Financial%20Markets

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Financial Markets

• Economics 252
• Robert Shiller
• Introductory Lecture

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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

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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

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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

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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

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Radical Financial Innovation

• Risks not easily conceptualized
• Public resistance to risk management
• Each major risk category requires difficult
  institutional innovations to manage

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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

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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.

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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

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Finance and Law

• 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

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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

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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

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Packet of Readings for Econ252

• Audubon Copy Whitney Ave. Near Clarks
• Required purchase

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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

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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

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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

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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

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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?

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Lecture 7 Behavioral Finance The Role of
Psychology

• Research in psychology
• Anomalies in finance
• Kahneman Tversky Prospect Theory

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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Lecture 19 Forwards and Futures

• Forward contracts and their limitations
• Futures contracts since Osaka in 1600s
• Fair value
• Hedging function
• Failure to hedge

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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

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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

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Lecture 22 Other Derivative Markets

• Swaps, Swaptions
• Macro Securities and the American Stock Exchange

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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

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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.