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 Econ252

Audubon Copy Whitney Ave. Near Clarks
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
7

Nov-00
6

Yield

3
Jan-04
2

0
0.1

10
Maturity in Years

100

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.