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Financial Markets

Economics 252

Robert ShillerIntroductory Lecture

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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

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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

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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

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Major Financial Sectors

Securities

Banks

Insurance

Social Insurance

All of these have a long history of promoting

risk management and dealing with moralhazard. They are fundamental elements ofour successful modern economy

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Radical Financial Innovation

Risks not easily conceptualized

Public resistance to risk management

Each major risk category requires difficult

institutional innovations to manage

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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

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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.

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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

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Finance and Law

Lawyers are often financial inventors

Often government role in process

Law schools deal with all the minutiae

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Text #1:Foundations of

Financial Markets and

Institutions Frank J. Fabozzi, Author/Editor of 117 books,

publisher (Frank Fabozzi Associates), AdjunctProf. Yale SOM

Franco Modigliani, Prof. Of Economics andFinance Emeritus, MIT

Frank J. Jones, Guardian Life Insurance Co. of

America Michael G. Ferri. George Mason University

Entire book assigned

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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

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Text #3New 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 fora broad advance in the depth of risk management

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Packet of Readings for Econ252

Audubon Copy Whitney Ave. Near Clarks

Required purchase

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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

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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

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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 thisinvention

The extension through time of insurance practice

into increasingly more realms of human risk

Modern insurance companies and their regulators

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Lecture 5: Portfolio

Diversification and Supporting

Financial Institutions How risks are spread

Covariance with

market portfolio Beta

Mutual fund theorem

Investment companiesand their management

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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?

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Lecture 7: Behavioral Finance: The

Role of Psychology Research in psychology

Anomalies in finance

Kahneman & Tversky: Prospect Theory

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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

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Lecture 9: Debt Markets, Term Structure

of Interest Rates

0

1

2

3

4

5

6

7

0.1 1 10 100

Maturity in Years

Yield

Nov-00

Jan-04

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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

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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

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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

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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

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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 financialmarkets

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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

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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

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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

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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

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Lecture 19: Forwards and Futures

Forward contracts and their limitations

Futures contracts since Osaka in 1600s

Fair value

Hedging function

Failure to hedge

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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 worldeconomy

Innovation in the future

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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

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Lecture 22: Other Derivative

Markets Swaps, Swaptions

Macro Securities and the American Stock

Exchange

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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

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In Memoriam: Brad Hoorn Economics 252b Spring

2001

Graduated Yale 2001

Worked Fred Alger

Management, 93d Floor,World Trade Center, NorthTower, ResearchAssociate, InvestmentManagement

35 of the 38 Algeremployees at WTC werelost.