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Finance Theory (MIT Sloan School)

Jul 8, 2024

Lecture Notes on Finance Theory (MIT Sloan School)

Course Information

  • Course Title: 15.401 Finance Theory
  • Instructor: Professor Andrew Lo
  • Target Audience: First-year MBA students (and others with interest in finance)
  • Course Duration: 13 weeks
  • Course Material: Custom lecture notes, Brilliant Myers, additional readings

Lecture Overview

  1. Introduction to Finance

    • Definition: Finance = Mathematics + Money
    • Finance is applicable to all business and management aspects.
    • No prerequisites assumed other than admission criteria.
    • Finance applies to a range of mathematical complexities from simple arithmetic to advanced geometry.

  2. Instructor Background

    • 20 years at MIT in Finance Group
    • Formerly at Wharton School and Harvard University

  3. Motivation for Studying Finance

    • Finance applies rigorous and practical problem-solving to management issues.
    • Finance is core to business and enhances decision-making.
    • Finance integrates time and risk, creating a comprehensive framework for managing financial assets.

  4. Key Figures in Finance

    • James Simons: Founder of Renaissance Technologies; used advanced mathematics.
    • Warren Buffett: Employed basic arithmetic for valuations; focused on balance sheets and income statements.
    • Jack Welch: Former CEO of General Electric; emphasized financial decision-making and investment management.

  5. Concepts to Be Covered

    • Valuation of assets
    • Management of assets
    • Framework for financial analysis: Accounting, stocks, and flow
    • Importance of time and risk in finance
    • Financial assets valuation and pricing
    • Corporate finance applications

Fundamental Challenges in Finance

  • Valuation of Assets: Determining the value of financial products and decisions.
  • Management of Assets: Decision-making based on valuation results.

Finance Analysis Framework

  • Core Components: Households, Financial Intermediaries, Non-Financial Corporations, Capital Markets
  • Corporate Financial Decisions: Use of accounting principles to inform decisions involving cash flows.

The Role of Time and Risk

  • Time: Financial decisions over different periods.
  • Risk: Uncertainty of financial returns, and risk management
  • Tools: Valuation models, pricing theories, and risk assessments will be introduced over the course of the class.

Principles of Finance

  1. No free lunch (markets often priced appropriately).
  2. Preferences: More money, sooner rather than later, less risk.
  3. Self-interest: Economics redefined into preferences showing self-interest.
  4. Financial market efficiency vs reality.
  5. Time value and monetary returns.
  6. Risk-adjusted returns.

Course Structure

  • Section A: Introduction and motivation
  • Section B: Valuation, discounting, net present value, and pricing financial instruments.
  • Section C: Incorporating risk into valuations.
  • Section D: Applying finance principles in corporate contexts.
  • Final Lecture: Integrating and critiquing financial theories and marketplace imperfections.

Course Requirements

  • Class Participation: 10%
  • Case Study: 10%
  • Midterm Exam: 25%
  • Final Exam: 55%
  • Textbook: Brilliant Myers
  • Readings: Chapters 1 and 2 before next class

Suggested Reading Methods

  1. Skim lecture notes ahead of time.
  2. Take thorough notes during lectures.
  3. Review and absorb lecture contents afterward.
  4. Work on problem sets in groups and individually.
  5. Engage actively and ask questions.

Personal Finance Integration

  • Apply course concepts to personal household finance decisions.
  • Think about cash flows, investments, consumption, and financing in a personal context.

Supplemental Activities

  • Pro Seminar: The Practice of Finance (September 17th), provides practical industry insights and career advice.

Practical Demonstration

  • Class Exercise: Auction-based price discovery process for valuation demonstration.
  • Highlighted the principle of limited information affecting marketplace valuations.

Conclusion

  • Take the course content personally and apply to real-world contexts for greater understanding and benefits.
  • Finance knowledge beneficial for both personal and professional growth.

Any questions? Please prepare chapters 1 and 2 from Brilliant Myers for the next lecture.

Full transcript