Professor Robert Shiller:
This is Economics 252, Financial Markets,
and I’m Bob Shiller. Let me begin by introducing the
teaching fellows for this course;
and so I have them up here. We have five teaching fellows
at this time and they’re from all over.
I like to put their pictures up so you’ll know who they are.
The teaching fellows are very international and that reflects
my intention to make this a course that is also very
international because finance is something about the whole world
today, not just the United States.
So we cover the world very well with our T.A.’s.
Usman Ali is from Pakistan, Lahore, and he graduated from
the LUMS, Lahore University of Management Sciences.
He’s a PhD candidate now in Economics and he’s doing his
doctoral dissertation on stock analysts’ recommendations and
the relation to returns in the stock market.
He’s also interested in behavioral finance,
which is the application of psychology to finance.
The second teaching assistant–I see him right
there, if you could raise your hand–Santosh Anagol,
who is a representative of the United States,
although he seems to have connections to India as well.
He actually has a publication already in the American Economic
Review on the Return to Capital with Ghana.
He did this jointly with the Chairman of the Economics
Department here, Chris Udry and he has spent
time in India looking at the village economies.
You were going to be giving away cows, did you do that?
Student: No, I’m still working on cows but
we’re not giving them away. Professor Robert
Shiller: Okay, that’s the last time you’ll
hear about cows in this course. The idea was to give cows away
to village farmers and to observe the outcome.
It’s a big change in some of these very poor villages to get
a cow. Christian Awuku-Budu is from
Ghana, Accra, but he, again,
went to college in the United States at Morehouse College.
He is also a PhD candidate in Economics at Yale and he’s been
doing research on financial markets in developing countries.
Yaxin Duan is from China. She got her undergraduate
degree from Nanjing University. No?
You are from Nanjing, did I get a detail wrong?
Where did you go to college? Okay, well I’m sorry about that.
She is also a PhD candidate in Economics and is doing research
on the behavior of options prices in a phenomenon called
the “options smile,” as she’s smiling at me right
now. She is also interested in
behavioral finance, which is great to me because
that’s one of my interests. She is shown here standing
precariously on a cliff. It makes me nervous to look at
it overlooking Machu Picchu in Peru.
She also loves astronomy, which is incidentally an
interest of mine too, but you won’t hear about it
again in this course. Finally, Xiaolan Zhou is our
fifth teaching assistant and she’s also from China,
Hubei Province. She graduated from Wuhan
University and is a PhD candidate in Economics at Yale.
She is doing research on bank mergers. Let me say, I’ve been teaching
this course now for over twenty years and I’m very proud of all
of my alumni. Many of them are in the field
of finance. In fact, I like sometimes when
I give–I give a lot of public talks.
When I give a talk on Wall Street or even somewhere else in
the world I sometimes ask my audience, “Did you take my
course?” It’s not infrequent that I’ll
get one or even two people raising their hand that they
took Economics 252 from me. But I’m also proud of my alumni
in this course who are not in the world of finance.
I think this course goes beyond–It’s not just for people
who are planning careers in finance because finance is a
very important technology and it’s very important to know
finance to understand what happens in the real world.
Just about any human endeavor involves finance.
Now, you might say, “I could be a poet and what
does that have to do with finance?”
Well, it probably ends up having something to do with
finance because as a poet you probably want to publish your
poetry and you’re going to be talking to publishers.
Before you know it, they’re going to be talking
about their financial situation and how you fit into it.
I believe it’s fundamental and very important.
I think you will find this course as not a vocational
course–not primarily a vocational course–but an
intellectual course about how things really work.
I see finance as the underpinning of so much that
happens. It’s a powerful force that goes
behind the scene and I hope we can draw that out in this
course. There is another course–we
have two basic courses in finance for undergraduates at
Yale. The other one is Economics 251,
Financial Theory; this is Financial Markets,
that one is Financial Theory. Last year it was taught by
Rafael Romeu, because John,
Geanakoplos who usually teaches the course, was on leave and so
we had to find someone else. I assume that next fall John
Geanakoplos will be teaching 251 again.
So what happened? Why do we have these two
courses? Well it was something like
eight years ago that we reached the present situation with two
finance courses. John Geanakoplos and I had a
meeting and we tried to divide up the subject matter of finance
into two courses. We thought Financial Theory and
Financial Markets would be the two.
But the problem was that both John and I are interested in
both theory and applications. John Geanakoplos is actually
Chief Economist for a large investment called Ellington
Capital in Greenwich, Connecticut,
which you’ll see a lot in the news.
It has been very successful. He is very much interested in
the real world and I am interested in financial theory,
so we find it–we decided, after talking about it,
that we really can’t divide up the subject matter of finance
into separate courses on theory and practice.
If you tried to do one alone it would not work,
so we decided to divide it up imperfectly and there may be
some repetition between our two courses.
Both of them are self-contained courses, so you could take
either 251 or 252, or you could take both.
I think maybe the best option is to take both if you’re really
interested in the subject matter. It is true though that his
course is more tuned into theoretical detail than mine.
John is a mathematical economist and we both love
mathematics, but maybe John is going to do more of it than I
am. This course actually will not
use a heavy amount of mathematics.
I try to keep it so that people who are not comfortable with a
lot of math can take this course and I wanted to emphasize that
this is–I’ve said that it’s–I think this course is vocational
preparation in a sense. I pride myself on the fact that
people who have taken this course find it useful in their
subsequent lives, but on the other hand,
I think that it’s really interesting.
At least I find it really interesting and so I hope that
you will too. Now I don’t know,
I may be different than other people, but I think organic
chemistry is really interesting. How many of you have that
feeling? Can I get a show of hands,
who is interested in organic chemistry?
I’m not getting a lot of hands raised.
Unfortunately, I’ve never taken a course in
it, but I’ve started reading it lately out of just my broad
intellectual interest. That is a course that has a bad
reputation, doesn’t it? Because people say I’ve got to
take that if I want to be pre-med.
But, you know, to me there’s a lot of detail
in organic chemistry. To me, when you read the detail
you’re getting into something deep and important about the way
everything works and so I start to find it interesting.
So I don’t know how people feel about taking–maybe I’m turning
you off by saying this–There’s going to be a lot of detail in
this course. Maybe I made a big mistake by
likening it to an organic chemistry course–I don’t mean
to turn you off. The idea in this course is that
by being a financial markets course, you have to know how the
world works. We’re going to be thinking
about that in connection with Financial Theory,
but we have to get into the details;
so we are going to be learning about facts. Let me start by talking about
the textbook. So the principal textbook is
Frank Fabozzi, the other authors are
Modigliani, Jones and Ferri,
Foundations of Financial Markets and Institutions.
This textbook is very detailed and it may be–I’ve had some
reaction by students–more than you wanted to know. I actually had a great
experience reading it. Actually, it was an earlier
edition, when I first assigned this book in the year 2000,
I took it with me on vacation. I was going to the Bahamas with
my family and with Jeremy Siegel’s family–we’ll come back
to Jeremy Siegel in a minute. I sat down by the pool with
this book. Other people were reading
novels and I don’t know what else, but I was reading Fabozzi.
I had such a great time with it, so I’m telling you my
experience. Maybe it was because it was
filling in gaps in my knowledge–things I’ve always
wanted to know and was always curious about.
That’s partly what you have to develop when you get interested
in a field: some sense of curiosity about all the details.
So I read the whole book, 650 pages, maybe I kind of read
fast because I knew a lot of it. It might take you a little
longer to get through it, but I wanted you to have the
same experience. I’ve been assigning this book,
now it’s in another edition and–Fabozzi is working on a
fourth or next edition, I forget what number.
I’ve been assigning–I’ve gotten some complaints from
students that this book is tough going because there’s so much
information in it. I used to tell people,
” I’m assigning the whole book and you have to know everything
in the book.” That’s a little ambitious.
I finally backed down because I met a man on Wall Street,
a very prominent Wall Street person,
and he said, “You know, my son started to
take your course.” I said, “What do you mean
started the course?” He said, “Well,
he dropped out when he saw this book and the requirements.”
I didn’t like that. I don’t want students to drop
out. So what I decided is that you
need to know the whole book in the sense that you need to know
all of the key terms and key points.
Now if you look at the structure of this book,
it has sections that say Key Points and Key Terms.
Anything that’s mentioned there is fair game for me in an exam
and that’s the way I’ve done it. There are key points and key
terms. Also, anything in my lecture is
of course fair game for the exam.
Let me also add that I have a reading list that has clickable
things on it and also things that are on reserve in the
library. Anything that’s clickable is
required reading. I don’t expect you go to the
library, however, because I think that we’re
moving into an age where you tend to want to be online,
right? So the library books are all
optional background. Fabozzi, a faculty member here
at Yale, has offered to give me–we have at least one chapter
from the new edition that hasn’t come out yet.
I’m going to put that on reserve in the library;
but again, I think that the edition that you have is
reasonably up to date and so that’s all that I’m expecting
you to read. The other author,
Franco Modigliani–in the book, the second author–was my
teacher at MIT. He died in 2003.
He is also a Nobel Prize winner and I think has a remarkable
intellect. So this book,
Fabozzi, et al.–Fabozzi, Modigliani, Jones and Ferri–is
a very solid book about financial markets.
The second book that I’m assigning is Jeremy Siegel,
Stocks for the Long Run. This is an old friend of mine.
I met him in graduate school. Funny story,
I met him because at MIT they signed us all up for chest
x-rays alphabetically–that’s the way MIT does things,
an orderly way. Shiller and Siegel are next to
each other in the alphabet, so I was standing in line with
him for an x-ray and was talking with him and I’ve known him ever
since. A funny coincidence is that
since our names are close in the alphabet–you often find our
books right together in bookstores because Shiller and
Siegel–if they’re shelving alphabetically–would end up
together. He wrote a book called
Stocks for the Long Run, starting in 1993.
It just came out with the fourth edition and that book was
a best seller. I think it sold over a half
million copies. I’m not sure where it is now
but it has done very well. It’s been a perennial classic.
It emphasizes the long run performance of the stock market,
but it’s really a general treatise of financial markets.
I get a very good reaction from students about this book.
This one is very readable. It’s not as intense as Fabozzi,
et al. Jeremy Siegel holds the unique
distinction–Business Week did a poll asking MBA’s
about their favorite professor. This was about ten years ago.
They ranked business school professors according to their
popularity. He came out number one in the
United States as business school professor.
I think you’ll like this book. The next book is my own and
called Irrational Exuberance.
This is the last book–That’s a phrase that was coined by Allen
Greenspan in 1996 and it refers to the stock market boom of the
2000s–of the 1990s and the boom and the bust–well I think it’s
related to the bust that came out later,
after 2000. I wrote this book in 2000 right
at the peak of–fortunately right at the peak of the stock
market. But what I’m assigning to you
is the second edition, which came out in 2005,
pretty much at the peak of the housing market.
We’re going to talk about both the housing market and the stock
market in these different books. These books are all on sale at
Labyrinth Books, which is an independent
bookstore here in New Haven. I put it there because,
well, I think the major chain bookstores fulfill an important
function but I also like to support independent bookstores.
I don’t know if you know the story, but Labyrinth Books is
independent, it’s not a chain, and independent bookstores are
This is finance. In the book business,
there’s something difficult about maintaining an independent
operation. Labyrinth was at Columbia
University and Yale. For some reason they shut down
their Columbia bookstore, but they’ve opened up now in
Princeton. There was this famous bookstore
in Princeton on Nassau Street called Micawber’s,
which is a wonderful bookstore. I’ve been in there a number of
times. But they just went out of
business. Labyrinth has moved in to take
their place. Anyway, that’s where all the
books are and they are available now. We’re going to have these
lectures on Mondays and Wednesdays.
We’re going to have T.A. sections in the second part of
the week. We’re going to ask you to look
at your schedule sometime before our next lecture and think about
when you can come to a teaching assistant section.
They will be Wednesday, Thursday, and Friday and we
have six problem sets. The six problem sets are due
generally on Mondays and we’ll go over the problem sets in the
teaching sections, several days after you turn
them in. This is one of the biggest
classes at Yale, but I think we’ve got it so it
will be a good and satisfying experience for you.
We have very qualified–I’m very impressed with our teaching
assistants. The important thing is for you
to stay with them and get to know them and I urge you to
attend the T.A. sections.
The course is going to be graded.
We have two mid-terms and one final.
The in class mid-terms–the grades will be roughly 10%
problem sets, 20% first mid-term,
30% second mid-term, 40% final.
But we will also use judgment and I’m going to appeal to the
T.A.’s to help me on judging the grading. Also, I ask the teaching
assistants to give me little capsule descriptions of you so
that if in ten years, or 20 years from now,
I get a call from a reporter asking about this illustrious
person who was once my student, I can have something to prod my
memory. That’s why I hope you’ll stay
with–you’ll each find a teaching assistant and will stay
with that person. I want to say something about a
particular interest of mine because it is part of this
course, although not the entire course.
Behavioral finance refers to a revolution in finance that has
occurred over the last ten or 20 years and that is
incorporated–Behavioral finance is the theory of finance mixed
in with the theories of other social sciences,
notably psychology, sociology, political science,
and anthropology. I think it’s the most important
revolution in finance of the last couple decades.
Maybe I’m biased because I’ve been very much involved in it.
I’ve been organizing workshops in behavioral finance at the
National Bureau for Economic Research since 1991 with Dick
Thaler at the University of Chicago.
We think that we’re avant-garde of a major revolution.
The unity of the social sciences is, I think,
very important. It’s a mistake to try to
consider finance in isolation. There is a whole array of other
information related to finance. This will be a theme of my
course and also a theme of this book, Irrational
Exuberance. That’s what exuberance refers
to–it’s a psychological term. So that’s an important element
of this course. Another thing that I will be
talking about is less important to this course but you have
heard of this: the subprime crisis.
This is the big financial event that is hitting the United
States and the entire world right now.
I’m actually writing another book about this.
It’s not done in time for you to read but I think I will have
it done at some time during this semester.
What does it mean? “Subprime” refers to the
mortgages that were made mostly over the last ten years or so to
subprime borrowers. A “subprime borrower” is
somebody who has a poor credit history or some other indication
that would suggest that they might not be able to repay the
mortgage–they might default. The industry,
subprime lending, has grown dramatically over the
last ten years and, as you probably know,
it’s in big trouble now. What’s happening is the housing
market is dropping, home prices are falling,
people are defaulting in record numbers, and there are
foreclosures. What happens if you don’t pay
your mortgage? If you buy a house and you
don’t pay the mortgage, the contract says you lose the
house–you’re out–you’ve got to pay or it goes back to the
mortgage originator. This crisis is very interesting
to me because it’s had so many ramifications throughout the
financial world. It’s exposing defects in many
of our biggest financial institutions and every day we
see more news about failures, huge losses,
resignations, or firings of top finance
people. So it’s a very interesting time
in finance. These things happen from time
to time, but they happen with enough regularity that there’s
something we really want to understand as a systematic
phenomenon. So that’s another thing that I
will be talking about. Let me make another point about
technology. Finance, I believe,
is a technology and that means it is a way of doing things.
It has a lot of detail. A financial instrument is like
an engineering device. Here I’m tying to the
engineering–Is anyone here from engineering?
A couple of you, well this could be–In fact,
some engineering schools offer courses in finance,
did you know that? Engineers find it congenial
because they have a way of thinking constructively about
the world that is kind of parallel to finance.
We have theories–mathematical theories–that lead us to devise
financial structures, which are complicated devices
just like engines or nuclear reactors.
They have a lot of components and they have to work right.
When people first devise some new financial instrument it
typically has trouble. Like when they devised the
first engines or the first nuclear reactors,
it didn’t work so well at first and then from the experience of
many people working on it, over many years,
a body of knowledge emerges and that’s what we call technology.
So technology is a powerful force in our society and I
respect power of this kind. That’s why I like to follow it
up. But technology is also
dangerous. Nuclear power,
for example, may be our salvation when we
run out of oil–or virtually run out of oil–it seems to be
coming up over the next several decades–we’re going to have to
do that, we’re going to need nuclear
power. But it’s also dangerous,
as you know. The same thing is true about
finance. I think that,
in a sense, the subprime crisis that we have is an example of
the dangers of new technology. We have been seeing financial
technology advance in recent years and this advancement of
technology has brought us some problems.
Some people want to go back, some people think there’s a lot
of anger about the subprime prices and there’s some anger
expressed against the financial community.
I think that we should be very careful not to let that deflect
us from the recognition that this is important technology and
that it’s not the technology that’s at fault;
we have to get it right and then it will be powerful.
I’ve had some experience giving talks in less developed
countries. I’m not a development economist.
Now a development economist–that’s Santosh’s
field–Development economics is a very important field in
economics that is helping less developed countries emerge.
I’m very proud to say that Yale has a strong department at the
Growth Center on development economics.
I’m not a development economist. Nonetheless,
when I’ve spoken in less developed countries,
I find that they’re really interested in finance.
I think that’s because there’s a growing recognition that
that’s what you need to know and that the countries that are
emerging successfully are those that have well developed
financial institutions that are adopting the technology.
They have to adapt it to their own situation,
but in many ways they’re copying technology.
There’s nothing bad about copying technology,
that’s what everybody does. When somebody invented the
automobile, before you knew it everyone was driving automobiles
and they all looked pretty much the same.
When someone invented the airplane, before you knew it
every country had an airplane because there was a best
practice, there was a best technology and
it was not unique to any one country.
So that’s why I view this course as fundamentally about
technology. I want to say something about
morality and about mixed feelings that people have about
finance. I know that undergraduates–I
don’t know how you feel about finance.
Some people have a reaction–If you say you’re taking a course
in finance, they think that maybe you’re selling out or
maybe you value money too much and that you should really be in
some other field. This is a longstanding conflict
in our thinking. There is some contempt for
finance, I believe, because it makes so much money
for many people. Many of our students go into
finance. Yale is very strong in
providing people to the financial community and,
I have to say, they do very well.
My first advice is if you want to make money,
which I don’t particularly advise, but if you do it’s not a
bad idea to go into finance. Just as, you know,
you can make a lot of money with organic chemistry too.
I think that what you have to do as a young person is develop
your human capital and that means knowing how to do things.
But there is hostility toward finance that I think is very
fundamental to a lot of our thinking.
I wanted to say something about that.
Part of it is that some people in finance get so rich.
If you look at the list of the richest people,
they’re all connected to finance, right?
I mean they understand it. Maybe they’re not–-Maybe
they’re in publishing or some other field but they understand
finance and a lot of them are directly in finance.
So what do we make of that? Well part of it is that we get
very–We get a sort of jealousy of these people because why
should someone have billions of dollars?
Did they really deserve that? Some people who make a lot of
money get self-important–who make a
lot of money–and they end up not making a lot of friends in
the process. The Yale University Press is
publishing a new book by Steve Fraser about Wall Street.
He gives examples in this book about hostility toward–it goes
way back–In Fraser’s book he gives an example of–I’ve never
heard of this person before, but William Durr,
who was a financier in colonial America in the 1700s,
made a lot of money and helped finance the Revolutionary War in
the United States. He ended up being chased down
the street by an angry mob. People hated him and why was
that? Well it was partly because he
got so rich and he started wanting to show off.
He had what they called “livery servants,” not just servants,
but servants who were wearing livery, like a military uniform.
It looked like aristocracy coming back in the form of rich
financial successes and we don’t like that.
There is a feeling of hostility toward that.
There has been a long discussion about what people owe
each other and how okay it is to try to make money.
I don’t know if you remember–I have to start erasing here–one
of the most well known Yale professors of the nineteenth
century was William Graham Sumner,
who wrote a famous piece called, What Social Classes
Owe to Each Other. Sumner graduated from Yale in
1863. He was a member of Skull and
Bones–have you heard of that? You know that group?
He spent his entire career at Yale and he wrote–He was Head
of our social sciences department,
before we had separate departments of economics and
psychology, etc. He was a very prominent
exponent of the idea that people should go out for their own
interest. One social class does not owe
anything to another and we should not feel guilty about
pursuing financial interests. That led to an attitude among a
good segment of our society that it’s okay to go out and make
money because making money means doing productive things for the
economy and ultimately it’s a benefit to society. But we have some discomfort
with that. Another book,
which I haven’t put on reserve yet but I’m going to,
is by Peter Unger, who is a philosopher.
It’s a remarkable book called Living High and Letting
Die that refers to a more broad philosophical issue that
we have. It is that most of us are
really making money for ourselves–that’s what we do
with our lives–and whether or not that is moral.
It’s not just rich people who do that–the rest of us do it
also–and in Peter Unger’s book he–On the first page,
he has an address and it’s an address for UNICEF,
which is the United Nations Children’s Fund,
and he starts out his book with that address where you could
send money right away. I thought it was very
impressive that he put that on page one of the book because it
puts the reader in a moral dilemma.
He points out that it’s estimated that for every $3 you
send to UNICEF, you can save a life.
That’s because there are people in this world who are not
getting medical care. There are people who are dying
of diseases for which there are known cures because they don’t
have the best medicine, which are often not even
expensive but they’re living in such poverty.
So he says, why don’t you stop right now and send $100 to
UNICEF. It was very impactful to start
a book that way because I doubt that hardly any readers actually
write out a check on the spot to UNICEF;
but if you don’t, then you are in some sense
responsible for the loss of 30 lives.
It’s quite striking and it helps you to reflect on what
makes us behave the way we do. By the way, when you go back to
your computer, Google UNICEF,
and you can give $100 to UNICEF within the hour.
Maybe I could ask for a show of hands of how many people did
that. I expect that not many of you
will and I don’t think that proves that you are bad
people–this is a very interesting philosophical
question–but what it means is that there is a moral dilemma
underlying all of our economic lives and I think this moral
dilemma is the same as the moral dilemma in finance.
It’s just that people in finance are sometimes very
successful and they could give a lot more than $100 to UNICEF.
One thing that I wanted to emphasize in this course,
or try to emphasize, is that part of finance is
actually philanthropy. The most important–The most
successful people in finance, I believe, end up giving the
money away and that means–you can’t consume a billion dollars.
There’s no way that you can do that.
You can only drive one car at a time and if you have five
cars–well I mean that’s kind of–all right you could have
five cars and you could drive a different one everyday,
but it’s starting to seem a little ridiculous,
right? At any rate,
you’re not using them and they’re going to end up being
used by somebody else. So I think the outcome should
be philanthropy and those of you who are successful really ought
to give it away. I’m bringing in outside
speakers as part of this course and, among them,
I’m going to bring in people who I think have been
philanthropists. That’s the mode of thinking
that is most attractive when you think about financial markets.
So let me tell you about–I have slots now for four outside
speakers. I’ve lined up two of them and
let me tell you about the two that I’ve already lined up.
The first one is our own David Swensen.
David Swensen came to Yale University in 1985 from Wall
Street, although he was a Yale graduate.
At that time the Yale endowment was actually slightly under one
billion dollars. What is the endowment of Yale?
The endowment is defined as the financial assets that Yale
University owns. Yale also has an art
collection, which is worth many billions, but we don’t count
that as part of the endowment because they will never sell it
so it doesn’t provide income for us.
Yale also has a physical plant, like this beautiful building
that we’re in, but that’s not part of the
endowment either. The financial assets that Yale
had, at that time, were about one billion dollars.
Since then, David Swensen has invested or has managed the
investment of this endowment and it has done phenomenally well.
Yale now has over twenty-two billion dollars in its
endowment. The return he got from 1996 to
2006 was 17% a year on investments.
Last year the return on the Yale portfolio was 28% in one
year. Now I don’t know how impressed
you are, the year before that it was 22% in one year.
Now some of this might be luck but I don’t think it’s all luck
because he’s done this consistently for so many years.
If you look up around this campus now, you’ll see a lot of
construction, a lot of things are being
spruced up and improved. I think David Swensen has had a
big hand in doing that because we have the money that makes it
possible. The endowment at Yale is
something like two million dollars per student now that’s
just sitting there as money that could be spent. How did he do this?
That’s one of the amazing things.
It seems to have something to do, I think, with academic
understanding. That being part of a university
community is a good thing for investing and you can see some
evidence in that. Harvard University,
Princeton University, and other universities have
done extremely well on their endowments;
however, not quite as well as Yale.
Yale, I think, is the number one performer so
it’s very interesting that we’re able–it’s very significant that
we’re able to get David Swensen. He doesn’t do a lot of public
speaking but he is willing, for young people like you,
to do this–so that’s one of our outside speakers.
He also has two books about investing that we’ll talk about.
The second person I have set up now to come–although the date
on the syllabus online is going to be changed–is Andrew
Redleaf, who is also a Yale graduate and
who set up a hedge fund called Whitebox Advisors.
It has done phenomenally well in investing. I think–I have on the syllabus
a New York Times article about him.
He’s a very original and creative thinker who looks at
things from a unique perspective and I find it very interesting
talking with him. To do well in investing you
have to have your own independent view of things and
really be thinking about how things work and he is someone
who does that. Incidentally,
the New York Times had another article about Redleaf,
saying that he was really one of the first persons to clearly
delineate the subprime crisis that we’re now in.
He saw it coming and, I have to say,
profited from it. If you know the subprime crisis
is coming, then there’s always a way to profit from that and
that’s what he did. But he also has a philanthropic
side so it all comes out very well.
I think in the remaining time I will just go through an outline
of the course and that means go through the topics of the
various lectures and then I’ll let you go for today.
So the way this course is divided up is different than the
Financial Theory course. If you look at John
Geanakoplos’s course on Financial Theory,
his mathematical concepts are central to his outline of the
course; but this being a Financial
Markets course, I’m dividing it up more in
terms of markets and institutions.
I still want to start with some theory and I thought that–well
I will–I plan to start by talking about the most basic
concepts of risk management, which underlie finance.
That will be Wednesday’s lecture.
I call it the universal principle of risk management
pooling and the hedging of risk. I think it’s the most important
theoretical concept that underlies finance and insurance,
which we’ll also talk about a little bit in this course.
The idea is that if you spread risks they don’t disappear,
they’re still there, but they’re spread out over
many people and the impact on any one person is reduced.
So a basic principle of insurance is that if each person
or each family suffers the risk, for example,
that a parent, father or mother,
might die then it is a terrible blow to the family;
but it’s not a blow to society as a whole because people die
and it has a certain statistical regularity.
It makes sense that we pay families who have lost a father
or a mother so that they can keep going.
It benefits everyone to have a situation in place for that.
I wanted to talk about that with a little bit of reference
to probability theory and so that’s what I will be covering.
The next lecture will be among the more mathematical,
although it’s very elementary. If you had a course in
probability and statistics, then you’ll find it easy to
follow, but it’s self-contained again.
I feel like I have to introduce concepts like variance and
co-variance and correlation in order to talk about finance;
so that’s what we’ll do in Lecture Two.
The following lecture–I want to come back to some basic
themes that–the third lecture–about technology and it
relates to another book that I wrote.
I’m not assigning it, but I wrote a book called
New Financial Order in 2003 about technology and
finance. A theme of that book was
that–I’ve already said this to you, but it’s a very important
point–financial technology is evolving and improving just the
way engineering technology or biochemical technology is
improving. It’s getting better year by
year and the course of finance over your lifetime will be
dramatic, so the financial institutions
that we have ten years from now will look very different from
the ones we have now. We have to understand–in
understanding the progress of financial technology–is its
fundamental relation to information technology.
Computers, the Internet, and communication devices are
fundamental to financial progress and they make things
possible that wouldn’t have been possible before.
Oftentimes, inventions that seem, in the abstract,
to be good ideas may be impossible because something
that you have to do to make it actually come into practice is
too expensive and so it’s not economic to produce the
invention. But then developments in other
fields can change the relative prices and suddenly make an idea
that had been hypothetical and unapplied suddenly work well.
So financial inventions also involve experimentation.
Like in any other invention, nobody knows what will work and
abstract theory doesn’t guide you completely. Once an invention is seen to
work it is rapidly copied around the world.
We can see various breaks in financial history when some new
idea was suddenly proven workable.
Traditionally, financial inventions were not
granted patent rights, but now in the United States
and in a number of other countries it has become possible
to patent financial inventions. I know I’ve done that in my
life and so I think it gives a different perspective on
finance. Then I want to talk about
insurance. The institution of insurance is
something that really came in–it’s one of the earliest–I
consider it a division of finance–really came in the
1600s when probability theory was invented.
The mathematical theory of probability was unknown until
that time and you can see that insurance suddenly made an
appearance at that time. This will be an historical as
well as a theoretical discussion of insurance.
Then I will move to portfolio diversification and supporting
financial institutions. This is again a more
theoretical lecture. It will be about the capital
asset pricing model. It will be about the securities
market line, about the beta, about the mutual fund theorem,
and it will also be about institutions that we have–about
investment companies and their management.
So it’s really parallel to an insurance discussion.
Insurance pools risks like life risks or fire risks by writing
policies to individual policyholders.
Portfolio management pools risks in a different way:
by assembling a diversified portfolio or a portfolio that’s
negatively correlated with a risk that someone has.
Then I want to go to the efficient markets theory.
“Efficient markets” is a theory about–well it came in about
three decades ago, maybe it’s closer to four
decades ago–it’s a theory that financial markets work very well
and incorporate information very well.
The efficient markets hypothesis was
encouraged–actually the idea goes back over 100 years–it’s
encouraged by the observation that financial markets seem to
respond with great speed to new information and,
when new information appears, prices will suddenly adjust in
the financial markets. Certain kinds of financial
markets called “prediction markets,” which may,
for example, predict the outcome of an
election have been seen to be very accurate predictors,
often better than pollsters can manage.
So there seems to be some deep wisdom of the market.
I think that “efficient markets” is an important
concept. On the other hand–and this is
something that I want to emphasize–you don’t want to
carry that too far and one of the lessons of behavioral
finance is that markets are not really efficient in a global
sense. Human psychology drives markets
a great deal. If markets were perfectly
efficient, David Swensen could not have done what he did.
It would not be possible to make excess returns in finance.
I believe it’s clear that it is and that people who do so are
people who understand more than the core efficient markets
theory. They understand something about
human nature and how human nature interacts with our
institutions. The next lecture is about
behavioral finance and I want to talk in that lecture about
research and psychology, things that come out of another
department here, the psychology department,
which has traditionally been ignored in economics and finance
but is coming back. I want to talk about Kahneman
and Tversky’s Prospect Theory, which is a very important and a
little technical–psychologists can become mathematical and
technical as well. It’ll be an important part of
our understanding of financial markets.
Then I want to talk in the next lecture about regulation,
which means government oversight of financial markets
and not just government oversight,
there are also the so-called self-regulatory organizations
that are created in the financial industry to self
regulate. So, for example,
FINRA, which used to be called The National Association for
Security Dealers, is a membership organization of
people in the financial community and it imposes rules
on its members. It’s not a government
organization but it is a regulator. The problem is that not
everyone is nice and not everyone is high-minded so
financial markets–the success of financial markets is,
in many ways, a success of regulation.
Governments establish regulators who set down rules
for participants in financial markets and these rules may be
perceived as onerous and costly to people in the financial
community, but ultimately it’s their
salvation and it’s what makes everything possible.
After that, I want to talk about the debt markets.
Debt is the simplest of financial instruments.
It consists of a promise to pay, usually denominated in
currency, and there are both long-term and short-term debt
instruments. The shortest term debt
instrument in the United States is the Federal Funds Rate,
which is an overnight rate–one day maturity–and the longest
issued by the Government is a thirty-year government bond,
which will be repaid three decades in the future.
There have also been one hundred-year bonds and there
have also been perpetuities that–in the UK,
for example, the British Consoles–have no
expiration date and they have infinite maturity.
So the debt market is something worthy of studying because it
really represents a market for time itself.
What is it that we’re talking about when we talk about the
rate of interest? It has units of time,
it represents the price of time, and it is something that
fluctuates through time in interesting patterns.
They are very important drivers of our economy and our lives.
The theory of the term structure is the theory of how
interest rates differ according to maturity or term.
There are not only debt instruments that are payable in
currency, but there are also indexed debt instruments that
are indexed to the price level so that they give real interest
rates. We’ve had episodes in our
history when real interest rates have made major moves and these
movements are very important for what is happening in our lives.
Most recently–A few years ago, we were living in a regime of
negative real interest rates, when the Fed was pursuing a
very aggressive monetary policy. I suspect that with the
subprime crisis the Fed will be pushing real interest rates down
dramatically again and we may be in a period of negative real
interest rates again. After that I want to talk about
the stock market and I want to–there’s a lot to talk about.
Of course, stocks are shares in companies and they’re traded on
stock exchanges and they’re interesting to analyze because
there’s sort of an ambiguity about stocks that is not widely
perceived by a lot of people. That is, share repurchase can
change the units of measurement in a security and companies have
to decide how leveraged the stock will be,
which changes the stock price–leverage,
meaning how much debt the company takes on.
Moreover, companies have to decide how much dividends to pay
on the stock. That’s a decision of the
management of the company and we have to understand how they make
that decision and what that means to people who are valuing
stocks. It’s a very simple idea.
The idea of dividing a company up into shares and selling them
off, but in practice it involves a lot of complexities.
We’ll be talking about the Modigliani-Miller Theorem and
related issues in this lecture as well as something about the
behavior of the stock market and its tendency to go through
dramatic movements. For example,
like it has done recently if you’ve been following it earlier
this year. The next lecture will be about
real estate and that brings us into the subprime crisis and
connects with interests that are central to my own thinking.
The housing market is a huge market.
Right now the total value of single-family homes in the
United States is about twenty trillion dollars and the market
has been becoming increasingly speculative.
Home prices have become unstable.
Nationally, home prices in the United States rose 85% between
1997 and 2006 in real terms–in inflation-corrected terms.
We’ve seen almost a doubling in the price of the average home in
the United States. Why did that happen?
Now they are falling and in real terms home prices have
fallen almost 10% since the peak in 2006.
This is not just a U.S. phenomenon;
many countries around the world are experiencing home price
booms and the beginnings of what might be a home price bust.
I want to consider the market for homes and the market for
mortgages, which are the instruments that finance homes.
To what extent was the housing boom that we saw in recent years
the result of revolution in financial technology?
There have been many changes in our mortgage institutions that
might be part of the reason for the boom in home prices.
There’s also a question of psychology.
The following lecture will be about banking,
the supply of money and the money multiplier.
It’s also about: how banks operate;
what their function is in our society;
and, why they are such important institutions that have
gone back for hundreds of years and remain powerful,
central features in our economy.
It’s also about bank regulation, such as the Basel
Accord, Basel I and Basel II. I also want to talk about the
impact of information and technology on banking.
The following lecture is about monetary policy.
What do central banks do? In the United States,
the central bank is called the Federal Reserve.
In the United Kingdom, it’s the Bank of England.
In Japan, it’s the Bank of Japan.
And in Europe, it’s the European Central Bank.
All of these banks are really in control of short-term
interest rates and these interest rates are used to try
to manage and stabilize the economy.
In response to the subprime crisis that we are now in,
our central bank, the Federal Reserve,
has been cutting interest rates aggressively to try to save the
economy that appears to be declining.
I want to try to understand in that lecture–help us to
understand how this works and how we’re getting
solutions–possible solutions to these problems.
Then I want to talk about investment banking.
An investment bank is a different kind of bank.
I was talking, up to this point,
about commercial banks. An investment bank is not a
bank that accepts deposits; it doesn’t deal with the
general public. Instead it deals with financial
institutions and it gets involved in underwriting
securities for financial institutions.
It’s a very important industry and it’s also one in which many
of our students have found jobs, so I think it’s important for
us to try to understand the history of investment banks,
the role they have in our financial community,
and how they’re regulated. Then I want to talk about money
managers–professional money managers–people like David
Swensen. This is a community of people
in a different segment of the financial industry.
These are people who manage portfolios. We want to think about what
kinds of forces operate on them and what kind of–I’m interested
in viewing them partly as people who are experts in a certain
kind of technology who live in a very competitive environment and
try to understand why some of them succeed much more than
others. It also relates to behavioral
finance. That is, ultimately they are
human beings like anyone else and some of their differences in
success or failure may have to do with their own
interconnections and their own psychology and interpersonal
psychology. Then I want to talk about
brokerages. Those are institutions that
arrange for or manage the buying and selling of financial assets,
such as the New York Stock Exchange.
Now the brokerage industry–The New York Stock Exchange goes
back into the eighteenth century, it’s very old.
In fact, the idea of the stock exchange goes back to the
fourteenth century, when in Flanders the first
stock exchange called The Bourse was established.
So it goes back many hundreds of years but it’s in rapid
change now because of information technology.
It’s one of the most rapidly changing, hard to keep up with
areas because someone can set up an electronic exchange overnight
and suddenly become a base for trading trillions of dollars of
securities. It fits in well with the theme
of this course about technology because in understanding what’s
happening with brokerages, our technology,
the new information technology, is central.
Then I want to move to futures markets and forward markets.
A forward contract is a contract made between two
parties for execution in the future.
Generally these are called over-the-counter contracts
because they’re not arranged through exchanges.
We also have standardized contracts that are traded on
exchanges and they’re called futures contracts.
The futures contracts were invented in Japan in the 1600s
at Osaka and they were developed for the rice market in Japan.
They were uniquely Japanese until pretty much the nineteenth
century and then they were copied all over the world and
are now very important. I’m going to talk about one
futures market that I have been instrumental in developing.
I’ve been working with the Chicago Mercantile Exchange to
create a futures market for single-family homes,
which is sort of my connection to the futures industry.
Of course, there are many futures markets that we’ll talk
about. They’re very interesting to me
and I wonder why the business community isn’t more aware of
them. A futures market has a
prediction going out years into the future of what every
financial variable will be doing,
so you can see the future in a sense through the futures
prices. It’s not always correct to
think of it that way–we have to get into the theory of futures
markets. In many cases that is not the
right way to think about futures prices, but there are very
important futures markets that–In the next lecture I want
to talk about the various kinds of futures markets that matter.
We have a stock index futures market and notably we have an
oil futures market. The oil futures market is very
significant because it represents the price of energy
on dates into the future. We can now see the price of oil
going out years into the future. We’ve just hit $100 barrel
price of oil, but what does that mean?
Does that mean we’re going to live in a world with $100 oil?
Well not if you look at the futures market,
which is in backwardation now and it’s predicting major drops
in the price of oil. Then I want to talk about
options markets–this is getting close to the end of the course.
An option is the right to buy something.
Typically, we think of it as a stock option.
An option is a contract that says you can buy so many shares
of a company. The options have been traded
for several decades, starting with the Chicago Board
Options Exchange. But now there are many options
exchanges. We have prices of options that
change minute by minute. Now what do these changes and
these prices mean? The options are a very useful
technology for managing risks and I think that we’ll see a
rapid–Over the next few decades,
we’ll see rapid expansion in the scope of options contracts
traded on the exchanges. Finally, for the last lecture
for this semester, I want to pull this together
and talk about one of the themes that is summarized in terms of a
theme of this course: the democratization of finance.
Finance used to be a very esoteric field that only a few
people in London and Paris and other world centers
understood–Amsterdam and other places where financial
technology emerged–but it’s becoming democratized.
With each year that goes by the concepts of finance are being
applied more broadly and involving more and more people.
With electronic technology, it’s becoming more economical
to offer sophisticated financial services to everyone.
This is something that we’re seeing.
I think the subprime crisis that is the current financial
crisis highlights this very well.
What does subprime mean? Well I think it stands for the
general population. The subprime mortgage market
was bringing people into the mortgage market who in prior
decades would not have been involved–would not have had any
mortgage. The problem,
of course, with the democratization of finance is
that if you raise the participation in financial
markets, then you bring in people who
are: less and less knowledgeable;
less and less understanding of concepts of finance;
and less capable and more vulnerable to exploitation.
So the democratization of finance is, I think,
the ultimate mission of–I find central to this course but it
brings with it dangerous hazards and we have to think very
carefully about how we do it.