This week, Finance 4366 will proceed asynchronously!

Dear Finance 4366 Students,

Because of health-related issues in my family, our Finance 4366 class will not meet in person this week and will proceed asynchronously on March 12th and 14th.

I’ve uploaded a lecture for March 12th titled “Binomial Trees (2nd lecture)”. I will upload another lecture note by Wednesday at the latest for March 14th, completing the presentation of the Binomial tree and introducing American options.   Since Finance 4366 will not meet in person this week, I expect everyone to watch and report on both lectures online. To earn attendance and participation credits, watch both lectures and submit synopses for each in PDF format via Canvas. The synopsis for the March 12th lecture is due at 5 pm on March 13th, and the synopsis for the March 14th lecture is due at 5 pm on March 15th.  I have created two separate assignments for your lecture synopses that can be found on the course Assignments page on Canvas.

I will also be available for virtual (Zoom) office hours on Tuesday, March 12, and Thursday, March 14, from 3:30-4:30 p.m.  If you like, you can also make an appointment on MW by typing “appointment.garven.com” in the address field of your device’s web browser.

Here are the links for the March 12 and March 14 lectures:

March 12 (Binomial Trees (2nd lecture)): https://mediaspace.baylor.edu/media/Binomial+Trees+%282nd+lecture%29/1_15th0kft

March 14: TBA

The Trillion Dollar Equation Video

The video “The Trillion Dollar Equation” explores the profound influence of the Black-Scholes/Merton equation on the theory and practice of modern finance. This equation, which originated from physics, transformed the derivatives market into a multi-trillion-dollar industry and revolutionized how risk is assessed and managed.  This video, lasting just 31 minutes, offers an exceptionally clear and comprehensive explanation of options, enriched with historical background, unlike any I have encountered before.

Initially, the video narrates the historical context where Sir Isaac Newton, despite his mathematical prowess, suffered financial losses due to the unpredictable nature of the stock market. Contrasting Newton’s experience, it introduces Jim Simons, a mathematician who achieved unparalleled success in the stock market by leveraging mathematical models.

The narrative then shifts to the origins of financial models with Louis Bachelier, who proposed a mathematical solution to pricing options, laying the groundwork for modern financial theory. It explains the concept of options and their benefits. It introduces the concept of random walks in stock prices, likened to particles undergoing Brownian motion—a phenomenon first described by Albert Einstein.

The video discusses how Ed Thorp applied mathematical strategies from blackjack to the stock market, significantly impacting hedge fund strategies and introducing the concept of dynamic hedging. This laid the foundation for the groundbreaking work by Fischer Black, Myron Scholes, and Robert Merton, who developed a formula for pricing options, transforming the financial industry accurately.

The narrative highlights the rapid industry adoption of the Black-Scholes/Merton model, leading to the explosive growth of derivative markets and new financial instruments like credit default swaps and securitized debts. It illustrates how these tools can both mitigate and amplify market risks, impacting global financial stability.

There’s much to look forward to during the upcoming second half of Finance 4366!

Tomorrow: 2024 Collegiate Day of Prayer

Did you know Baylor University is hosting the 2024 Collegiate Day of Prayer? All Baylor students are encouraged to come together tomorrow (February 29) at 7 p.m. for the worship and prayer service in Waco Hall. The Hankamer School of Business will also have Foster Room 143/144 reserved tomorrow from 8 a.m.-5 p.m., with stations for prayer guidance for students, faculty, and staff.

For more information, visit baylor.edu/dayofprayer.

Shameless plug…

During class today, I referred to a journal article that I published early in my academic career that Professor Robert C. Merton cites in his Nobel Prize lecture (Merton shared the Nobel Prize in economics in 1997 with Myron Scholes “for a new method to determine the value of derivatives”).

Here’s the citation (and link) to Merton’s lecture:

Merton, Robert C., 1998, Applications of Option-Pricing Theory: Twenty-Five Years Later, The American Economic Review, Vol. 88, No. 3 (Jun. 1998), pp. 323-349.

See page 337, footnote 11 of Merton’s paper for the reference to Neil A. Doherty and James R. Garven (1986)… (Doherty and I “pioneered” the application of a somewhat modified version of the BSM model to insurance pricing; thus, Merton’s reference to our Journal of Finance paper in his Nobel Prize lecture).

Here is the APA-compliant listing for the above-referenced Doherty-Garven:

Doherty, Neil A. and James R. Garven. 1986. “Price Regulation in PropertyLiability Insurance: A Contingent Claims Approach.” Journal of Finance, 41 (5):1031-1050.

WSJ Page 1: The Small University Endowment That Is Beating the Ivy League

From WSJ: “The more than $200 million Paul and Alejandra Foster Pavilion at Baylor University opened in January, with proceeds from the endowment helping to fund its construction.

WSJ (2/14/2024) Page 1 story about Baylor’s 2 billion dollar endowment, and how it is managed…

https://www.wsj.com/finance/investing/the-small-university-endowment-that-is-beating-the-ivy-leagues-8ce37cf1?st=ncxhvwphm1vrrx8&reflink=desktopwebshare_permalink

On the importance of “arbitrage-free” pricing in finance

The notion of “arbitrage-free” pricing is important not only in Finance 4366 but also in your other finance studies. In Finance 4366, we take it as given that investors are risk averse. However, it turns out that we don’t need to invoke the assumption of risk aversion to price risky securities such as options, futures, and other derivatives; all we need to assume is that investors are “greedy” in the sense that they prefer more return to less return, other things equal. Through a variety of trading strategies, we can synthetically replicate any security we want and do so in such a way that we (in theory anyway) can take no risk, incur zero net cost of investment, and yet earn positive returns.

Without question, the notion of arbitrage-free pricing is THE key concept in Finance 4366. However, it is also important in corporate finance. For example, the famous Modigliani-Miller Capital Structure Theorem; i.e., that the value of a firm’s shares is unaffected by how that firm is financed, is based upon this principle. For your personal enjoyment and intellectual edification, I attach a copy of a short (3-page) teaching note that provides a “no-arbitrage” proof based on a simple numerical example:

The Modigliani-Miller Capital Structure Theorem – A “No-Arbitrage” Proof