Practice English Speaking&Listening with: 1. Finance and Insurance as Powerful Forces in Our Economy and Society

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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


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


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 tryingstruggling--to

survive. 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


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


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-importantwho 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


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


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.

The Description of 1. Finance and Insurance as Powerful Forces in Our Economy and Society