Retirement Finance, Lifecycle Investing and Asset Management Spring 2015 R.C. Merton

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1 Retirement Finance, Lifecycle Investing and Asset Management Spring 2015 R.C. Merton Class times and location Lectures : Monday/Wednesday, 1:00-2:30pm, Room E Recitation: Friday, 11:00am-12:00pm, E Professor Robert C. Merton, E62-634, rmerton@mit.edu Teaching Assistant: Michael Abrahams, miabraha@mit.edu Courses that fit well with this course are: / Finance Theory I (required prerequisite) Investments (strongly recommended) Options and Futures Markets (strongly recommended) Fixed Income (recommended/co-requisite) Analytics of Finance Analytics of Finance II 15.S04 Applied Fixed Income Strategies Functional and Strategic Finance Introduction to the Practice of Finance It is strongly recommended that at least one of these courses, in addition to the required prerequisite and strongly recommended courses, be taken as a co- or prerequisite. Students can register for this class using the Graduate P/D/F Option in order to take the class in a way that is different from normal letter-grading. Contact Sloan Educational Services for more information about this option. Course Overview This is a course organized around applying finance science and financial engineering in three related financial activities: retirement finance, lifecycle investing and asset management. We will develop the necessary tools of derivative pricing and risk measurement, portfolio analysis and risk accounting, and performance measurement to analyze and implement concepts and new product ideas. It is expected that the student has familiarity with basic portfolio-selection theory, CAPM, options, futures, swaps and other derivative securities. Basic knowledge of fixed-income concepts such as duration and interest-modeling will be very useful.

2 Career Perspective of the Course Students pursuing careers in the financial-services industry and financial markets, focused on professional asset management and related financial product design (within investment counseling firms, insurance companies, mutual funds, hedge funds, and investment, merchant and commercial banking), institutional sales and trading, product design, pension consulting and internet advisory for personal financial services. Those planning a career in government regulatory oversight of the pension and asset management businesses will also find it useful training. Educational Objectives of the Course The goal of the course is to help prepare students for a long-term career as a finance professional in the financial-service industry. The course develops a conceptual framework and the analytical tools to support decision-making in 1) the development and delivery of asset management services to clients of a firm; 2) the organization of the asset management firm itself and 3) the innovation and design of financial products and services in the area of retirement and asset management With the longrun horizon in mind, the emphasis is on topics and tools that are believed to have a long "shelf life" of usefulness across geo-political borders, even in a rapidly changing institutional, regulatory and technology environment that characterizes the global financial system. It is thus a "conceptual-tools" course with more emphasis on finance concepts than on highly technical specialized modeling and estimation techniques or detailed trading strategies. Nevertheless, the issues are addressed from a rigorous analytical framework and a high comfort level with mathematical manipulations will be very helpful. It is expected that the students will master the finance tools, so they can apply them in a wide range of asset management situations. Course Organization: Lectures: The teaching structure for lectures anticipates active in-class student participation. There will be a few formal case-study classes and guest speaker presentations. I will call on students in case-study classes with the expectation that they have prepared the case for discussion including the necessary quantitative analysis to answer the study questions. The balance of the classes will be "interactive" lectures. The preparation material for interactive lecture classes will be readings and in some cases, a list of thought questions. Class participation on lecture days comes either from sharing your conclusions to the thought questions or from asking "good" questions ones that either enrich the discussion or help you and the rest of the class understand better what is going on. There will be written homework assignments to be done without collaboration with others. Recitation: The recitation meeting will be used for three purposes: 1) Finance concepts and tools needed for the course such as portfolio selection, CAPM, option and futures, and interest rate concepts like duration which are covered in many other

3 finance courses will be presented for those who would like a review; 2) Mathematically enriched elaborations on specific topics covered in lectures such as advanced dynamic strategies and jump-diffusion models; 3) review of homework, calculation exercises and answering questions about materials given in lectures. Recitation topic will be announced on course website. Course Mechanics Preparation In general, whether the materials for the class are cases, readings, or web sites, preparation for class participation should be the same. Read the case or go to the web site and prepare for discussion of the assigned questions. For non-case materials, there are two categories of reading given for the assignment: Required Reading means that the material be studied in detail and this is typically where the core of what is needed for the specific questions is found; Optional readings will be typically either to provide additional coverage for those who would like to have more examples to help them to better understand the concepts, or to provide a more quantitative approach to the material for those who have the mathematical background to handle it. Sometimes it will be used to provide added breadth for those who are especially interested in that subject. In class sessions for which no discussion questions are given in advance, preparation consists of doing the assigned reading and developing questions, both clarifying and substantive, to ask in class. A summary of the "takeaway" will be provided at the end of each class. Course Requirements 1. Background Finance Theory or its equivalent is required Investments and Options and Futures Markets are strongly recommended. Many of the students in the class will have taken several other finance courses. The subject matter of the course will involve areas that are among the more analytical and technical in the field of finance. Facility with mathematical and statistical analyses and formulas is important. All students are presumed to be proficient in using Excel spreadsheets for model building and analysis. 2. Written assignments: There will be written homework assignments during the term which count as part of class participation, in addition to the usual oral discussion in class. Homework assignments are to be done without collaboration with others. There will be a proctored final exam given during the MIT-scheduled final examination period. 3. Regular class attendance, preparation, and participation in class discussions are expected. If you do not display your name card, it is likely that you will be marked absent. If you would like "credit" for attendance when you are physically going to miss a class (for other than acute hardship events), you must submit written answers/discussion of the assignment for that class before the class meets. This can be

4 done by , with an attachment or not. 4. Code of conduct for the MIT Sloan School is expected to be rigorously met. Grading Course grades will be based 35% on class participation and written homework assignments, 10% on attendance and the balance 55% on the final exam. The final exam is proctored. The teaching assistant will record attendance and participation in each class. She will also assist, under my direction, in grading written assignments. I will make the final assessments of performance and grades, on class participation, written assignments during the term, and the exam. Office hours I will hold office hours by appointment on days that the class meets. The course teaching assistant, Michael Abrahams, can be contacted at miabraha@mit.edu. Please send s of urgency for me CC to my assistant, Therese Henderson, at tzh@mit.edu or call her at Course Materials Overview of Materials and Class Topics Textbook. Continuous-Time Finance, Robert C. Merton, Revised Edition, Blackwell, All readings on Stellar Hard copy handouts for each class Helpful Textbooks but not required: Capital Ideas, Peter L. Bernstein, Paperback Edition, Wiley, 2005 From : R. Brealey, S. Myers, and F. Allen, Principles of Corporate Finance, 9th or 10th edition, Irwin/McGraw Hill. Z. Bodie, A. Kane, and A. Marcus, Investments, 8th edition, Irwin/McGraw Hill, From : K. Back, A Course in Derivative Securities: Introduction to Theory and Computation, Springer, From : J. Hull, Options, Futures, and Other Derivatives, Prentice Hall Note: The textbooks have varying degrees of technical difficulty but the course focus

5 is not on the heavily technical dimension of the topics covered. Other Readings and Videos Journal articles, other published readings and videos will be available on the course website to be downloaded or as a web link. Class Notes and Case Studies Class notes and case studies will be available either as handouts in class or on the course website to be downloaded. These notes and case studies are to be brought to class as they will be referenced as part of the lecture or case discussion. Class Assignments and Problem Sets Assignments and problem sets will be available on the course website. Retirement Finance, Lifecycle Investing and Asset Management Classes Please Note: this is DRAFT for 2015 using Spring 2014 class titles; dates/class numbers will change for 2015; basically be the same subject matter. We will keep updating on SloanBid. (Guest speaker class dates will change for 2015) Recitations Introduction to Asset Management: Mean-Variance Portfolio-Selection and CAPM Replicating Portfolios: Option Pricing and the Greeks Measuring Interest Rate Risk: Duration Lectures Lectures I. Measuring Investment Performance and Risks 1. Performance Benchmarks: Alpha Sources and Sustainability 2. The Search for Dimensional Alpha: Priced Risk Factors and Smart Beta 3. Measuring the Cost of Capital with Off-Balance Sheet Assets and Liabilities 4. Risk Measurement for Non-traded Assets: Creating Tracking Portfolios 5. Measuring Credit Risk

6 6. Measuring Market-Timing Performance and Non-Linear Risk Strategies II. Asset Management and Lifecycle Investing: Fact and Fantasy 7. Case: The Risk of Stocks in the Long Run: The Barnstable College Endowment: HBS Case # High-Frequency Trading: Implications for Market Function. Guest Speaker: Bryan T. Durkin, Chief Operating Officer, CME Group 9. Portfolio Selection with Non-traded Assets: The Case of Human Capital 10. Delivering Superior Performance without Forecasting: Goals-based Investing, Smart Trading and Avoiding the Paths of Error III. Retirement Finance: Design of Plans and Development of Tools and Products 11. Asset/Liability Management: Managing Assets for Defined-Benefit Pension Assets 12. Current Challenges with Defined-Benefit and Defined-Contribution Plans 13. Meeting the Challenges: A Next-Generation Retirement Funding Solution 14. Dimensional Fund Advisors Entry into the Retirement Market Guest Speaker: Chairman, Co-CEO & Founder David Booth. 15. Next-Generation Retirement Post-Retirement Solution 16. Reverse Mortgage Design, Valuation and Risk: Efficient Use of House Asset and Separating Bequest Decision from the Retirement Decision IV. Innovations in Lifecycle Investing and Asset Management 17. Innovations in Lifecycle Products: Addressing Behavioral Dysfunctions and Enhancing Product Efficiency and Market Completion 18. Guest Speaker: Peter Hancock, CEO, AIG 19. Innovations with Options: Creating Synthetic Corporate Debt and Volatility Hedging

7 20. Executing Pure Risk Transfer: Derivatives and Alpha Transport 21. Extracting Forward-Looking Risk and Return Information from Derivative Prices V. Other Institutional Asset Management Issues 22. Crisis Management: The Case of Long-Term Capital Management (LTCM) Guest Speaker: Dr. Eric Rosenfeld, Co-Founder, LTCM 23. Endowment Management and Sovereign-Wealth Fund Management: An Integrated Risk-Balance Sheet Approach 24. Observations of a Financial-Service Entrepreneur Two Years after : Christina Qi, Partner, Domeyard LLC