Financial Markets Economics 252 Robert Shiller Introductory Lecture

Financial and Insurance as Powerful Forces in Our Economy and Society • This course seeks to understand the full role of advanced risk management in our economy and society • Finance, insurance, some public finance

The Fundamental Role of Risk Management • • All manner of enterprise involves risk Difficulties in quantifying Judgment Financial theory provides an understanding of these risks • Financial institutions provide a framework for applying theory

Moral Hazard • Example: burning down a house to collect on fire insurance • Ubiquity of moral hazard problems • Practical finance has developed institutions to promote risk management while dealing with moral hazard

Major Financial Sectors • Securities • Banks • Insurance • Social Insurance All of these have a long history of promoting risk management and dealing with moral hazard. They are fundamental elements of our successful modern economy

Radical Financial Innovation • Risks not easily conceptualized • Public resistance to risk management • Each major risk category requires difficult institutional innovations to manage

Democratization of Finance • Trend over the centuries has been to apply financial and insurance principles to a broader and broader segment of population • Advance of information technology

Finance and Psychology • The Behavioral Finance Revolution • NBER-Sage Seminars on Behavioral Finance, with Richard Thaler, starting 1991 http: //www. econ. yale. edu/~shiller • A Revolution in the finance profession. But not everyone has been captured by it.

Finance and Management • Most central discipline for managers is finance • Integration into all aspects of business management, including accounting, corporate strategy, industrial organization • Integration into government finance as well • Integration growing through time

Finance and Law • • • Lawyers are often financial inventors Often government role in process Law schools deal with all the minutiae

Text #1: Foundations of Financial Markets and Institutions • Frank J. Fabozzi, Author/Editor of 117 books, publisher (Frank Fabozzi Associates), Adjunct Prof. Yale SOM • Franco Modigliani, Prof. Of Economics and Finance Emeritus, MIT • Frank J. Jones, Guardian Life Insurance Co. of America • Michael G. Ferri. George Mason University • Entire book assigned

Text #2 Stocks for the Long Run Jeremy Siegel, 1994, 1998, 2002 • Book is best known for making the case for stocks as best long-term investment • But in fact offers a wide view of empirical literature on financial markets

Text #3 New Financial Order Robert Shiller 2003 • Extrapolates trends from the past into the financial future • Last 20 years saw massive financial innovation • Next 20 years will see even more financial innovation • Financial theory offers a conceptual framework for a broad advance in the depth of risk management

Packet of Readings for Econ 252 • Audubon Copy Whitney Ave. Near Clark’s • Required purchase

Lecture 2: The Universal Principle of Risk Management: Pooling and Hedging of Risk • Origins of concept of probability • Multiplication rule, law of large numbers is basis of risk management • Examples of risk pooling in operation • Review of basic statistical and associated economic concepts: Expected utility theory, variance, covariance regression analysis

Lecture 3: Technology and Invention in Finance • Financial institutions are inventions as much as engines are • Once discovered, inventions copied around the world • Relation to new information technology • Evolving role of patent law

Lecture 4: Insurance: The Archetypal Risk Management Institution • Private insurance institutions were invented after fire of London 1666 • Role of discovery of probability theory in this invention • The extension through time of insurance practice into increasingly more realms of human risk • Modern insurance companies and their regulators

Lecture 5: Portfolio Diversification and Supporting Financial Institutions • How risks are spread • Covariance with market portfolio • Beta • Mutual fund theorem • Investment companies and their management

Lecture 6: Efficient Markets and Excess Volatility • Efficient Markets Hypothesis vs. Random walk • Apparent inability of professionals to make money • Warren Buffet and David Swensen: What does their experience prove?

Lecture 7: Behavioral Finance: The Role of Psychology • Research in psychology • Anomalies in finance • Kahneman & Tversky: Prospect Theory

Lecture 8: Human Foibles, Manipulation and Regulation • • Louis Brandeis and insiders vs. outsiders Securities and Exchange Commission, 1934 The battle against fraud Regulation around the world

Lecture 9: Debt Markets, Term Structure of Interest Rates

Lecture 10: Corporate Equity: Earnings & Dividends • • Issues in dividend payout Modigliani-Miller theorem Historical changes in dividend-price ratios Financial innovation blurring the role of dividends

Lecture 11: Corporate Equity, Debt & Taxes • Issues firms face in decided how much to borrow • Modigliani Miller irrelevance theorem • Historical changes in leverage • Behavioral finance response to extreme version of Modigliani Miller

Lecture 12: Real Estate Finance Today and in the Future • Risk management as practiced today in real estate • Efficiency of markets for houses, commercial real estate • Real Estate Investment Trusts and existing other institutions • New institutions: Home equity insurance, housing partnerships, SAMs, Macro securities

Lecture 13: Banking in a Changing World • • Multiple expansion of credit Money multiplier Major banks of world, size distribution Importance of banks in less developed countries • Bank regulation, Basel Accord • Impact of information technology on banking

Lecture 14: The Evolution and Perfection of Monetary Policy • Board of Governors of Federal Reserve System has been model for world Central Banks • Independent central bank and FOMC procedures adopted around the world • Monetary Policy Rules • Effects of monetary policy on financial markets

Lecture 15: Investment Banking and Secondary Markets • • The role of underwriters Directly placed offerings Regulation of investment banks Role of investment banks in financial innovation

Lecture 16: The Changing Role of Institutional Investing • Objectives and risks facing institutional investors • Limits to arbitrage • Regulation and other forces operating on institutional investors • Impacts on institutional investing of a changing financial world

Lecture 17: Brokerage, ECNs • The traditional exchanges: New York Stock Exchange, Amex, regional exchanges • Nasdaq and electronic exchanges • The stock brokerage business • Stock price indexes • Spiders and other exchange-traded instruments

Lecture 18: Consumer Finance • Credit cards, home equity loans, etc. • Laws to protect consumers • Rising levels of consumer debt, concerns about rising personal bankruptcy • The transformation wrought by new information technology

Lecture 19: Forwards and Futures • • • Forward contracts and their limitations Futures contracts since Osaka in 1600 s Fair value Hedging function Failure to hedge

Lecture 20: Stock Index, Oil and Other Futures Markets • The history of commodity futures • The evolution since 1980 of financial futures • Stock index futures • Interest rate futures • Oil as a fundamental factor in world economy • Innovation in the future

Lecture 21: Options Markets • • Definition of options Black-Scholes formula Chicago Board Options Exchange The use of options in hedging and speculation • Increasing scope of options contracts in the future

Lecture 22: Other Derivative Markets • Swaps, Swaptions • Macro Securities and the American Stock Exchange

Lecture 23: Stock Market Booms & Crashes • • • Stock market crash of 1929 Stock market crash of 1987 Mexican Crisis 1994 Asian financial crisis 1997 -1998 Nasdaq crash 2000 -2001 Role of financial innovations in these crashes and in their likelihood in the future

In Memoriam: Brad Hoorn • Economics 252 b Spring 2001 • Graduated Yale 2001 • Worked Fred Alger Management, 93 d Floor, World Trade Center, North Tower, Research Associate, Investment Management • 35 of the 38 Alger employees at WTC were lost.