This course attempts to explain the role and importance of the financial system in the global economy. Rather than separating the financial world from the rest of the economy, financial equilibrium is studied as an extension of economic equilibrium.
The course includes:
This module introduces the financial theory's historical context, tracing its development from business schools to its current applications in Wall Street. The efficient markets hypothesis, a key tenet of financial theory, is scrutinized, especially in light of the financial crisis of 2007-09. The lecture discusses critical questions that the standard financial theory can still address, while introducing the leverage cycle as a critique of traditional perspectives. A class experiment illustrates scenarios where the efficient markets hypothesis holds true.
This module explores economic models, emphasizing their role in understanding counterfactual reasoning and paradoxical conclusions. It defines equilibrium as a solution to simultaneous equations, focusing on the supply and demand model, which has historical roots in ancient Greece and literature. The modern theory of general economic equilibrium extends this model to incorporate continuous quantities and multiple commodities, forming the foundation for financial equilibrium models discussed in subsequent lectures.
This module aims to make economic decisions tangible and vivid by calculating equilibrium prices and allocations in simple economies. Using two illustrative examples, the lecture shows how theory assists in determining economic equilibria, employing both hand calculations and computational methods. The module sets the stage for more complex financial economies involving stocks, bonds, and diverse financial assets in future classes.
This module examines evolving justifications for free markets from economists over time. Initially, competitive allocation was seen as maximizing the sum of agents' utilities. When this was found insufficient, Pareto efficiency emerged as a critical concept. The lecture revisits two proofs of Pareto efficiency by Edgeworth and Arrow-Debreu. Further, it discusses how expanding economic models may undermine free market justifications. The module also highlights Irving Fisher's contributions of time and assets to the economic equilibrium model.
This module addresses philosophical and theological critiques of interest, tracing their historical context. It highlights Irving Fisher's model, which integrates time and assets into general equilibrium, revealing the analogous nature of trades across different time frames. Fisher's insights emphasize the significance of future dividends in assessing stocks and bonds, ultimately leading to the conclusion that the real rate of interest is determined by market preferences. This understanding challenges long-held philosophical beliefs about interest.
This module builds on the previous discussions of financial equilibrium by delving into the relationships between productivity, patience, and interest rates. It provides solutions to Fisher's famous examples, analyzing how changes in patience influence interest rates, the effects of anticipated windfall riches, and the implications of wealth redistribution from poor to rich. This exploration deepens our understanding of economic behavior and its impact on financial systems.
This module contrasts historical and modern understandings of interest and collateral. It highlights Shakespeare's early economic insights, which often prefigured those of Irving Fisher. The module also introduces present value as a concept to explain various financial instruments, including coupon bonds, annuities, perpetuities, and mortgages. Through this framework, students will appreciate the evolution of financial instruments and their foundational roles in modern finance.
This module addresses the deferred maintenance challenges faced by Yale University in the 1990s. It applies financial principles to budget planning for significant renovations and evaluates initial budget cuts. The latter part discusses the measurement of investment performance, comparing various yield measures such as yield-to-maturity and current yield. This analysis provides a basis for understanding financial planning in long-lived institutions.
This module transitions from present values to dynamic present values, illustrating how interest rate changes can influence the present value of cash flows. By employing backward induction, it simplifies the computation process. The module also explores how dynamic present values can aid in understanding trading strategies and preventing market abuses, while examining the mechanics of mortgages, including amortization and remaining balances. An analysis of Social Security's challenges further underscores present value applications.
This module continues the discussion on Social Security, tracing its origins and financial troubles since its establishment in 1938. It contrasts perspectives from Democrats and Republicans on the program's success and sustainability. The lecture applies present value analysis to clarify misconceptions about the financial issues plaguing Social Security, including the myths surrounding baby boomers, privatization, and the implications for current retirees.
This module employs the overlapping generations model to explore the sustainability of Social Security and the necessity of intergenerational support. It introduces enhancements to the classic model by incorporating land, demonstrating how financial equilibrium can be reduced to general equilibrium. By assuming stationarity, complex analyses are simplified to a single equation, shedding light on the relationship between Social Security, real interest rates, and the perpetual nature of land as an asset.
This module uses the overlapping generations model to analyze how demographic shifts affect interest rates and asset prices. It critically evaluates Tobin's assertion that population growth could resolve Social Security issues and revisits the link between birth rates and stock market levels. Furthermore, it establishes a philosophical and statistical foundation for addressing uncertainty in financial markets, enhancing understanding of demographic impacts on economic frameworks.
This module incorporates uncertainty into financial models, moving beyond previous assumptions of perfect forecasting. It covers statistical concepts crucial for understanding risk, including expectation, variance, and covariance. The lecture demonstrates how diversification can mitigate risk exposure and illustrates the computation of conditional expectations. Additionally, it examines the implications of interest rate uncertainty on the valuation of future cash flows and investment decisions.
This module discusses the rational expectations hypothesis, emphasizing traders' knowledge of probabilities for future events and their impact on asset valuation. It explores the implications of this hypothesis in predicting market behavior and evaluating corporate and sovereign bond risks. Additionally, the module delves into the challenges posed by uncertain discount rates, introducing hyperbolic discounting as a contrast to traditional exponential discounting, which can alter long-term valuation perspectives.
This module wraps up discussions on bond default probabilities, employing duality techniques for rapid calculations. The focus shifts to backward induction and its application to optimal stopping problems, illustrated with relatable examples beyond economics. The module emphasizes the value of retaining options to continue, highlighting how optimal strategies can prevent premature decision-making in various contexts.
This module investigates callable bonds, focusing on the option to repay loans early. Using backward induction, it calculates optimal strategies for borrowers, emphasizing the significant value of these options. The most notable example is the fixed-rate amortizing mortgage, where prepayment options impact mortgage rates. The analysis reveals common inefficiencies in mortgage prepayment decisions, illustrating the complexity of these financial instruments.
This module teaches the intricacies of mortgages, focusing on the promises made, collateral backing, and the prepayment option's complexity. It discusses how to model and forecast prepayments, contrasting traditional non-contingent forecasts with modern agent-based approaches. The latter accounts for individual behavior and heterogeneity, demonstrating the risk involved in trading mortgages, even without default. This understanding raises critical questions about effective risk management strategies for investors and banks.
This module provides a personal narrative from Professor Geanakoplos, detailing his journey into mortgage securities and the evolution of the mortgage market. It discusses his experiences at Kidder Peabody and Ellington Capital Management, shedding light on securitization, tranching of mortgage pools, and the roles of investment banks and hedge funds. The module offers insights into subprime and prime mortgage market developments and the impact of these changes on the broader financial system.
This module introduces dynamic hedging, explaining how to mitigate risks associated with mortgage prepayment forecasts while avoiding reliance on uncertain interest rate predictions. It illustrates the challenges of hedging over a mortgage's lifespan and focuses on the principle of adjusting hedges annually to maintain protection against potential risks. Using relatable examples, the module emphasizes the value of hedging in managing complex financial scenarios.
This module expands on dynamic hedging, emphasizing marking to market as a crucial concept in managing numerous potential scenarios over time. It introduces the average life of a bond, explaining how traders utilize this measure to determine appropriate hedges against interest rate fluctuations. The insights gained from this module reinforce the importance of dynamic risk management in the ever-changing financial landscape.
This module introduces risk aversion concepts, detailing the Bernoulli brothers' early contributions. It examines the Capital Asset Pricing Model (CAPM) derived from the assumption of quadratic utility. The module discusses how this model influences prices and asset holdings in equilibrium, particularly under conditions where risks cannot be hedged collectively. Utilizing tools from earlier modules, students will appreciate the implications of risk aversion in financial markets.
This module elaborates on the Mutual Fund Theorem and covariance pricing theorems, foundational concepts derived from CAPM. It highlights Tobin's theorem regarding optimal portfolios and diversification, emphasizing that every investor should maximize the Sharpe ratio through a mix of cash and market assets. The covariance pricing theorem reveals how asset pricing is determined by expected payoffs and market covariance, culminating in a surprising resolution of previously posed valuation puzzles.
This module addresses crucial aspects of CAPM, including methods for testing the theory and evaluating fund managers' performance. It invites students to consider how different management styles should be assessed and discusses the return differentials between stocks and bonds. Additionally, it revisits Social Security, contemplating how CAPM principles could shape investment strategies and reconcile differing political perspectives on privatization and asset management for future workers.
This module explores the Leverage Cycle theory and its implications for understanding the financial crisis of 2007-09. It critiques traditional financial theories that overlook collateral and introduces the endogeneity of default and collateral in the lending process. The module discusses how changes in collateral requirements can lead to asset price fluctuations, setting the stage for a detailed examination of the subprime mortgage crisis and its broader financial ramifications.
This module provides a detailed understanding of the Leverage Cycle's predictions and mathematical underpinnings. It solves two mathematical examples illustrating how supply and demand influence leverage and interest rates, emphasizing the roles of impatience and volatility. The module identifies three critical elements in a financial crisis: heightened uncertainty, collapsing leverage, and a shift in market sentiment, underscoring the need for effective monitoring and regulation to mitigate future crises.