## Problem Set 8 solutions erratum

If you have previously downloaded what you assumed were solutions for Problem Set 8  (between 4:47 pm on Thursday 11:20 am this morning), toss that document and replace it with the corrected version which now appears in its place at http://fin4335.garven.com/fall2022/ps8solutions.pdf.  (Technical note: If you have previously downloaded this document you might have to first clear your browser cache to get the corrected version of the solutions; in most cases, this can also be accomplished by simple reloading the http://fin4335.garven.com/fall2022/ps8solutions.pdf page a few times).

## Midterm 2 and Current Course Grades in Finance 4335

I just uploaded the Midterm 2 Exam grades, along with current Finance 4335 attendance, quiz, problem set, and 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 August 26th blog posting entitled “Finance 4335 Grades on Canvas”, as the fall semester progresses and I continue to collect grades in the attendance/participation, 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 49 students enrolled in Finance 4335; here are the current grade statistics:

From this table, you can get a good idea of 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 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 in Finance 4335, then by all means, stop by my office (Foster 320.39) 3:30-4:30 pm TR, or set up a Zoom appointment with me.

## Next up in Finance 4335…

On Tuesday, November 1, 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 next 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

In closing, Quiz 8 is based on these readings, and it must be completed prior to the start of class next Tuesday.

## Solutions for Problem Set 6 Erratum…

I realized this afternoon during (virtual) office hours that there were some important errors on page 2 of the original version of the Problem Set 6 Solutions I had posted last Friday, so I corrected these errors and the corrected version of the solutions is now available at http://fin4335.garven.com/fall2022/ps6solutions.pdf.  Therefore, if you downloaded these solutions prior to sometime later this afternoon, please delete that version of the solutions and redownload this corrected version.

The problem I discovered was not with the calculations (of expected value and expected utility) for the three proposed compensation packages per se.  On Friday, I inadvertently uploaded a preliminary (i.e., not fully edited) version of the solutions in which errors were confined to the last 3 paragraphs on p. 2.  I have now uploaded the correct (fully edited) version of the solutions which clearly explains that the only compensation scheme which is incentive compatible (with the manager maximizing expected profit) is compensation scheme #3.

## Midterm 2 Exam Helpful Hints

Students will likely find the study guide to be quite helpful in preparing for the second midterm exam in Finance 4335 (scheduled for Thursday, October 27 in class).  The exam covers:

We also worked on class problems related to some of the topics listed above.  The class problems and their solutions, along with solutions for problem sets 5-7, are available on the Problem Set Solutions page.

Midterm Exam 2 consists of four problems.  A formula sheet will be included on the last page of the exam booklet; this same formula sheet is also available at http://fin4335.garven.com/fall2022/formulas_part2.pdf.  On this exam, you will only be required to complete three of four problems. If you complete all four problems on the exam, only the three highest-scoring problems will count toward your Midterm Exam 2 grade.  Each problem will be worth 32 points, and you will receive 4 points for including your name on the exam booklet. Thus, the maximum number of points possible on Midterm Exam 1 will be 100.

Whenever you take an exam in Finance 4335, it is important to not only show your work but also provide complete answers for each question; i.e., besides producing appropriate numerical results, also clearly explain your results using plain English.

## Capital Market Theory Class Problem

Here’s a Capital Market Theory Class Problem for your consideration.  Assuming that y’all have viewed the Capital Market Theory Lecture and read the Important insights from portfolio and capital market theory and the Synopsis of Capital Market theory topic blog postings, working this class problem will help reinforce what you’ve learned about capital market theory and Capital Asset Pricing Model (CAPM) from these resources.

I’ll post the solution for this class problem on the course blog sometime tomorrow.

## Important insights from portfolio and capital market theory

The portfolio and capital market theory topics rank among the most important finance topics; after all, the scientific foundations for these topics won Nobel Prizes for Markowitz (portfolio theory) and Sharpe (capital market theory). Here’s a succinct outline of these topics (as covered in Finance 4335):

• Portfolio Theory
1. Mean-variance efficiency
2. Portfolio Mean-Variance calculations
3. Minimum variance portfolio (n = 2 case)
4. Efficient frontier (n = 2 case under various correlation assumptions)
• Capital Market Theory
1. Efficient frontiers with many (large “n”) risky assets (also known as the “general” case)
2. Portfolio allocation under the general case
• degree of risk aversion/risk tolerance determines how steeply sloped indifference curves are
• indifference curves for investors with high (low) degrees of risk tolerance (aversion) are less steeply sloped than indifference curves for investors with low (high) degrees of risk tolerance (aversion)).
• Optimal portfolios (i.e., portfolios that maximize expected utility) occur at points of tangency between indifference curves and the efficient frontier.
3. The introduction of a risk-free asset simplifies the portfolio selection problem since the efficient frontier becomes a straight line rather than an ellipse in $E({r_p}), {\sigma _p}$ space. The same selection principle holds as in the previous point (point 2); i.e., investors determine optimal portfolios by identifying the point of tangency between their indifference curves and the efficient frontier. This occurs on the capital market line (CML) where the Sharpe ratio is maximized; everyone chooses some combination of the risk-free asset and the market portfolio, and risk tolerance determines whether the point of tangency involves either a lending (low risk tolerance) or borrowing (high risk tolerance) allocation strategy.
4. The security market line (SML), aka the CAPM, is deduced by arbitrage arguments. Specifically, it must be the case that all risk-return trade-offs (as measured by the ratio of “excess” return ($E({r_j}) - {r_f}$) from investing in a risky rather than risk-free asset, divided by the risk taken on by the investor (${\sigma _{j,M}}$) are the same. If not, then there will be excess demand for investments with more favorable risk-return trade-offs and excess supply for investments with less favorable risk-return trade-offs). “Equilibrium” occurs when markets clear; i.e., when there is neither excess demand nor supply, which is characterized by risk-return ratios being the same for all possible investments. When this occurs, then the CAPM obtains: $E({r_j}) = {r_f} + {\beta _j}(E({r_M}) - {r_f})$.

## Capital Market Theory Lecture (required viewing for Finance 4335)

Having completed the lectures on portfolio theory last week, this week we explore the logical implications of portfolio theory for determining how risk is priced in financial markets. This leads us to the capital asset pricing model, the acronym for which is CAPM. Under the CAPM, the expected return on a risky investment includes compensation for the time value of money (at the “riskless” rate of interest), plus a risk premium (corresponding to the excess return on an average risk investment, multiplied by the risky investment’s “beta”, a “standardized” covariance measure which shows how risky, or safe such an investment is compared with an average risk investment in the economy).

Here’s the link to the (56 minute, 35 second) video: https://mediaspace.baylor.edu/media/Garven+Capital+Market+Theory.mp4/1_kss9r388.

The lecture notes on which this lecture is based can be downloaded from http://fin4335.garven.com/fall2022/lecture13.pdf.

## Fall 2022 Insurance Career Night

Come learn about the many, varied, and rewarding opportunities available for all types of majors in the insurance industry at the Risk Management and Insurance Career Night on Thursday, October 27, 2022, in Foster 143/144 at 5 p.m. Leading companies are participating to answer questions and make prospective connections. Reception starts at 5:00 followed by a dinner buffet and alumni panel from 6:00-7:30.

Please RSVP by Tuesday, October 25 at https://bit.ly/rnicareernight.

## Mea Culpa – premature posting of “Synopsis of Capital Market theory topic”

Without getting too much in the weeds, I inadvertently published a blog posting entitled "Synopsis of Capital Market theory topic" which I was trying to schedule for posting next week after we complete the Capital Market topic. Therefore, I have, for the time being, removed this post from the course blog. It will appear next week (and therefore make much more sense) after we have completed our coverage of this topic in Finance 4335.