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
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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
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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), 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
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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
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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
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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
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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
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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
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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
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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.