SYLLABUS FOR F600 ASSET
PRICING THEORY, SPRING 2013
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Professor: |
Craig W. Holden |
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Office: |
BU 356C |
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Office Hours: |
Tues-Thurs |
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Office Phone: |
855-3383 |
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E-Mail: |
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Holden web site: |
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Career Resources: |
COURSE DESCRIPTION
Welcome
to the start of the finance sequence! This course will build the foundation for
all of the finance courses to follow. Specifically, I have set four goals for
each student to obtain:
(1) develop a fundamental knowledge of
asset pricing theory under perfect capital markets,
(2) develop key analytic tools and
modeling skills,
(3) develop basic academic writing
skills and presentation skills, and
(4) gain exposure to research in
asset pricing theory under imperfect capital markets.
Perfect
capital markets is the base case to which nearly all models are compared.
Hence, asset pricing theory under perfect capital markets is the foundation of nearly
all finance research. Modeling skills are essential to success in all
theoretical research and, to a lesser degree, in empirical research. We will develop key
analytic tools (continuous time techniques, solving PDEs, many portfolio
problems, etc.) and discuss a variety of modeling tricks, traps, and
techniques. Academic writing skills are critical to communicating your
research ideas to other people. The written style of academic papers is unique,
complex, and subtle. Hence, a major component of the original research paper
will be developing skills at academic writing. A significant amount of current
research in asset pricing theory is being done under imperfections of one kind
or another. Hence, we will provide some exposure to this type of research.
MY TEACHING APPROACH
My
approach to teaching involves four key features:
1.
Assignment Preparation. There is an approximate schedule of assigned readings.
You are expected to read all of the assigned readings before class. It
is good to stay a little ahead of the schedule, in case we end up going a bit
faster than the schedule.
2.
Class Participation. You are expected to be ready to lead the class
discussion on any part of the assigned reading and to generally participate in
the class discussion. Some of the time I will ask for volunteers to lead the
class discussion and other times I will cold-call students to insure that
everyone participates. This is an “active learning” approach, where students
are the primary source of classroom learning and interaction.
3.
Clicker Participation. I will frequently ask clicker
questions to the entire class. All
students are asked to respond to these questions using their clickers. Two
points will be given for a correct response and one point for an incorrect
response. Total clicker points will be scaled to fit the grading scale listed
below. Let me know if you change clicker devices so that I can track you and
give you credit. No allowance will be made for forgotten clickers, battery
failures, or missing class. You are not allowed to submit clicker responses for
a classmate. We will use clicker channel 60.
4.
Learn By Doing. The best way to learn how to do research is to actually do research.
The best way to learn how to present your research to others is to actually
present your research to others. Therefore, you are expected to do an original
research paper and to do a class presentation of your research.
COURSE OUTLINE
PART I: NO ARBITRAGE PRICING
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Session Topics |
Assignment Preparation |
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(1.) Jan 8 ·
·
The No
Arbitrage Pricing Methodology. ·
The Binomial
Approach To Continuous Time. |
Reading: Holden Sect 1.1–1.2 Excel Models:
Binomial Approach To Continuous Time |
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(2.) Jan 10 ·
Diffusion
Processes. ·
Four Special
Cases. |
Reading: Holden Sect 1.3–1.4, Shimko
Pages 1-12 |
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(3.) Jan 15 ·
Ito’s Lemma. ·
·
Simple
Examples. |
Reading: Holden Sect 1.5–2.1, Shimko
Pages 13-16, 19-21 |
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(4.) Jan 17 ·
Solutions To Frequently Occurring ODEs. ·
Jump
Processes. |
Reading: Holden Sect 2.2–2.3, Shimko
Pages 16-18, 21-23, 33-36 |
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(5.) Jan 22 ·
Separation of
Variables. ·
Ch.3
Finite-lived Assets. ·
Simple
Examples. ·
Laplace
Transform Technique. |
Reading: Holden Sect
2.4–3.2, Shimko Pages 37-38, Appendix |
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(6.) Jan 24 ·
Solutions To
Frequently Occurring PDEs ·
Ch. 4
Options, Forwards, and Futures. ·
Introduction to
Options and Forwards. |
Reading: Holden Sect 3.3–4.1, Shimko
Pages 39-43, Hull Sect 1.1–1.10, 2.1–2.3, 9.1–9.4, 11.1–11.4 Excel Models: Trading Strategies Held To Maturity |
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(7.) Jan 29 ·
Black-Scholes
Formula. |
Reading: Holden Sect 4.2, Hull 14.1–14.2, 14.6, 14.8–14.9 Excel Models: Black Scholes Option Pricing |
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(8.) Jan 31 ·
Greeks and
Trading Strategies |
Reading: Holden Sect 4.3, Hull 18.1–18.9 Excel Models: Trading Strategies Over Any Horizon, Daily Delta
Hedging |
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Session Topics |
Assignment Preparation |
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(9.) Feb 5 ·
Kickoff
Discussion of Original Research Paper ·
Binomial Option
Pricing. |
Reading: Holden
Sect 14.1–14.3, 4.4, Hull Sect 12.1–12.5 Excel Models: Binomial Option Pricing, Binomial Covergence to Normal, Binomial Covergence
to Black Scholes |
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(10.) Feb 7 ·
15-Minute
Discussion of Student-Selected Articles |
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(11.) Feb 12 ·
15-Minute
Discussion of Student-Selected Articles |
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(12.) Feb 14 ·
Risk-Neutral
Valuation ·
Put-Call
Parity. |
Reading: Holden Sect 4.5–4.6, Hull Sect 10.4, 14.7, Appendix
of Ch. 14 |
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(13.) Feb 19 ·
Applications of
Put-Call Parity ·
Put-Call Parity
with Foreign Currency. ·
Interest Rate
Parity (IRP). ·
Futures vs.
Forwards. |
Reading: Holden Sect 4.7–4.10, Hull Sect 2.11, 5.7, 5.10,
5.12, Shimko Pages 70-72 |
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(14.) Feb 21 ·
Implied
Standard Deviations (ISD’s). ·
Variations. ·
American
Options ·
Exotic Options. |
Reading: Holden Sect
4.11–4.14, Hull Sect ,
10.5–10.6, 14.12, 16.1–16.2, 17.8, 25.6, 25.8, 25.10–25.12, 27.5–27.7 Excel Models: Implied Standard Deviations in Black Scholes Option
Pricing, Exotic Options on Black Scholes Option Pricing |
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(15.) Feb 26 ·
Pricing By
Simulation. ·
Pricing By Finite
Differences. ·
Ch. 5 Bond
Pricing Basics. ·
Introduction To
Default-free Bonds. |
Reading: Holden Sect
4.15–5.1, Hull 20.6–20.8 Excel Models: Pricing By Simulation, Pricing By Finite
Differences |
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(16.) Feb 28 ·
Four Equivalent
Ways of Describing
Bonds. ·
Duration,
Immunization, and Convexity. |
Reading: Holden Sect
5.2–5.3, Excel Models: Bond Duration, Bond Convexity, US Yield Curve
Dynamics |
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(17.) March 5 ·
International
Fisher Effect (IFE) ·
Swaps ·
Ch. 6
Term Structure Dynamics. ·
Single Factor
Models. |
Reading: Holden
Sect 5.4–6.1, Hull Sect 7.7–7.9, 30.1-30.2 |
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Session Topics |
Assignment Preparation |
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(18.) March 7 ·
Two Factor
Models. ·
Arbitrage-free
Models |
Reading: Holden Sect
6.2–6.3, Hull Sect
30.3, 31.1 |
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Spring Break |
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(19.) March 19 ·
Ch. 7 Corporate
Bonds ·
Structural
Models ·
Reduced-Form
Models |
Reading: Holden Sect
7.1–7.2 |
PART II: INDIVIDUAL
OPTIMIZATION
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(20.) March 21 ·
Ch. 8 Individual
Optimization. ·
Rational Vs.
Irrational Agents. ·
Useful Utility
Functions. ·
The Portfolio
Problem. |
Reading: Holden Sect
8.1–8.3, Ingersoll
Pages 38-41 |
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(21.) March 26 ·
Mean-Variance
Analysis. ·
The St.
Petersburg Paradox |
Reading: Holden Sect
8.4–8.5, Ingersoll Pages 82-89,
98 Excel Models: Portfolio Optimization |
PART III: EQUILIBRIUM
PRICING
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(22.) March 28 ·
Ch. 9 Single
Period Asset Pricing. ·
Standard Supply
and Demand Problem. |
Reading: Holden Sect
9.1 |
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(23.) April 2 ·
CAPM. ·
APT. ·
Ch. 10
Multi-Period Asset Pricing in Discrete Time. ·
Dynamic
Programming Three Cases. ·
Ch. 11
Multi-Period Asset Pricing in Continuous Time. ·
Constant
Investment Opportunity Set and State Independent Utility. |
Reading: Holden Sect
9.2–11.1, Ingersoll
Pages 92-93, 98, 235-248 (ç just skim these pages), 271-276 |
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(24.) April 4 ·
Live Exercise
in Designing a Theoretical Study ·
Stochastic
Investment Opportunity Set and/or State Dependent Utility. ·
Consumption
CAPM. ·
Endogenous Riskfree Rate. |
Reading: Holden Sect
11.2–11.4, Ingersoll
Pages 280-282, 286-287 |
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Session Topics |
Assignment Preparation |
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(25.) April 9 ·
15-Minute
Research Paper Presentations |
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(26.) April 11 ·
15-Minute
Research Paper Presentations |
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(27.) April 16 ·
CIR General
Equilibrium Model. ·
Ch. 12
International Asset Pricing. ·
International
Parity Conditions. |
Reading: Holden Sect
11.4–12.1, Cox,
Ingersoll, and Ross (1985a) (ç focus on big picture of this paper – I will explain
the details) Excel Models: International Parity |
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(28.) April 18 ·
Solnik’s Model. ·
International
Investment Problem |
Reading: Holden Sect
12.2–12.3, Ingersoll Pages
289-290, Solnik (1974), Adler and Dumas (1983) |
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(29.) April 23 ·
International
Asset Pricing and Intertemporal State Variables. ·
Stylized Facts
About International. |
Reading: Holden Sect
12.4–12.5, Adler and
Prasad (1992) |
PART IV: IMPERFECTIONS
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(30.) April 25 ·
·
Transaction
Costs. ·
Endogenous Real
Exchange Rate. |
Reading: Holden Sect
13.1–13.2, Dumas and
Luciano (1989), Dumas (1992) |
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(31.) April 30 ·
Round 3 Original
Research Paper and Response to the Referee is due at 5:00 p.m. |
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GRADING
1. Grading is done on a curve based on total points
for the course. The following items are graded:
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Project |
Points |
Percent |
Kick Off |
Due Date |
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Class Participation in the First Half Class Participation in the Second Half |
100 points 100 points |
12.5% 12.5% |
---- ---- |
---- ---- |
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Clicker Participation in the First Half Clicker Participation in the Second Half |
100 points 100 points |
12.5% 12.5% |
---- ---- |
---- ---- |
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Original Research Paper:
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80 points 120 points 200 points |
10% 15% 25% |
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Total Points |
800 points |
100.00% |
---- |
---- |
2. I
expect you to participate in the class discussion. I record class participation
for each student immediately after class.
ARTICLE
DISCUSSION
You are asked to lead a 15 minute class discussion while
sitting in your chair (i.e., no PowerPoint) of a published or forthcoming article on Asset Pricing Theory. It can
be pure theory article or a theory and empirical mix article, but there has to
be true theoretical contribution in the article (i.e., there must be a
proposition or a theorem in the article). The article must have been published in
the years 2007 to the present or currently be forthcoming in the top-tier
finance journals (JF, JFE, RFS, and JFQA) or in top-tier accounting or
economics journals. To search for articles, try looking at the table of contents or recent issues, clicking on interesting
abstracts, and then downloading the full articles that seem especially interesting.
15 minutes is a short amount of time. You need to focus
on the big picture. You need to cover the overall motivation, key assumptions,
and key results / intuitions. Don't get bogged down in the details and
derivations. This is not a presentation, so PowerPoint is not permitted.
Instead, you will lead the class discussion from your chair and I will show key
article pages on the screen.
Article discussion sign-ups will begin on January 26 after
class. Please
supply a PDF file of the requested article in its final published form from the
journal web site (not in its working paper form). Sign-ups will be first-come, first served. The PDF file of each selected
article will be distributed to the entire class. Students are expected to give each
selected article at least a 15 minute “quick read” prior to the class
discussion. A quick read means completely reading the introduction and then
selectively reading key parts, such as the assumptions, figures, propositions,
data description, or tables.
TEXTBOOKS
AND NOTES
Options, Futures, and Other
Derivatives, Eight Edition by John Hull –
The entire text is available by
logging onto OnCourse,
clicking on F600, and then clicking
on Courseload.
You have already paid
for it! There is no
need to purchase it a second time. If it doesn’t load, try a different browser.
Notes for F600 Asset Pricing Theory by Craig W. Holden
Optional: The Theory of Financial Decision Making
by Jonathan Ingersoll
ELECTRONIC
RESOURCES
I have created a zip file containing an electronic
copy of the F600 notes, F600 books, F600 asset pricing articles, Excel models,
handouts, and career resources. This zip file can be downloaded by logging into Oncourse (oncourse.iu.edu) and then clicking on the F600 tab, the Resources link, and the file F600
Electronic Resources.zip.
ORIGINAL
RESEARCH PAPER
You
are to develop an original research paper following the three round process
listed below.
Round
1. Identify an asset
pricing theory paper (on the syllabus, on the list of presentation articles, or
elsewhere) and brainstorm three-to-five possible theoretical extensions that
could be made to the model. The round 1 write-up (limit of one page write-up
per extension – can be handwritten if you wish) should specify for each
possible extension:
Response
1. Drop by my office and we
will discuss the merits of each possible extension.
Round
2. Develop a “core model’ that
captures the key economic idea that you want to address. Often you will need to
iterate through a series of models/assumptions/approaches until you find one
that is both tractable and which captures your key economic idea. Write up it
up in the standard format of an academic paper. The body of the paper (excluding the title page, appendices, tables, or
figures) is limited to 10 double-spaced pages with normal size font and
one-inch margins all around. The literature review is limited to 1 page
in the introduction. Journal space is very limited, so it is a good habit
to learn to write your papers with a very tight, efficient use of space. Submit
your paper as a PDF file to cholden@indiana.edu. Your write up should include:
·
to your extension
- I want you to focus your effort on your extension and not on reading
extra articles.
·
the model set-up
·
step-by-step
development of the model - explain each step once in math and a second time in
words
·
flag key
assumptions and results
·
optional:
comparative statics and other ways to milk the model for all it is worth
·
a brief
conclusion, including possible future extensions.
Class Presentation. Develop a 15 minute, PowerPoint presentation for the class. Your
presentation should explain:
·
what your are research question(s),
·
what is the motivation for this line of research,
·
what is your model setup, including key assumptions,
·
what are your key results to date, and
·
what are your key interpretations / intuitions for your results.
On the presentation date, please
come to class a few minutes early and copy your presentation to the Windows
Desktop of the classroom computer.
Response 2.
I will add comments on both the substance
and exposition in your paper. I will send
you an email that I have read your report and asking you to stop by my office.
In my office I will provide additional explanation of my comments.
Round 3. Incorporate a response to my comments. Add
any additional results and polish the exposition. Write a one-page "response
to the referee" report explaining with terse bullet points how you
have responded to my comments and what additional items have been added. Submit
your final version and your response to the referee report as PDF files
to cholden@indiana.edu. Your grade for the research
paper substance and academic writing will be based on the Round 3 paper and
response to the referee report.
Important Dates:
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Feb 21 |
The Round 1
write-up is due. |
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Feb 25, 26, or 27 |
Drop by my office
to discuss the merit of each possible extension. |
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April 4 (early submissions welcome) |
The Round 2 PDF
paper submission is due. |
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April 8 or 10 |
15 minute presentation
of your research to the class. |
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April 30, 5:00
p.m. |
The Round 3 PDF
paper and response to the referee report submissions are due. |
PLAGIARISM
·
Plagiarism is obvious. When a paper is 10 times more sophisticated that what
a first or second year doctoral would produce, it is obvious. When a paper’s
writing style is 10 times more polished compared that what a first or second
year would produce, it is obvious. When a paper uses perfect English grammar
compared to what a non-native English speaker would produce, it is obvious.
·
Plagiarism is easy to verify. Just take a unique sentence from the paper, type it
into Google in quotes, and you will instantly get the plagiarized document. The
entire published literature, all books, and all working papers are online. So
everything worth plagiarizing is in Google’s index.
·
The penalties for plagiarism are severe. Anyone I catch will get an “F” in this class
and, most likely, you would be dismissed from the doctoral program.
·
If you are in trouble, talk with me. The most likely context for plagiarism is that
someone gets to a deadline and has nothing to turn in. I will understand your
situation and will work with you. In the big picture, it is far better to get a
lousy grade than to blow-up your career.
REFERENCES
Black, F., 1990, "Equilibrium Exchange Rate
Hedging," Journal of Finance 45, 899-907.
Constantinides, G., 1983, "Capital Market Equilibrium With
Personal Tax," Econometrica, 51: 611-636.
Duffie,
D. and R. Kan, 1996, “A Yield-Factor Model of
Interest Rates,” Mathematical Finance, 6: 379-406.
Geske, R., 1979, "The Valuation of Compound
Options," Journal of Financial Economics, 7: 63-81.
Harrison,
J. M., and D. Kreps, 1979, "Martingales and Arbitrage in Multiperiod Securities Markets," Journal of
Economic Theory, 20: 381‑408.
Heath,
D, R. Jarrow, and A. Morton, 1990b, “Contingent Claim
Valuation with a Random Evaluation of Interest Rates,” Review of Futures
Markets, 9: 54-76.
Markowitz, H., 1952,
"Portfolio Selection," Journal of Finance, 7, 77-91.
Merton,
R., 1971, "Optimum Consumption and Portfolio Rules in a Continuous‑Time
Model," Journal of Economic Theory, 3: 373‑413.
Merton, R., 1973a, "An Intertemporal
Capital Asset Pricing Model," Econometrica,
41: 867‑80.
Merton,
R., 1982a, "On the Microeconomic Theory of Investment under
Uncertainty," in Kenneth J. Arrow and Michael D. Intriligator,
eds., Handbook of Mathematical Economics Vol. 2, New York, North Holland
Publishing Co.
Merton,
R., 1982b, "On the Mathematics and Economic Assumptions of Continuous Time
Models," in William Sharpe and Catherine Cootner,
eds., Financial Economics: Essays in Honor of Paul Cootner
Pye, G., 1974, “Gauging the Default Premium,” Financial Analyst Journal, January-February, 49-50.
Ross, S., 1976, "The Arbitrage Theory of Capital
Asset Pricing," Journal of Economic Theory, 13: 343-362.
Ross,
S., 1978, "Mutual Fund Separation and Financial Theory ‑ The
Separating Distributions," Journal of Economic Theory, 17: 254‑86.
Rothschild,
M., and J. Stiglitz, 1970, "Increasing Risk I: A
Definition" Journal of Economic Theory, 2: 225‑43.
Rothschild,
M., and J. Stiglitz, 1971, "Increasing Risk II:
Its Economic Consequences," Journal of Economic Theory, 3: 66‑84.
Solnik,
B. H., 1974, "An Equilibrium Model of the International Capital
Market," Journal of Economic Theory, 8, 500-524.
Smith, C., 1976, "Option Pricing: A Review,"
Journal of Financial Economics, 3: 3-51.
DOCTORAL
PROGRAM LEARNING GOALS
F600 contributes to achieving
the following doctoral program learning goals: (1) comprehensive and intensive
disciplinary knowledge, (2) comprehensive and intensive knowledge of research
methods, (3) communication of disciplinary research, and (4) evaluations of
disciplinary research. The course teaches comprehensive and intensive
disciplinary knowledge by teaching the key ideas in asset pricing theory, such
as no arbitrage pricing, dynamic term structure models, individual portfolio
optimization, single-period equilibrium, multi-period discrete equilibrium,
continuous-time equilibrium, equilibrium with intertemporal
state variables and state-dependent utility, international asset pricing,
portfolio adjustment under transaction costs, real exchange rates under spacial separation, etc. The course teaches comprehensive
and intensive knowledge of research methods by teaching the key research
methods in asset pricing theory, such as continuous time stochastic processes, the
binomial method, risk neutral pricing, solving partial differential equations,
pricing by simulation, pricing by finite differences, dynamic programming, measurement
currency, high-contact conditions, etc. and by having student do their own
original research paper and providing individual feedback on the substance of
their paper. The course teaches the communication of disciplinary research by
having students present their own research to the class and by providing
individual feedback on the academic writing quality of their paper. The course
teaches evaluations of disciplinary research by discussing the strengths and
weaknesses of each academic paper that we cover and by having each student lead
a discussion of a recently published or forthcoming paper.
APPENDIX
Doctoral Program Learning Goals
Goal 1:
Comprehensive and Intensive Disciplinary Knowledge
Students
who earn a doctorate degree in business will be able to demonstrate a
comprehensive and intensive knowledge of the theories, concepts, frameworks,
empirical findings, and controversies in a chosen business discipline.
Goal 2:
Comprehensive and Intensive Knowledge of Research Methods
Students
who earn a doctorate degree in business will be able to demonstrate a
comprehensive and intensive knowledge of the research methods and analytical
techniques applicable to a chosen business discipline.
Goal 3:
Communication of Disciplinary Research
Students
who earn a doctorate degree in business will be able to design, conduct, and
communicate – in both written and oral formats – original research that makes a
substantial contribution to a selected business discipline.
Goal 4:
Evaluations of Disciplinary Research
Students
who earn a doctorate degree in business will be able to evaluate research ideas
and completed research projects critically, assessing their conceptual and
methodological soundness and importance of contribution to existing knowledge
in the field.
Goal 5:
Teaching
Students
who earn a doctorate degree in business will be able to teach effectively in a
selected discipline at the university level.