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 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 7 Nov-00 6 5 Yield 4 3 Jan-04 2 1 0 0.1 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.