Financial Markets

Economics 252Robert 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 InsuranceAll 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 RunJeremy 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 OrderRobert 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 Econ252

• 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

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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

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 1600s• 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 252b Spring

2001• Graduated Yale 2001• Worked Fred Alger

Management, 93d Floor, World Trade Center, North Tower, Research Associate, Investment Management

• 35 of the 38 Alger employees at WTC were lost.