Extra Credit Opportunity: Free Enterprise Forum with Glenn Loury, “Capitalism and Race”

I am pleased to announce the Baugh Center’s upcoming Free Enterprise Forum with Glenn Loury, Merton P. Stoltz Professor of the Social Sciences at Brown University. The lecture, “Capitalism and Race,” is Thursday, April 22, at 5:30pm CST via Zoom. The event is co-sponsored by Baylor’s Department of Economics.

Professor Loury is one of the world’s leading experts on the economic and social aspects of race. He will discuss recent developments in race relations including the concept of antiracism, the shift of emphasis within organizations and institutions from diversity to equity and inclusion, and the role of markets in addressing racial bias.

Professor Loury has been on the faculty of Brown University since 2005. He was previously at Boston University where he served as University Professor and Founder and Director of the Institute on Race and Social Division. He has also taught at Harvard, Northwestern, and Michigan. He received his PhD in Economics from MIT. He has published widely in the areas of applied microeconomic theory, game theory, industrial organization, natural resource economics, and the economics of race and inequality. He is a Fellow of the American Academy of Arts and Sciences and the Econometric Society and also served as Vice President of the American Economic Association, and is a recipient of the Guggenheim Fellowship.

As a prominent social critic and public intellectual, writing mainly on the themes of racial inequality and social policy, Professor Loury has published over 200 essays and reviews in journals of public affairs in the U.S. and abroad. He is a member of the Council on Foreign Relations, is a contributing editor at The Boston Review, and was for many years a contributing editor at The New Republic. Professor Loury’s books include One by One, From the Inside Out: Essays and Reviews on Race and Responsibility in America (The Free Press, 1995 – winner of the American Book Award and the Christianity Today Book Award); The Anatomy of Racial Inequality (Harvard University Press, 2002); Ethnicity, Social Mobility and Public Policy: Comparing the US and the UK (ed., Cambridge University Press, 2005); and, Race, Incarceration and American Values (MIT Press, 2008).

Since this panel discussion has the makings of an extra-credit opportunity for Finance 4335, let’s have it! You can earn extra credit by attending this Zoom webinar and reporting on what you learn. If you decide to take advantage of this extra-credit opportunity, I will use the grade you earn on your report to replace your lowest quiz grade in Finance 4335 (assuming that your grade on the extra credit is higher than your lowest quiz grade). Submit your report as a (PDF formatted) 1-2 page executive summary. In order to receive credit, the report must be uploaded to the Assignments section of the Course Canvas page by no later than 5 pm CST on Monday, April 26 (Click on the Assignment entitled “Free Enterprise Forum with Glenn Loury, ‘Capitalism and Race’, April 22, 2021“).

Registration is required at https://bit.ly/FEF_Loury. After registering, you will receive a link to the Zoom webinar.

On the role of replicating portfolios in the pricing of financial derivatives

Replicating portfolios play a central role in terms of pricing financial derivatives. Here is a succinct summary of the replicating portfolio approach:

  1. Buying forward is equivalent to buying the underlying on margin, and selling forward is equivalent to shorting the underlying and lending money. Like options, forwards and futures are priced by pricing the replicating portfolio and invoking the “no-arbitrage” condition. If the forward/futures price is too low, then one can earn positive returns with zero risk and zero net investment by buying forward, shorting the underlying and lending money. Similarly, if the forward/futures price is too high, one can earn positive returns with zero risk and zero net investment by selling forward and buying the underlying with borrowed money. This is commonly referred to as “riskless arbitrage”; it’s riskless because you’re perfectly hedged, and it’s arbitrage because you are buying low and selling high.
  2. The replicating portfolio for a call option is a margined investment in the underlying. For example, on pp. 15-20 of the Derivatives (Part 1) lecture note we price a one time-step call option where the price of the underlying asset is $100, the exercise price is also $100, u = 1.05, d = .95, the interest rate r = 5%, and the time-step \delta t = 1/12. Given these parameters, the payoff on the call is $5 at the up (u) node and $0 at the down (d) node. The replicating value consists of half a share that is financed by a margin balance of $47.30; thus, the “arbitrage-free” price of the call option is (.5(100) – 47.30) = $2.70.
  3. Since the replicating portfolio for a call option is a margined investment in the underlying, it should come as no surprise that the replicating portfolio for a put option consists of a short position in the underlying combined with lending. Thus, in order to price the put, we need to determine and price the components of the replicating portfolio.  We also priced an otherwise identical put option last Tuesday; i.e., where the price of the underlying asset is $100, the exercise price is also $100, u = 1.05, d = .95, the interest rate r = 5%, and the time-step \delta t = 1/12. Given these parameters, the payoff on the put is $0 at the up (u) node and $5 at the down (d) node. The replicating value consists of half a share that is sold short, plus a riskless bond that is worth $52.28; thus, the “arbitrage-free” price of the call option is (.5(100) – 47.30) = $2.70.

Midterm 2 and Current Course Grades in Finance 4335

I just uploaded the Midterm 2 Exam grades, along with attendance, quiz, problem set, and current Finance 4335 course grades to Canvas.

As indicated in the course syllabus, final numeric course grades will be determined according to the following equation:

Final Course Numeric Grade =.10(Attendance and Participation) +.10(Quizzes) +.20(Problem Sets) + Max{.20(Midterm Exam 1) +.20(Midterm Exam 2) +.20(Final Exam),.20(Midterm Exam 1) +.40(Final Exam),.20(Midterm Exam 2) +.40(Final Exam)}

As I noted in my February 1st blog posting entitled “Finance 4335 Grades on Canvas”, as the spring semester progresses and I continue to collect grades in the attendance, quiz, problem set, and exam categories, then the course grade listed on Canvas will dynamically incorporate that information on a timely basis for each student; now that we have Midterm 2 Exam grades, the equation that I am currently using (until the Final Exam) is as follows:

Course Numeric Grade after Midterm 2 = (.10(Attendance and Participation) +.10(Quizzes) +.20(Problem Sets) +.20(Midterm 1+.20(Midterm 2))/.8

There are 32 students enrolled in Finance 4335; here are the current grade statistics:

From this table, you can get a good idea concerning how your grades compare with all other students who are currently enrolled in Finance 4335. You can also see where you stand in terms of a hypothetical letter grade for Finance 4335 by comparing your course grade with the letter grade schedule which appears in the course syllabus:

If you are disappointed by your performance to date in Finance 4335, keep in mind that the final exam grade automatically double counts in place of a lower midterm exam grade. In case if both midterm exam grades are lower than the final exam grade, then the final exam grade replaces the lower of the two midterm exam grades.

If any of you would like to have a chat with me about your grades, by all means, then set up a Zoom appointment with me.

On the upcoming 3rd (and final) part of Finance 4335, starting on Thursday

On Thursday, we enter the 3rd and final part of Finance 4335. During the first part of the course, we focused our attention on developing decision rules for risk management by individuals. We base these rules on expected utility theory, which not only captures the effect of risk attitudes on decision-making and the pricing of risk but also produces (as “special” cases) the so-called mean-variance and stochastic dominance models. For a synopsis of the first part of Finance 4335, see “Finance 4335 Midterm 1 Synopsis“.

During the second part of the course, we began by exploring applications of expected utility theory to 1) the demand for insurance and 2) roles played by contract designs in mitigating moral hazard and adverse selection problems that arise from asymmetric information. The combination of these topics along with the Part 1 topics provides the framework needed for modeling risk management decision-making at a personal level. Taken together, the portfolio and capital market theory topics act as a segue for modeling corporate risk management decision-making. The good news is that this approach provides a logically coherent framework for such an effort. The bad news is that portfolio and capital market theory yields a very unsatisfying prediction for corporate risk management. Specifically, since investors have incentives to hold “fully” diversified ownership stakes in firms, apparently firms need not manage so-called “unsystematic” risks (also commonly referred to as idiosyncratic, or unique risks) since investors are already taking care of this problem by being fully diversified. This result is disconcerting because risk management is a critically important “core competency“ for well-managed companies. For a synopsis of the second part of Finance 4335, see “Finance 4335 Midterm Exam 2 synopsis“.

In Part 3 of Finance 4335, we begin by undertaking the study of financial risk management. Specifically, we focus attention on the pricing of financial derivatives, and it is here that we not only develop a logical framework for managing financial risks but also discover why “unsystematic” risks do in fact affect corporate value. So stay tuned!

Next up in Finance 4335…

On Thursday, after going through the solutions for today’s midterm exam 2, I will introduce the topic of (financial) derivatives (specifically, options and futures) in Finance 4335. Besides studying how derivatives are used to manage price-related risks (for more on this, see “A Beginner’s Guide to Hedging“), further study of derivatives also yields important insights into how firm-specific risks affect corporate value.

The assigned readings for Thursday’s class include:

1. Derivatives and Options (Doherty, Chapter 6)
2. Teaching the Economics and Convergence of the Binomial and Black-Scholes Option Pricing Formulas, by James R. Garven and James I. Hilliard

Finally, Quiz 8 is based on these readings, and it must be completed prior to the start of class on Thursday afternoon.

Midterm 2 Exam reminders about required exam protocols

Here are some friendly reminders about tomorrow’s exam in Finance 4335:

  1. Log in to Zoom as usual, with your webcam turned on and audio muted.    I will turn Zoom on by 1:45 p.m. CT, and students can begin the exam as early as 1:50 pm CT or as late as 2:10 pm CT, and still have a 90-minute window for completing it.
  2. The first “Question” on the exam consists of an “Honor Pledge”, which requires you to certify that all work on the exam is your own.
  3. This midterm exam comprises four problems. I only require you to complete three out of four problems. At your option, you may complete all four problems, in which case I will count the three highest-scoring problems for your exam grade.
  4. The total time allotted for completing the exam and uploading a single PDF file comprising your written work is 90 minutes. Plan on allotting 80 minutes to complete the exam, and 10 minutes to create and upload your written work in PDF format. The final “Question”, labeled “Question 6”, is where you upload your written work.
  5. Do not, under any circumstance, click on the ”Submit Quiz” button prior to completing the exam and uploading your PDF file. If you submit your completed exam without your PDF file, then you will receive a grade of zero for this exam.
  6. If you have questions during this exam, use the Zoom Chat feature to chat privately with Dr. Garven.  You may also call or text Dr. Garven at 254-307-1317. DO NOT under any circumstances unmute yourself on Zoom, as this would be very disruptive for your classmates.

You Can Bet on the Vaccine, Literally

This WSJ  article tells a compelling story about how prediction markets offer important tools for managing risk.  For example, consider the following quote from this article:

…investors can bet on a contract “Will 100 million people have received a dose of an approved COVID-19 vaccine in the US by April 1, 2021?” (At this writing, the betting suggests a likelihood slightly above 1 in 3.)