ignorance of a rule is never a defense. 4
For a discussion of what constitutes a breach of academic integrity (including but not limited to cheating, plagiarism, and fabrication), see Part 4 of the Student Code. Please note that closely paraphrasing someone else s work without due credit is considered plagiarism. Disability Accommodations Students with disabilities should contact me and the Division of Rehabilitation-Education Services (DRES) as soon as possible. To contact DRES, email disability@uiuc.edu, call (217) 333-1970 (V/TDD) or visit 1207 S. Oak Street in Champaign. Letters of recommendation I will be happy to write you a letter of recommendation if you earn an A or A+ in this course. 5
Key dates Problem set 1 due: September 10 th (available on Compass on August 29 th ) Problem set 2 due: September 19 th (available on Compass on September 10 th ) Problem set 3 due: October 1 st (available on Compass on September 19 th ) Problem set 4 due: October 10 th (available on Compass on October 1 st ) Problem set 5 due: October 22 nd (available on Compass on October 10 th ) Problem set 6 due: November 5 th (available on Compass on October 24 th ) Problem set 7 due: November 14 th (available on Compass on November 5 th ) Problem set 8 due: December 5 th (available on Compass on November 14 th ) Midterm exam: In class on Thursday, October 24 th Final exam: 1:30-4:30PM, Wednesday, December 18 Broad course plan Part I: Markets 1. Introduction. Broad overview of the course. How economists use models. Positive versus normative analysis. 2. Consumer decision theory = How do people make choices? Utility maximization with a budget constraint. From utility maximization to demand curves. Income and substitution effects. Elasticities. Normal versus inferior goods. 3. Firm behavior = How do firms make choices? The production function, returns to scale. Fixed versus variable costs. Average versus marginal costs. Long run versus short run. Profit maximization. Cost minimization. From profit maximization to supply curves. Elasticities. Accounting profit versus economic profit. 6
4. Markets = What happens when firms and consumers meet. Gains from trade and arbitrage. Perfect competition. Equilibrium of supply and demand. Short run versus long run. Out-of-equilibrium analysis. Consumer and producer surplus. Deadweight loss. Tax incidence. 1 st and 2 nd Theorems of Welfare Economics. General versus partial equilibrium. 5. Intertemporal choice and risk. Choices over time, discounting. Investment. Choices under uncertainty. Part II: Market Failures 1. Externalities. 2. Public goods. 3. Other forms of competition: Monopoly Oligopoly Cournot Stackelberg 4. Price discrimination. Part III: Game Theory and Strategy 1. Basic game theory: Decision trees. Sequential move games. Simultaneous move games. 2. Imperfect information. 3. Moral hazard and adverse selection. 4. The principal-agent problem. 7
Part IV: Macroeconomics 1. Gross Domestic Product (GDP) Definition. Significance. Measurement. Real versus nominal GDP, inflation. 2. Monetary systems. 3. Growth. Solow model. The role of savings and investment. Endogenous growth. 4. Trade and exchange rates. Small open economy. Large open economy. Fixed versus floating exchange rates. 5. Short-run versus long-run: Why economic fluctuations occur. Investment and savings. Demand for money. Government intervention. The Phillips curve. Open versus closed economy. 6. The financial crisis of 2008. a. What happened? b. Government intervention. 8