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 Investments  posted by  duggu   on 12/28/2007  Add Courseware to favorites Add To Favorites  
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Gallati, Reto, 15.433 Investments, Spring 2003. (Massachusetts Institute of Technology: MIT OpenCourseWare), (Accessed 12 Jul, 2010). License: Creative Commons BY-NC-SA

Graph of utility function.

Graph of utility function. (Graph by Prof. Reto Gallati.)

Course Highlights

This course teaches how to make sound investment decisions through in-depth knowledge of the financial markets, rigorous analytical thinking and precise mathematical derivation. Included is a comprehensive set of lecture notes for all 23 lectures to explain core concepts. Also, students gain hands-on experience with optimization, data analysis, and other quantitative techniques by completing the five group assignments.

Course Description

The focus of this course is on financial theory and empirical evidence for making investment decisions. Topics include: portfolio theory; equilibrium models of security prices (including the capital asset pricing model and the arbitrage pricing theory); the empirical behavior of security prices; market efficiency; performance evaluation; and behavioral finance.


The focus of this course is on the financial theory and empirical evidence that are useful for investment decisions. The topics covered in this course can be broadly categorized into five groups:
  • Financial Theories
    This includes portfolio theory, the capital asset pricing model and the arbitrage pricing theory, all of which have become an integrated part of the decision-making in investments.
  • Empirical Evidence in the Equity and Equity Options Markets
    This includes patterns in cross-sections of stock returns, the time-series behavior of stock returns time-varying expected returns and stochastic volatility, and further empirical evidence from the equity options market.
  • Introduction to Fixed-Income and Credit Sensitive Instruments
    This includes default-free as well as defaultable bonds, yield curve analysis, the effect of Fed target rates, fixed-income derivatives such as swaps, caps, floors, and swaptions, models of default and ratings transitions, and more recent development of credit derivatives.
  • Market Efficiency and "Active" Investments
    We start with the efficient market hypothesis, which is a useful framework for modeling financial markets. Like any model, the efficient market hypothesis is not a perfect description of reality: some prices are almost certainly "wrong". Hence there are reasons to believe that active management can have effective results. Topics in active investments include security analysis, active portfolio management, hedge funds, and risk management issues.
  • Brief Introduction to Behavioral Finance
    While traditional finance assumes investors act rationally to maximize a well-defined utility function, behavioral finance tries to use other theories of behavior, from psychology, sociology, and anthropology, to explain financial markets. This topic will be covered by just one lecture, the main purpose of which is to get you exposed to this active and fast growing field in Finance.
Course Objectives
A sound investment decision requires in-depth knowledge of the financial markets, rigorous analytical thinking and precise mathematical derivation. The main objective of this class is to teach you these three elements:
  • Analytical Tools
    Among others, an important analytical skill you should acquire from taking this class is the ability to transform a real life investment problem into an analytically tractable model. This modeling skill is an important aspect of this class, and will be emphasized throughout the course.
  • Quantitative Skills
    Modern finance has its quantitative aspect. Powerful mathematical techniques such as optimization, dynamic programming, probability theory and statistical analysis pave the way for many complex investment problems.
    In this class, you will be exposed to this quantitative aspect. You are not expected to be fluent in mathematics, but I hope to teach you the fundamentals, which are portable from one situation to another. Moreover, through 5 group assignments, you will have hands-on experiences with optimization, data analysis, Monte-Carlo simulation, etc.
  • Empirical Knowledge
    Essential to any investment decision is the knowledge of the investment environment. Broadly speaking, the financial instruments can be categorized into equity, debt, and derivatives. Important empirical evidence from all three types of financial markets will be examined in this class. Although I will emphasize concepts and the big picture a lot, please realize that 15.433 involves a fair bit of algebra, notation, and basic mathematics. So if you are uncomfortable with the above three notions, please talk to the course instructor about it.
Course Materials
Required Reading
Bodie, Zvi, Alex Kane, and Alan J. Marcus ("BKM"). Investments. 5th Edition. McGraw-Hill/Irwin, 2002.

Recommended Reading
P. Bernstein. Capital Ideals: The Improbable Origins of Modern Wall Street. New York: Free Press, 1992.

TA's and Review Sessions

The TA's for the course will hold weekly office hours, review sessions are announced in the class.


Regular attendance and class participation     10%
Five group assignments                                   20%
Mid-term examination                                       30%
Final examination                                             40%

Class Preparation and Participation

Both class preparation and participation are important. The classroom is a great place to test and enhance your understanding of the material by asking and answering questions. It will be hard to contribute to the discussions if you are unprepared. I strongly encourage you to prepare for class in study groups. For details, see Course Schedule and Reading List.

Class participation, from clarifying questions to creative and insightful comments, is greatly encouraged. Your active participation will transform this class into a great learning experience for everyone, including myself.

Group Assignments

There are five group assignments. Each is worth between 3 to 5 points toward your final grade. Group assignments are due at the beginning of class on the due date.

Please work in a group of three to five students when preparing these assignments. Each group should hand in only one set of answers. Each group member will receive the same grade on an exercise, and each is expected to make a significant contribution to the solution of every problem.

  1       Capital Market Theory       3
  2       Security Analysis       5
  3       Futures Problem       4
  4       Simulation Based Option Problem       5
  5       Performance Attribution       3
          Total       20

Both mid-term and final exams are in-class, closed-book and closed-notes. The mid-term will be given after lecture 11, and the final will be given during the scheduled final examination date (after lecture 24).

Unlike the group assignments, you may not work on the exams in groups. If you have to miss the exams due to medical reasons, please contact me before the exams.



  LEC #        TOPICS       READINGS
  1       Introduction       Read Course Syllabus, BKM chapters 1-2, Merton (1990) and Sharpe (1995)
  2       Securities, Random Walk on Wall Street       Read BKM chapters 3 and 5, Fama (1995) and Kritzman (1993).
                  Financial Theories
  3       Portfolio Theory, Part 1: Setting Up the Problem       Read BKM chapters 6 and 7, Elton and Gruber (2000) and Kritzman (1992).
  4       Portfolio Theory, Part 2: Skewness Preference and Dynamic Rebalancing       Read BKM Appendix A, B of chapter 6, Black (1995).
  5       Portfolio Theory, Part 3: Multiple Risky Assets       Read BKM chapter 8, Kritzman (1994) and Kritzman (1991).
  6       The CAPM and APT, Part 1: Theory       Read BKM chapters 9-11, Roll and Ross (1995) and Kritzman (1991).
  7       The CAPM and APT, Part 2: Applications and Tests       Read BKM chapter 13, Jagannathan and McGrattan (1995) and Kritzman (1993).
                 Equity and Equity Options
  8       The Equity Market, Part 1: Patterns in the Cross-Section of Stock       Returns Read Fama and French (1992).
  9       The Equity Market, Part 2: More Patterns in the Cross-Section of Stock Returns       Read Cochrane (1999), Kritzman (1991a) and Kritzman (1991b).
  10       Equity Options, Part 1: Introduction       Read BKM chapter 20.
  11       Equity Options, Part 2: Empirical Evidence, Volatility       Read BKM chapter 21.
  12       Mid-term Exams        
                  Fixed-Income and Credit-Sensitive Instruments
  13       The Fixed Income Market, Part 1: Introduction       Read BKM chapter 14, Kritzman (1993).
  14       The Fixed Income Market, Part 2: The Yield Curve       Read BKM chapter 15, Kao (1993).
  15       Futures, Swaps, Caps/Floors, Swaptions, and Other Derivatives       BKM chapters 22 and 23.
  16       The Credit Market, Part 1: Default Risk, Credit Spreads and Ratings Transitions       Read Duffie and Grleanu (2001).
  17       The Credit Market, Part 2: Credit Derivatives       Read Reyfman and Toft (2001) and Altman, Caouette, Narayanan (1998).
                  "Active" Investments and Market Efficiency
  18       Market Efficiency       Read BKM chapter 12, Rubinstein (2001) and Daniel and Titman (1999) and Fama (1998).
  19       Security Analysis and Stock Selections       Read BKM chapters 17-19 and Business Week (2001).
  20       Active Portfolio Management       Read BKM chapters 26 and 27, Thomas (2000), Waring, Whitney, Pirone and Castille (2000).
  21       Hedge Funds and Proprietary Trading       Read Kritzman (1994a), Kritzman (1994b), Ross (1999) and Perrold (1999).
  22       Risk Management       Read BKM chapter 27, Chow and Kritzman (2001), Bernstein (1995).
  23       Commodity       Read BKM chapters 22 and 23.
                  Behavioral Finance and Summary
  24       Behavioral Finance       Read Statman (1999).
  25       Summary and Review        
  26       Repetition        
  27       Final Exams        

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