Markus Brunnermeier

Edward S. Sanford Professor

Director of the Bendheim Center for Finance
Department of Economics
International Economics Section
ECO525: Financial Economics 26 Prospect Avenue
Fall 2015 Princeton, NJ 08540-5296
MW, 4:15AM-5:45AM [email protected]
BCF 103 http://scholar.princeton.edu/markus

ECO 525: Financial Economics I: Asset Pricing

Course Description:
The aim of this Ph.D. course is to provide an introduction to asset pricing under asymmetric
information, to macroeconomics with financial frictions and to theory of money and capital.
Module I introduces students to rational expectations models and strategic market
microstructure models, especially insider trading and sequential trade models. Module II pays
explicit attention to models of bubbles and limits to arbitrage. Herding models form part of this
module. Module III outlines with recent liquidity models that have important implications for risk
management and systemic risk measurement. Module IV covers recent developments in
macroeconomics with financial frictions. Module V touches on the “Theory of Money”, while
Module VI covers some aspects of the “Theory of Capital”.

Structure of the Course:

I) Asymmetric Information Models [3]

1. Market Microstructure Models
 Rational Expectations Equilibrium versus Bayesian Nash Equilibrium Concept
 Insider Trading Models and Sequential Trade Models
 Herding Models
2. Allocative and Informational Efficiency
3. Higher Order Uncertainty, No-Trade Theorems (optional)
4. Information Acquisition – Rational Inattention (optional)

II) Bubbles, Limits to Arbitrage, Systemic Risk [1]

1. Rational Bubbles – Predictability Studies
2. Noise Trader Risk (myopic versus long horizons) – Role of Hedging Demand
3. Synchronization Risk

III) Liquidity and Systemic Risk– Market, Funding and Technological Liquidity [2]
1. Debt Funding and Credit Frictions
Debt overhang, credit rationing, info insensitivity (optional)
2. Maturity Choice and Funding (Rollover) Risk
3. Liquidity Asset Pricing and Liquidity Spirals
4. Systemic Risk Measures

IV) Macroeconomics with Financial Frictions [2]

1. Endogenous Systemic Risk
2. Volatility Paradox
V) Theory of Money with Financial Frictions [1]
1. The I Theory of Money
2. Redistributive Monetary Policy

References Part I: Asymmetric Information Models

*Brunnermeier, Markus K., 2001, Asset Pricing under Asymmetric Information - Bubbles,
Technical Analysis, Herding and Crashes, Oxford University Press.
CHAPTER 1-3, 6. (see detailed references in this book)

Vives, Xavier, 2008, Information and Learning in Markets: The Impact of Market Microstructure,
Princeton University Press.

Veldkamp, Laura L., 2011, Information Choice in Macroeconomics and Finance, Princeton
University Press.

Foucault, Thierry, Marco Pagano and Ailsa Roell (2015), Market Liquidity: Theory, Evidence, and
Policy, Oxford University Press

O’Hara, Maureen, 1995, Market Microstructure Theory, Blackwell Publishers.)

References Part II: Bubbles, Limited Arbitrage and Systemic Risk

*Brunnermeier, Markus K. and Martin Oehmke, 2013, Bubbles, Financial Crises, and Systemic
Risk, Handbook of the Economics of Finance, Vol. 2.
http://scholar.princeton.edu/markus/files/05b_Brunnermeier_Oehmke_Systemic_Risk_websit
e.pdf

*DeLong, J. Bradford, Andrei Shleifer, Lawrence H. Summers and Robert Waldmann, 1990a,
Noise Trader Risk in Financial Markets, Journal of Political Economy 98, 703-738.

*Abreu, Dilip and Markus Brunnermeier, 2003, Bubbles and Crashes, Econometrica 71, 173-
204.

*Abreu, Dilip and Markus Brunnermeier, 2003, Synchronization Risk and Delayed Arbitrage,
Journal of Financial Economics 66, 341-360.

DeLong, J.B., A. Shleifer, L. Summers and R. Waldmann, 1990b, Positive Feedback Investment
Strategies and Destabilizing Rational Speculation, Journal of Finance 45, 375-395.

Friedman, M., 1953, The Case of Flexible Exchange Rates, in Essays in Positive Economics,
Chicago: University of Chicago Press.

Shleifer, Andrei and Robert W. Vishny, The Limits of Arbitrage, Journal of Finance, 52(1), 35-55.

Mitchell, Mark, Todd Pulvino and Erik Stafford, 2002, Limited Arbitrage in Equity Markets,
Journal of Finance 57, 551-584.

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*Markus K. Brunnermeier, Jan. 2001, Asset Pricing under Asymmetric Information - Bubbles,
Technical Analysis, Herding and Crashes, Oxford University Press (CHAPTER 6).

*Allen, F., Morris, S., Postlewaite, A., 1993. Finite Bubbles with Short Sales Constraints and
Asymmetric Information. Journal of Economic Theory 61, 206-229.

*Blanchard, Olivier J. and Watson, Mark W., 1982, Bubbles, Rational Expectations, and
Financial Markets, in Paul Wachtel, ed., Crises in Economic and Financial Structure. Lexington
MA: Lexington Books, 295-315.

Cutler, David M., Poterba, James M. and Summers, Lawrence H., 1989, What moves Stock
Prices? Journal of Portfolio Management 15, 4-12.

Nagel, Stefan and Ken Singleton, 2013, Empirical Cross-Sectional Asset Pricing, Annual Review
of Financial Economics. http://goo.gl/IpcuGI

*Adrian, Tobias and Markus K. Brunnermeier, CoVaR, (see my website)

*Markus K. Brunnermeier and Schnabel, Isabel, 2015, Bubbles and Central Banks: Historical
Perspectives. (see my website)

References Part III: Liquidity

Tirole, Jean, 2005, The Theory of Corporate Finance, Chapter 3.

Facoult, Thierry, Marco Pagano and Ailsa Röell, 2013, Market Liquidity: Theory, Evidence and
Policy, Oxford University Press

Brunnermeier, Markus K., 2009, Deciphering the Liquidity and Credit Crunch 2007-08, Journal
of Economic Perspectives.

*Myers, 1977, Determinants of Corporate Borrowing, Journal of Financial Economics, 5, 147-

175.

Lamont, Owen, 1995, Corporate Debt-Overhang and Macroeconomic Expectations, American

Economic Review, 85 (5), 1106-1117

*Townsend, Robert, 1979, Optimal Contracts and Competitive Markets with Costly State
Verification, Journal of Economic Theory, 21, 417-425.

Bolton, Patrick and David S. Scharfstein, 1990, A Theory of Predation Based on Agency
Problems in Financial Contracting, American Economic Review, 80, 93-106.

*Stiglitz, Joseph E. and Andrew Weiss, 1981, Credit Rationing in Market with Imperfect
Information, American Economic Review, 71(3), 393-410.

*Holmstrom, Bengt and Jean Tirole, 1997, Financial Intermediation, Loanable Funds, and the
Real Sector, Quarterly Jouranl of Economics, 112, 663-691.
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Rajan, Raghu, 1992, Insiders and Outsiders: The Choice between Informed and Arm’s length
debt, Journal of Finance, 47, 1367-1400.

Sharpe, S, 1990, Asymmetric Information, Bank Lending and Implicit Contracts: A Stylized
Model of Customer Relationships, Journal of Finance 45, 1069-1087.

Diamond, Douglas and Philip Dybvig, 1993, Bank Runs, Deposit Insurance, and Liquidity,
Journal of Political Economy.

Calomiris, Charles W. and Charles M. Kahn, The Role of Demandable Debt in Structuring
Optimal Banking Arrangements, American Economic Review, 1991, 497-513.

*Brunnermeier, Markus and Martin Oehmke, 2013, “Maturity Rat Race”, Journal of Finance.

Gorton, Gary and George Pennacchi, 1990, Financial Intermediaries and Liquidity Creation,
Journal of Finance 45, 49-72.

DeMarzo, Peter, 2005, The Pooling and Tranching of Securities: A Model of Informed
Intermediation, Review of Financial Studies, 18, 1-35.

*Grossman, Sandy and Merton Miller, 1988, Liquidity and Market Structure, Journal of Finance
43, 617-633.

*Brunnermeier, Markus K. and Lasse Pedersen, Market Liquidity and Funding Liquidity, 2007,
www.princeton.edu/~markus/liquidity.

Genotte, Gerard and Hayne Leland, 1990, Market Liquidity, Hedging and Crashes, American
Economic Review 80, 999-1021.

*Shleifer, Andrei and Robert W. Vishny, Liquidation Values and Debt Capacity: A Market
Equilibrium Approach, Journal of Finance, 47, 1343-1346.

Pedersen, Lasse H. and Nicolae B. Garleanu, 2011, “Margin-Based Asset Pricing and the Law of
One Price, Review of Financial Studies, 24 (6), 1980-2022.

Hart (1975), On the Optimality of Equilibrium when the Market Structure is Incomplete, Journal
of Economic Theory, 11 (3), 418—443.

Stiglitz (1982), The Inefficiency of Stock Market Equilibrium, Review of Economic Studies, 49,
241-261.

Geanakoplos and Polymarchakis (1986), Existence, Regularity, and Constrained Suboptimality

of Competitive Allocations When the Asset Market is Incomplete, Chapter in “Uncertainty,
Information and Communication”, Essays in honor of Kenneth J. Arrow, Volume III. 65 – 95.

*Brunnermeier, Markus K. and Lasse Pedersen, 2005, Predatory Trading, Journal of Finance,
60, 4, 1825-1863, www.princeton.edu/~markus/predatory_trading.
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Bruce Carlin, Miguel Lobo and S. Viswanathan, (2007), Episodic Liquidity Crisis: Cooperative
and Predatory Trading, Journal of Finance.

Rajan, Raghuram, 2005, Has Financial Development Made the World Riskier? in The
Greenspan Era: Lessons for the Future, Federal Reserve Bank of Kansas City.
http://www.kc.frb.org/PUBLICAT/SYMPOS/2005/PDF/Rajan2005.pdf
subsequent discussion http://www.kc.frb.org/publicat/sympos/2005/PDF/GD5_2005.pdf

*Adrian, Tobias and Markus K. Brunnermeier, CoVaR, working paper

http://scholar.princeton.edu/markus/publications/covar

*Brunnermeier, Markus K., Gary Gorton and Arvind Krishnamurthy, 2012, Risk Topography,
NBER Macroeconomics annual 2011, 26, 149-176,
http://scholar.princeton.edu/markus/files/risk_topography.pdf

*Brunnermeier, Markus K. and Martin Oehmke, 2013, Bubbles, Financial Crises, and Systemic
Risk, Handbook of the Economics of Finance, Vol. 2. (Part III)
http://scholar.princeton.edu/markus/files/05b_Brunnermeier_Oehmke_Systemic_Risk_websit
e.pdf

References Part IV: Macroeconomics with Financial Frictions

See website: http://scholar.princeton.edu/markus/MacroMoneyFinance

Brunnermeier, Markus K., Thomas Eisenbach and Yuliy Sannikov, 2013, “Macroeconomics with
Financial Frictions: A Survey”, (please study it carefully before class)

*Brunnermeier, Markus K. and Yuliy Sannikov, 2014, “A Macroeconomic Model with a Financial
Sector”, American Economic Review 104(2), pp. 379-421.

*Brunnermeier, Markus K. and Yuliy Sannikov, 2015, International Credit Flows and Pecuniary
Externalities, American Economic Journal: Macro. 7(1): pp. 297-338.

He, Zhiguo, and Arvind Krishnamurthy (2013), Intermediary Asset Pricing, American Economic
Review 103(2): pp. 732-70.

He, Zhiguo, and Arvind Krishnamurthy (2012), A Model of Capital and Crises, Review of
Economic Studies 79(2): pp. 735-777.

References Part V: Value of Money and Capital

*Brunnermeier, Markus K. and Yuliy Sannikov, 2015, The I Theory of Money.

*Brunnermeier, Markus K. and Yuliy Sannikov, 2012, Redistributive Monetary Economics.

Jackson Hole.

Drechsler, Itamar, Alexi Savov and Philipp Schnabl, 2015, A Model of Monetary Policy and Risk
Premia, Journal of Finance (forthcoming).
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Additional Course Material:
Additional course material (if necessary) will be made available on the course website on Princeton
blackboard.

Preceptor:
Fernando J. Mendo Lopez
Office: BCF 303A
E-mail: [email protected]

 The preceptors’ job is to act as a catalytic in that process. Please ask him when something is not
clear – if you did not understand something, the odds are that somebody else did not either

Office hours (preliminary):

Monday: 1:00 p.m. to 2:30 p.m.

Grading:
The overall grade is calculated based on the following weighting scheme:

Class Participation: 20 %
Final examination: 80 %

The final will be held in January.

Although the exams are closed book, you may bring into the exam one 8 ½ x 11 sheet of paper. You
can write on both sides and as small as you wish, but I recommend using this only as a psychological
support to have a formula available “just in case.” The exams won’t be “fill in the blanks” exercises,
nor will they rely on intensive formula-based computations. Preparing lots of pre-fabricated solutions
from previous exams or assignments will only be distracting during the exam. You will be allowed to
use a silent battery operated calculator during the exams.

Appeals policy:
Since the preceptor will grade all assignments and exams, all appeals of grades should first be
addressed to the preceptor within one week. Verbal appeals of grades will not be accepted. We will
be glad to regrade any assignment or exam. However, you must provide a statement in writing as to
where and why there is a problem. Importantly, the entire exam or assignment will be regraded. As
a result, the regraded score may increase, remain the same, or decrease. Exams or assignments
written with pencil cannot be regraded.