Financial Economics

This book presents an introduction to arbitrage theory and its applications to problems for financial derivatives. This second edition includes more advanced materials; appendices on measure theory, probability theory, and martingale theory; and a new chapter on the martingale approach to arbitrage theory. The chapters cover the binomial model, a general one period model, stochastic integrals, differential equations, portfolio dynamics, arbitrage pricing, completeness and hedging, parity relations and delta hedging, the martingale approach, incomplete markets, dividends, currency derivatives, barrier options, stochastic optimal control, bonds and interest rates, short rate models, forward rate models, and LIBOR and swap market models.

This book gives a comprehensive introduction to arbitrage theory for the pricing of contingent claims, such as options, futures, and other financial derivatives. The arbitrage theory for the term structure of interest rates is given particular consideration. Also included is a self‐contained exposition of stochastic optimal control, with applications to portfolio optimisation. The mathematical development is precise but avoids the explicit use of measure theory.

Relying on the existence, in a complete market, of a pricing kernel, this book covers the pricing of assets, derivatives, and bonds in a discrete time, complete markets framework. It is primarily aimed at advanced Masters and PhD students in finance. Topics covered include CAPM, non-marketable background risks, European-style contingent claims as in Black–Scholes and in cases where risk-neutral valuation relationship does not exist, multi-period asset pricing under rational expectations, forward and futures contracts on assets and derivatives, and bond pricing under stochastic interest rates. All the proofs, including a discrete time proof of the Libor market model, are shown explicitly.

Asset prices are driven by public news and information that is dispersed among many market participants. Traditional asset pricing theories have assumed that all investors hold symmetric information. Research in the past two decades has shown that the inclusion of asymmetric information drastically alters traditional results. This book provides a detailed up‐to‐date survey that serves as a map for students and other researchers navigating through this literature.

The book starts by introducing the reader to different knowledge, equilibrium, and efficiency concepts. After explaining no‐trade theorems, it highlights the important role of asymmetric information in explaining the existence and anatomy of bubbles. The subsequent overview of market microstructure models shows how information is reflected in prices and how traders can infer it from prices. Insights derived from herding models are used to provide explanations for stock market crashes. If investors have short horizons, price correcting arbitrage activity is limited and investors have a tendency to focus on the same (possible unimportant) news, a phenomena that led Keynes to compare the stock market with a beauty contest. The book concludes with a brief summary of bank runs and their connection to financial crises.

In summary, models with asymmetric information provide a better understanding of bubbles, crashes, and other market inefficiencies and frictions.

Banks and financial institutions are faced with two apparently conflicting phenomena — interest rate deregulation on the one hand and capital adequacy requirements and prudential norms on the other. In such a situation, these institutions need to work out a strategic framework which must evolve around the profit objective so as to build up quality loan-assets portfolios and to ensure adequate capital growth. This book provides a comprehensive analysis of lending strategies, credit appraisal, risk analysis, and lending decisions within the overall objectives of a lending organization. This revised edition takes into account recent global developments in the banking sector as well as changes in the notion of banking. It includes three new chapters in which the author discusses topical issues such as the impact of capital regulation on the risk attitude and profitability of banks, strategies to protect banks from a liquidity crisis, and the need of a portfolio approach in developing models for credit exposure and loan management within a risk–return framework.

Behavioral finance is the study of how psychology impacts finance. This book represents the first general, comprehensive treatment of the subject. The book explains how psychological phenomena impact the entire field of finance. Readers will learn to recognize the influence of psychology on themselves, on others, and on the financial environment at large. Psychology is the basis for human desires, goals, and motivations. Psychology is also the basis for a wide variety of human errors that stem from perceptual illusions, overconfidence, over‐reliance on rules of thumb, and emotions. Errors and bias cut across the entire financial landscape, affecting individual investors, institutional investors, analysts, strategists, brokers, portfolio managers, options traders, currency traders, futures traders, plan sponsors, financial executives, and financial commentators in the media.

Since financial myths exploded in the 1980s, the perspective of time creates a unique opportunity to update and expand the analysis begun in Glenn Yago's 1991 book, Junk Bonds: How High Yield Securities Restructured Corporate America (OUP). When first published, Junk Bonds drew controversial responses, but some 12 years later, enough time has passed to allow this dispassionate empirical analysis to shear away the hype and hysteria that surrounded the Wall Street scandals, Washington controversies, and media frenzy of the time. In retrospect, the evidence clearly casts favorable light on the role of high‐yield securities (junk bonds), and the research presented in this book demonstrates how financial innovations enabled capital access for industrial restructuring, capital and labor productivity gains, and improved global competitiveness. The book provides a one‐stop data, reference, and case study presentation of firms and securities in the contemporary high‐yield market in the USA (and elsewhere), and of the financial innovations that spurred growth in the 1990s and will continue to finance the future. The high‐yield market incubated successive waves of financial technologies that now proliferate beyond junk bonds to all the dimensions and dynamics of global debt and equity capital markets. The book charts the recovery of the market in the 1990s, the wave of fallen angels, distressed credits and defaults in 2001–2002, and suggests how the high‐yield market will be recreated in the global market of the twenty‐first century. It also explicates the linkages between the high‐yield market and other credit and equity markets in managing a firm's capital structure to execute its business strategy. Anyone active in corporate finance, financial institutions, or capital markets will find this book useful for interpreting and understanding the recent history of both the high‐yield marketplace and its interaction with private equity, public equity, and fixed‐income markets. The material presented is arranged in 11 chapters and four appendices. The latter provide definitions of junk bonds, some technical material from Ch. 4, a “tools of the trade” glossary, and a literature review containing short summaries of seven topics (bond ratings, macroeconomic relationships, regulation, use of proceeds, Drexel Burnham Lambert – a bond underwriter, default rates, and risk) with associated references, a table of annotated references, and further references.

This volume reviews the most recent research on brain drain and brain gain, producing new original results by the means of data sources specifically assembled for this study, and addressing several key policy issues. Part I focuses on brain gain, that is, it takes the standpoint of the recipient country. The first section provides an overview of skill‐selective immigration policies in the main destination countries and of the major shifts in these policies which have been recently observed. It also documents the strong economic gains from immigration of highly skilled migrants. But what drives the decisions of highly skilled migrants as to where to locate? The econometric analyses performed by the authors indicate that it is mainly the labour market that is key to attracting talent, wage premia on education in particular. R&D spending also induces greater inflows of highly skilled migrants, while generous welfare benefits and strict employment protection end up attracting more unskilled workers. Part II is devoted to the consequences of brain drain, taking the point of view of the sending country. This second section provides for the first time a measure of the net global impact of the brain drain on sending countries. The results indicate that most developing countries experience a net gain from skilled emigration. Adverse overall impacts are found to be limited only to a subset of countries exhibiting very high skilled emigration rates. A number of policy recommendations are also offered to increase the benefits of brain drain.

Business cycle theory is a broad and disparate field. Different schools of thought offer alternative explanations for cycles, often using different mathematical methods. This book aims to provide academics and graduate students of economics with an exposition of business cycle theory since Keynes. The author places the main theories — Keynesian economics, monetarism, new classical economics, the real business cycles theory, and new Keynesian economics — in a historical context by presenting them in the chronological order of their appearance and highlighting their differences and commonalities. He minimizes the necessary mathematical prerequisites by using a unifying mathematical approach: stochastic second-order difference equations, which is explained in detail. Throughout the book, the international dimension of business cycles is acknowledged. The theoretical results obtained are set alongside empirical facts in separate boxes. Each chapter finishes with a set of problems designed to deepen the reader's understanding of the theories presented, and further reading sections providing access to related material.

This book is timely since the Basel Committee on Banking Supervision at the Bank for International Settlements is in the process of making major revisions in the capital rules for banks. It is important that capital adequacy regulation helps to achieve financial stability in the most efficient way. Capital adequacy rules have become a key tool to protect financial institutions. The research contained within the book covers some key issues at stake in the capital requirements for insurance and securities firms. The contributors are among the leading scholars in financial economics and law. Their contributions analyze the use of subordinated debt, internal models, and rating agencies in addition to examining the effect on capital of reinsurance, securitization, credit derivatives, and similar instruments.