1. Introduction and What this Course Will Do for You and Your Purposes

published on July 13, 2020

Welcome to economics 2 5 2 this is financial markets and I'm Robert Shiller this is a course for undergraduates it doesn't presume any prerequisites except the basic intro econ prerequisite it's about well the title of the course is financial markets what I by putting

Markets in the title of the course I'm trying to indicate that it's down-to-earth it's about the real world and it's about but to me it can note that this is about our what we do in our lives

It's about our society so you might imagine it's of course about trading since it says markets but it's more general than that finance I believe is a as it says in the course description a pillar of civilized society it's the

Structure through which we do things at least on a large scale things it's about allocating resources through space and time our limited resources that we have in our world it's about incentivizing people to do productive things it's

About sponsoring ventures that bring together a lot of people and making sure that people are fairly treated that they contribute constructively and that they get a return for doing that and it's about managing risks that anything that

We do in life is uncertain anything big or important that we do is uncertain and that's what to me that's what financial markets is about so but it has a lot of that to me this is a course that will have a philosophical underpinning but at

The same time we'll be very focused on detail to me the I'm fascinated by the details about how things work it can be boring and I hope I'm not boring in this course but it's in the details that things

Happen and so I want to talk about particular institutions and I'm interpreting finance broadly in this course I want to talk about banking insurance sometimes people don't include insurance as part of Finance but I don't

See why not so will include it it's about securities about futures markets about derivatives markets and it's going to be about financial crises and it's also about the future I'd like to try to think about

The future although it's hard to do so where are we going this course will have a us bias since we live in the United States we I know the us better than any other country but at the same time I recognize that

Many of you or even most of you will work outside the US and and so it's important that we have a world perspective which is something I will try to my utmost to incorporate in this course the world perspective also

Particularly matters since we have other viewers for this course besides those people in this room this course is one of a couple dozen courses that Yale University is offering free to the world as part of open Yale and that means

There is a cameraman back there if you've noticed that's Dan Cody filming the course and it will be eventually posted on the internet and it will be available through open Yale and then by proliferation that you'll find it on

Many other websites as well I this is the second time this course has been filmed for open Yale the first time was in 2008 three years ago and I'm very pleased to report that I have a lot of

People in every imaginable country who have watched these lectures and I get emails from them so I know that they're out there so this but I thought that this course needs updating probably more than any course on open Yale you know of

Course in physics only has to be updated for the last three years of research in physics it's probably not a big thing for an undergraduate course but finance really has to be updated I think because it's going through such turmoil and

Change right now we've had the worst financial crisis since the Great Depression and it's been a worldwide crisis and governments around the world are working on changing our financial institutions we have organisations of

Governments notably the g20 which is very involved in finance it's one of the top items on their agenda for International Cooperation is changing our financial markets so I think that that's another reason why I want to try

To keep as international a focus as I'm good about good at doing in this course but I hope that you're not just in this room are not disturbed by the camera and feel you can ask questions and you can you don't have to be on camera I think

I'm just being filmed so that's where we are now I wanted to put this in a little bit broader context the other major finance course that we have here at Yale is economics 251 and it's taught by Professor John John accomplice who is a

Mathematical economist and also a practitioner he does the his research director for Ellington capital so he's somewhat like me and that he's interested both in theory and practice

But his course is more definitely more theoretical and mathematical than mine his is entitled financial theory and I can read some of the topics that in his courses also will appear on open the Yale shortly you can take the whole

Court but I don't know it's not up at this moment it will be up in a matter of months so I encourage you if you want C to take open Yale econ 251 but the things that he talks about in that course if you read the topics in this

Course you'll see that they're more mathematical and technical than mine he talks about utilities endowments and how it leads to equilibrium assets and time the mathematical theory of bond pricing dynamic present value social security

And the overlapping generations model uncertainty and hedging I'm quoting his titles state pricing that's kind of an abstract theory we talk about the price of a state of nature I won't explain that he talks in some length about risk

As the theory of risk and the capital asset pricing model and about the leverage cycle which is relevant to our crises so I recommend you take econ 251 but I don't expect you to take it this course is self-contained and I'm going

To keep mathematics to the minimum in these lectures but the idea here is that we can't avoid it completely I personally am mathematically inclined to but I'm understanding that we've divided our subject matter so jon-jon

Accomplice is doing the math and the theory and I'm doing the real-world Laura it's not a complete division like that but it's something like that so I'm going to stay to that and I'm going to talk about more about

Institutions and history than about mathematics so the but we in order since I know that most of you or many of you will not take economics to 51 what we are doing is I'll give a little indication of the mathematical

Principles more intuitive and I will we have review sessions with our teaching assistants we plan to have six of those and those will be on a Friday in this room and they won't be on open Yale those will cover the theory and it will

Be a like a short form of John accomplice course and then we'll have problem sets and there will be six problem sets one for each of those sessions so there will be some math in this course I wanted to talk about the

Purpose of this course it clarify one thing is what do I imagine you're going to do with this of course well first of all I pride myself that I think I teach if I might boast for a minute I think I teach one of the most useful courses in

Yale College at least that's the way I think about it because this course really prepares you to do things in the world I've taught this court this by the way I've been teaching this course now for 25 years

I first taught it in the fall of 1985 not know if that's depressing or not to me it's great I'd like to be able to keep moving ahead I wonder what my 1985 course looked like unfortunately they didn't do open Yale and I can't go back

And look at it but I think I've gotten more philosophical and maybe more real-world oriented as time is going by but the excitement I have is when I go I give a lot of public talks and often on Wall Street and when I do

One on Wall Street I'd like to ask people for a show of hands how many were you of you were in my economics 252 class and I typically get a 1 or 2 at least who raised their hands so that's a source of pride to me that I've been

Able to get people you know I was involved in the beginning of their careers and I hope I instilled some kind of moral sense to what they do so but you know I should say I don't think that most of you will go into finance because

I think that most of you have other purposes going what does it mean to go into finance well it sounds like that means you would be listed as someone who is is is very focused on on finance but I

Think everyone should know finance this should be a required course actually at Yale College because finances is so fundamental to what we do in a structure of our lives that I don't see how you can avoid doing finance if you want to

Do something big and important maybe you don't want to do that either so if you might want to become a hermit and then you don't need finance but to me I think that I like to think that many of you have a sense of purpose in life now I

Should say it's a big issue it sounded funny didn't it but what I'm saying is your purpose is not to make money and this is one thing about finance that bothers me is that people think that it's a field for money-grubbing people

Who just want to go out and make money and I don't think so I think it's a it's a technology for doing things and you know you don't want to be mystified by it you don't want it when someone talks some financial jargon you don't want to

Say I don't have a clue that's about because what that's about is how we make things happen and so so it's you know I I think that I hope that you have other purposes in life besides finance even those of you who go into

Finance but the question is whether this is a vocational course here at Yale College there has been a long tradition that we are not a vocational school I suppose you know that that Yale is a liberal arts in we teach you the Arts

And Sciences I actually went to look at the Charter and the act of the Connecticut government in 1701 that founded this university this university was initially mostly a training ground for the ministry but I actually read in

The in the acts of the governor and company of the colony of Connecticut Yale College is founded for the educating and instructing of youth in good literature arts and sciences I think that is the motive here for this

University and so I think it is in some level vocational but it's not you know vulgar vocational I want you to think about what we're doing and how it fits into what you do for your lives so I think I think of finance as a kind of

Engineering in a way but it's an engineering that works with not technomage in with what we call it the technical apparatus but with what with people and and so if we want to understand how to do these things we we

Have to get some technical apparatus under our up and that's what I'm going to try to do in this course the textbook that I chose for this course is by Frank Fabozzi who is a professor at the Yale

School of Management what with two co-authors we have Franco Modigliani for whom I have a some personal affection because he was my dissertation adviser at MIT and who unfortunately died in 2003 and Frank Jones of a life and

Guardian life insurance company this book is is I've also written joint papers with well with two of the three authors I've written joint papers with Phobos II and with Modigliani research papers but they have they're similar to

Me in many ways they're interested in the details I hope you get interested in the details I find this textbook fascinating for life for me well I first I first read this book when I first started designing

It I was going on vacation with my friend Jeremy Siegel who's at the end and our families who is a professor at the Wharton School and we I brought this book as my poolside reading and I was sitting there with this but other people

Were reading novels and fun things but I was thinking I don't know what they thought of me reading this text book rather pool but I thought gee this is great because you know I knew I thought I knew most of what's in here but

There's a lot of things that I still didn't know and it was answering all kinds of questions things you always want to know about real estate securities okay but you never found out well it's all answered here so I hope

You can take that spirit in reading the textbook that's the only book you have to purchase for this course and the it's it's it's the main work that you have so I'm going to ask you about the details on exams so you know it's not

You know the kinds of municipal securities and we have and how the rating agencies rate them that's part of this course I believe the details matter and so I'm not going to just ask you to broad

Generalities on the exam I can ask you the details it's a bit like teaching a language right if you're going to learn a lining a language is really important and you've got to learn all the words right there's thousands of them it's

Like that you're going to be learning the words of Finance and so I have another book also which is actually not done yet but you can access it through classes v2 and later it will come out as a published book but I'm working on a

Book called well I don't know what it will be called finally when you're writing a book one thing you learn as an author is you can never be sure what the title of the book will be because if somebody else uses the same title and

You're done you can't somebody else gets to it first you got to change your title but at this moment the title of my book is finance and the good Society and it won't be out I'm not sure when it will be out I was hoping next year but

Now I'm thinking it might take longer than that so you have something that's imperfect I hope you'll excuse me when you look at that the chapters of this book you don't have quite all the chapters either but I

Just thought it was a good thing to put it in process for you to maybe you can if you have ideas you can tell me and the book will have a change with your input to me it's a good way to write a book is to be writing a book and

Teaching a class at the same time on the same topic it's more social right you know you just sit in your office and write and you you end up feeling sterile so it this makes it more alive to me too do that at the same time but I tell you

What my book is about is the title that I now have finance and the good society may sound to some people like an oxymoron because they're kind of incompatible people are angry about finance these days we've had and this is

Going to be an important part of this course we've had the worst financial crisis since the Great Depression of the 1930s and it's been a worldwide financial crisis and it isn't over yet or it's not clear that it's over yet and

People are angry people are angry about finance people who seem to be getting rich at often it seems at the expense of others they seem to be lobbying their governments to give them breaks and bailouts and they walk home with

Billions of dollars something seems immoral and wrong well I'm sure some immoral things are happening but I don't think that finance as a whole is wrong and I think of it as a noble profession so I wanted to try to put it in

Perspective and it's especially important when talking to young people like yourselves because you're launching out on a career and I want that to be a moral and purposeful career and I want to put finance in the perspective so the

Theme that I want to develop in my book is that part you know we live in a capitalist world now and this world is is increasingly built on Finance some people call it we're living in the era of financial capitalism we have these

Big multinational institutions that are owned by huge numbers may be millions of shareholders dispersed all over the world and what makes the whole thing work and click it's it's it's the financial arrangements so I think that

It's and you know the world is discovering the importance of finance when I go to a foreign country and give a talk I find that people are general it doesn't matter what country they're generally very interested in finance

Because they think that our modern financial techniques are part of what's making so many places in the world grow at rapid rates now we're living in a time in history when developing world is exploding with growth and these

Countries that are doing that are countries that are adopting modern finance so I want this to be I want this to go right and I want this to be developing a good society that by good society I mean a just and fair of

Society that allows people to develop their talents and expertise so another thought I had was that the field of Finance let me give you another slide I like to compare I said I feel this course is one of the most important

Courses in in Yale College at least from a standpoint of your lives and lives and careers I wanted to compare finance jobs with jobs and I don't mean to put down other departments but at least vocationally let's put this in

Perspective I wanted to compare jobs in finance with jobs in other fields so this is a chart that I constructed using data from the Bureau of Labor Statistics and what it has is the number of people in various occupations in 2008 and their

Projections for the same in 2018 so the red bar is for 2018 and we'll emphasize that because you'll be just getting into your careers with that it comes so it says if you look at financial analysts in the United States there's almost

300,000 financial managers it's over half a million personal financial advisers a quarter of a meal and all right that's what these are people who specialize entirely in one form of finance or another but compare

That with economists look at that it's what is that about the 20,000 I think they're excluding professors but you know just economists out there not very many how about astronomers okay I can't even

Read that I love astronomy by the way but I think I made the right choice when I decided well I shouldn't say that never know we all have to do something different and you could become an astronomer but there aren't many jobs in

Astronomy sociologists political scientists just not many compared to this is just enormous ly bigger our mathematicians I like I also put one oddball field down here massage therapists okay the number of massage

Therapist jobs out numbers any of those other fields by what is it twenty one hundred to one so this is the this is the kind of disappointment that people face you go to the college or university and I this is very much on my mind you

Go to the University and you develop special skills and you leave and then you end up driving a taxi and that doesn't mean that I want to become vocational I mean I don't want to just train you for a job but I want to be

Relevant and it seems to me that I can be relevant in talking about finance and so that's that's the basic core that I wanted to get that so one thing that though I mentioned before that people think that finance is the

Field for people who want to get rich okay who want to make a lot of money well I think that's right actually okay I don't advise you to take that as your but I wanted to talk about that a little bit so one thing that you'll note forbes

Magazine writes has an annual list of the 400 richest people in america so i i went looked at that list who do you think they are me I know most of you probably have not read this list you might think that well who makes a lot of

Money well it's athletes football players right baseball players and who movie stars right they make a lot of money so how many do you think of those are on the Forbes 400 of the richest people in

America well as I read the list I didn't see a single movie star or a single athlete there is it taken to tell me how you define it Oprah Winfrey is on the list okay you've heard of her she's an entertainment that in the

Entertainment business but you know she's also a finance person she runs big businesses she's she into making things happen and I can assure you that she knows finance at least some basic financial because that's the finance

Gets you to build organizations that's how it's done and it means raising capital to make things happen on a big scale you know no athlete is is it powerful is one of these random guys on the Forbes 400 list

It's interesting I look down the list and I didn't spot a single Nobel Prize winner okay and therefore maybe I missed one I look for best-selling authors I found one Bill Gates who wrote a book called the road ahead

But there are not many best-selling authors either what do they have in common now about 1/3 of them just inherited it from their parents but most of them did it themselves they just made huge sums of money oh and what do they

Did well they're typically in some boring line of business they make something but they're doing it on a vast scale and so that means they're making deals they're putting things together they're buying companies they're

Absorbing other companies into theirs and there's something powerful about an ability to do that and I think that it's good for you to understand and appreciate that and so that's by the way Forbes has a another list called the

Forbes celebrity 100 and to be on that list you have to be a celebrity it's a completely different list Oprah is on both lists but she's practically the only one a Steven Spielberg is on both lists I think he's

The makes movies but he has a whole company called DreamWorks and he finances all kinds of movies so he's a business person as well so yeah I don't think of finance as of mathematical I mean it is mathematic or element of that

But to me it's about making things happen and about putting together deals and getting people incentivized to do something and getting capital getting resources in a massive scale so that something can happen and so that's what

This course is about Oh Jerry Seinfeld is listed by Forbes as a possibility to make the he's about the only one to make the list of the Forbes 400 but he isn't there yet I don't mean to diminish these celebrity people but

There's there's something else that goes on and finance it and it's quiet it's behind this actually most of the Forbes 400 you've never heard of they're kind of behind the scenes doing things that are big and important but they don't get

On the news so much it's one of the ironies of life you might aspire to do this to get on the Forbes 400 you can do it and still nobody knows who you are or cares so that's just as well I think for many people so the question is suppose

You get on the Forbes 400 what are you going to do with it in other word to get on the Forbes 400 you have to have made at least a billion dollars so that mean you have in your own portfolio a thousand million dollars

That's the minimum to make the list so what are you going to do with a thousand million any ideas what would you do with it you could buy cars you could buy how many sports cars can you buy for that what could you do you could buy 20

Houses but it doesn't begin you could buy 20 houses and so what you know you still have 900 million left over so what are you going to do with all that money and that's that's a quick some people who do that who make all this money try

To see if they can maximize their appearance of wealth that they try to show to the world how rich they are and so you just build the biggest mansion and you do something really spectacular when you've got a billion dollars you

Can't there isn't a house in the country you could buy for a billion dollars you you have multiple you can always stay in one at a time right so what are you going to do but there are people who do that and I think that there's a history

Of disgust for those people a long history we don't like people who do that and you know it's almost like it's a big mistake why would you do that when people don't like people who show off their wealth it's it there's evidence

That people feel that way many different countries and cultures because lots of countries in history have what are called sumptuous laws it goes back at least to 700 BC in ancient Greece with the Locrian code these are

Laws prohibiting people from conspicuous consumption and they've been in so many different countries that I think is evidence of it's evidence that something is amiss with making wealth as they as the objective of of your life so one of

The themes in the beginning of our reading list is I have I think there's a there's a movement afoot today around the world of thinking about this problem that you can get so big and powerful if you build a business and you use the

Financial techniques that are successful for other people but it's meaningless because you unless you unless you give it away and so what else can you do with all this wealth but plan to give it away so one thing I have on the reading list

Right at the beginning is a chapter from what where the title of the book is the gospel of wealth and other essays and it was written by Andrew Carnegie actually he wrote a short article in a magazine called wealth in 1889 and in the final

Paragraph he used the term gospel of wealth and it was picked up all over the world as just outrageous and so it became named the gospel of wealth so later in the early 20th century he came out with a book entitled the gospel

Of wealth and that's what I have assigned it can click on it on the reading list and Andrew Carnegie was one of these they didn't have Forbes 400 but he was one of the richest men in America through his Carnegie steel company very

Much steeped in finance but when he he decided when he wrote his essay gospel of wealth in 1889 that once a person reaches middle-age like 50 or 55 and who has made a lot of money they really have to go into philanthropy

There's a moral imperative so the theme of gospel of wealth was you know some people are just better at what he called affairs than other people that means business some people have a sense of how to make things happen these people have

A moral obligation to make this work for the benefit of humankind and that means they have to while they're still young they have to give their they have to take their fortune and give it all away before they die because if they don't

Give it all away it's nonsense if you make a billion dollars and you leave it to your children they're not chances are they're not like you they're not going to be interested in working hard and making things happen they're just going

To squander it and so that's what the moral obligation is you have to stop at age let's say 55 ok you've still got time left and then use your same talents so what his it was almost a theory of capital it is a theory of capitalism it

Is a theory that some people are just more practical and hardworking and business oriented and these people can find things to do that benefit mankind and they should do it so there's a natural selection the smartest mrs

Carnegie I'm not endorsing this entirely I think there's an element of truth to the Gospel of wealth but it's not exactly not exactly true but the element of truth is right that people like Carnegie was a very gifted person you

Know what he did he set up the Carnegie Institute of Technology now called Carnegie Mellon University he set up the Carnegie Endowment for world peace Carnegie Hall in New York if probably gave something to Yale

Is there a Carnegie he came to like every imaginable University I know it Princeton they have a lake Carnegie he was visiting Princeton and someone pointed out this it's kind of swampy land and said we'd like to really create

A lake so he said fine he gave the money to create lake Carnegie and he also gave the money for the first for the prize for the first true competition unlike Carnegie so he just had all kinds of gifts he gave it away and I also have

It's interesting I found this on the web Thomas Edison the inventor was so impressed with Carnegie's Gospel of wealth that Edison was developing the sound movie in 19 I think it was 1914 but he didn't perfect it but he said the

First sound movie should involve geniuses of our time so he made a sound movie of Carnegie reading from his gospel of wealth unfortunately the visual side of it somehow got lost maybe it didn't work we only have the

Soundtrack from the movie so you can listen to Carnegie reading from this book in 1914 and it's the only recording of Carnegie's voice that survived more since then Bill Gates and Warren Buffett and others of the fortune Forbes 400

Have done a campaign to get people billionaires around the world to commit to give most of their wealth away while they're still alive and I'm trying to get to one of these people to speak to our class but I haven't yet arranged

That but I also have on the web website a review from 1890 of Carnegie's original essay from a California newspaper and they were so negative I thought they said Carnegie thinks that making wealth and giving it away is

Is a noble cause this cannot possibly be right these people are not who make money are not the most enlightened and smart people in our world so I think that the truth lies somewhere in between but we

Do have a society now where people we have an increasing concentration of wealth at the top and I don't know what we're going to do about this this is a trend that may continue and so that's this is the thing I want to think about

In this course I don't think finance necessarily does this it may be a bubble that there is currently a bubble in financial careers and that you are going to be disappointed because 20 or 30 years from

Now if you go into a finance related field you'll find that it's not as lucrative as you hoped that that kind of happens right when a field becomes known for having a lot of successful people then more young people go into it and

They swamp the field on the other hand I think that will always be true that just because of the power of the technology the top wealthiest people in the world will be finance related and I think that they will have a moral obligation to

Give this away to give their wealth away in a productive in a productive way so I have several outside speakers and I tried to bring in people that are connected to the world and I positive I'm very trying to bring in inspirations

For you as outside speakers and there are people who are in finance but who are not selfish and they may be rich but there are good people so the first person that I'm going to bring in as I've done in previous years is David

Swensen who is head of the voice chief investment officer for Yale University Swensen also teaches a course economics 450 with Dean takahashi which you might want to take but I have I have him here just for

One lecture and what Swenson has done is turned the Yale endowment into a huge number he came to Yale in 1985 and at that time Yale had less than 1 billion dollars in its endowment Swenson is the most successful University endowment

Advisor of manager of the United States he turned less than 1 billion dollars into twenty two point nine billion dollars in 2008 the financial crisis hit and the endowment fell but as of June of 2010 it was still sixteen point seven

Billion so you know he has done so much to make Yale a success but it matters that that's a lot of money and it's all for a good cause now I say I believe Swenson is a good person I think he turned down opportunities to make much

More on Wall Street because he is known as and he's continually turning them down he's known as an investment genius he can command huge salaries and bonuses if he wanted to but he stays here with you I don't think that people in finance

Our money grubbers and this is an example of someone who is not the second speaker I have is Maurice Hank Greenberg who founded AIG it started out with in 1962 he's OK in 1962 he was made put in charge of North American operation

Operations of the American International Group an insurance company which was then failing the head of the company CV star put him in as to try to turn the country a company around it he turned it in over many years as CEO of AIG and

The biggest insurance company in the world and he ran it until 2005 the company have you heard of this AIG you must have heard of this in the recent financial crisis it has encountered some problems and in fact it was the biggest

Bailout of all it was bailed out by the US government and there's a scandal about that because the bailout was so huge it was in the hundreds of billions record-setting bailout and some people are angry with Greenberg but I think

That's completely unfair because it all happened after he left AIG and the problems were in a particular unit with energy that he was not really responsible for but Greenberg is a person who has I think a moral purpose

That I want to illustrate for you he's been criticized anyone who does business on that scale is going to be criticized for being too tough or too aggressive at times but he's he's he's very involved person he's he is the vice chairman for

The Council on Foreign Relations which is a think tank that thinks about the United States and its place in the world it's very important think tank he's also a major philanthropist and he's given to Yale notably he gave the Greenberg

Center which is part of the right next to the Center for globalization a beautiful new building so he has agreed to come I'm very pleased to have him the third outside speaker that I have now is Laura cha who is the although she won't

Be here in person we're going to have her image up on the screen because she is in Hong Kong and she is the non official member of the Executive Council of Hong Kong she's a member of the government of the People's Republic of

China at the vice-ministerial rank she's the first non Chinese delegate to the National People's Congress representing Hong Kong and has been vice-chair of the China Securities Regulatory Commission so she is very

Involved in finance she's also been affiliated with Yale and helped some of our initiatives so we're gonna have to get up very late at night I think to be on for 9:00 in the morning for us from Hong Kong I might get a one or two other

Speakers but that's where it stands right now so I wanted also to tell you about our teaching assistants we have four teaching assistants now we might get another but at this point the first is Oliver Bunn who is from Germany

University of Bonn and is a PhD student in economics he's also our head ta who coordinates coordinates the whole operation and then we have the second one is Elan fold from the United States and he's doing an interesting study of

The pizza delivery industry if it sounds funny but it's a interesting application of economic theory to very much the real world big at Caramon is from Bilkent University in Turkey and she's interested in behavioral finance that

Means I should have said this it's also an interest of this course I skipped by it in my notes behavioral finance is the application of psychology sociology and other social sciences to finance I know how I admitted mentioning that it's

About people and fire I didn't really completely omit mentioning it you've got the sense that I'm interested in people but there's been a revolution in finance over the last 20 years 20 years ago finance was thought of in academia as a

Essentially mathematical discipline that and nothing more well maybe I'm exaggerating a little bit but what's happened since then is people think of finance as involving psychology we have to bring

People with knowledge of human beings in and so her dissertation to topic is about has a major theme of it is how mutual funds operate mutual funds are companies that offer investment vehicles to the general public and she finds that

The mutual fund companies have complicated feasts Caggiula and they offer different choices to people and what sense does this mean why are these all these different choices you look at the fee schedules and you think it's

Just like in your telephone your cell phone plan right it's got different choices and you know which one I should take why are they doing all this well she tries to analyze what's going on and she finds that sometimes it seems

Like clients are steered toward a fee schedule that's really not in their interest and that the mutual fund managers are are doing some things that no maybe we don't want them to do if it's not ideal

That they're pushed by competitive pressures into offering products that are a little bit manipulative of people and her dissertation also brings up another theme which I thought I perhaps should have emphasized that all

Is not well in the financial world lots of bad things happen or not necessarily awful things but you know not socially conscious things and that's why we need regulators that's another reason why I brought in Laura Chou by

The way she's a regulator I wanted to have a voice from that side because I personally admire regulators and think that they have a very important function in our society so her work fits more into that regulatory side of of finance

And then finally our fourth teaching assistant is Finley from Beijing although he went to college at University College London and he has a broad interests including what leverage asset pricing and also

Behavioral finance so those are the teaching assistants so let me just give a brief outline of the cursor there are 20 lectures that I'm giving in in this course that this is the first and let me just go through what what's the content

Of these lectures maybe so lecture two that would be on Wednesday of this week I want to talk about the core concept of risk and also about financial crises the one reason why I wanted to update this course with open Yale this year is

Because I wanted to talk about the financial crisis that we've been through so I thought this lecture would start with something about the theory of probability but I'm not going to get into that very much that will be more

For a TA section that will come in later but even so this is not a probability course I just want to kind of remind you of concepts of probability and there's a concept of independent risks if risks are independent you can diversify away

Them and you can put together a portfolio that minimizes the risks the law of large numbers says if you have a lot of independent risks they'll average out if you have a large number of these different risks in your portfolio and

There's no risk left that's if they're independent but in fact risks are not as independent as you think and that's one reason why we had a financial crisis so a lot of people were making plans based on portfolio theory in finance but the

Plans assumed that there won't be a crisis that maybe one of our investments will go bad but they can't all go bad or large number of them can't go bad so that was a failure of the independence assumption in in finance that failure

Created the financial crisis that we've been through it was a near-miss onto another Great Depression the the financial crisis that began in 1929 I'll talk about that briefly in that lecture started with a stock market crash of

1929 and it the economy spiraled down until 1933 it just kept getting worse and worse more and more bankruptcies more and more layoffs so by 1933 25 percent of the US population was unemployed and it wasn't

Just the us it was all over the world it was a horrible crisis and we didn't get over that crisis until World War Two it's like we couldn't get out of it the crisis got so bad that nobody in the world could figure out what to do and I

Think that part of the reason we had World War two was because of the anxieties and animosities caused by this massive unemployment but we got out of it because World War two created a huge stimulus program I mean they drafted all

The unemployed made them fight what an awful outcome but that's what happened it's terrible and so this time we saw the beginnings of a similar crisis we saw crashes in the stock market and the real estate market we saw

Bankruptcies appearing we saw runs on banks and this time the government decided on a controversial bailout package and so Ben Bernanke and Mervyn King and other central bankers and government policymakers around the world

Had the idea that we can't let it happen the same way this time so there was massive bailouts controversial bailouts because they seemed to be unfair to many people that's a huge and interesting story I've written three books by the

About this crisis well some of them with two of them with co-authors so it's something that that fascinates me but I don't want to dwell on it too much in this course because I'm hopeful that it it will heal itself and we can put it

Behind us and the financial crisis doesn't call into question the basic principles of finance not in my mind the the vulnerability to a trash that we see in financial markets is like the same thing as the vulnerability to crash of

Airplanes airplanes crash from time to time you must know that when you get on one but that doesn't mean we shouldn't have airplanes and I think it's the finance financial system is advancing the world in such with such speed and

Such impressiveness that this crisis is just a blip on the screen of that that not something I think we should worry too much about the third lecture is about technology and invention in finance finance is a technology just

Like engineering our mechanical engineering it has principles it has techniques and it involves inventing of details that is financial institutions are complicated they're complicated the same way automobiles or

Airplanes or nuclear power reactors are you can see this complexity if you read some of the documents that are associated with the modern corporation there's a lot there and a lot of and the way the cash flows are divided up among

Different people involving options and derivatives are and other complicated financial instruments are part of the technology and this technology is advancing and it will advance a lot over the time of your career I don't have an

Ability to predict the future with any accuracy but I want to try to think about what we can say about the future I wrote a book in 2003 called new financial order and it was my take on the future but the problem is nobody

Really knows the future very well and it's impossible to you kind of have to just invent it or dream about what it might be like that's what I did I kind of thought about principles of financial theory and where they might go with the

Advance of information technology and the globalization of the world so I have a just a chapter from that for that section of the course then lecture 4 is about portfolio diversification how risks are spread and we'll talk briefly

About the capital asset pricing model now again the capital asset pricing model is a mathematical theory of diversification a very important theory and it's something that John John our capitalist will cover it with more rigor

In econ 251 that I already mentioned but for me I I will talk briefly about the capital asset pricing model and our teaching assistant will give a section on it but I want to also think about since this is of course about the real

World I want to think about financial institutions and so many of our institutions are offering diversification one way or another and so again I wanted to talk about the real-world component of this the fifth

Lecture is about insurance and the insurance industry developed over the centuries goes actually all the way back to ancient Rome but only minimally people didn't have the concepts until the 1600s when probability theory was

Invented there was an intuitive concept but sure I could start an insurance company I could put together a lot of insurance policies and charge for them and probably I won't you know some intuitive sense of about in law of large

Numbers or independence of risk probably I'll be ok and I can make good on the policies I wrote but it was never clear until probability theory was developed since then it's been growing and it's becoming a bigger and bigger part of our

And I think that insurance is actually a lifesaver I give you one example you know that in the earthquake in Haiti what was that was about a year ago the there was a tremendous loss of life but the earthquake in San Francisco decades

Earlier was of the same magnitude and had very little loss of life also the loss of suffered by people in terms of destruction of their homes in their office buildings was vastly higher in Haiti well it turns out that Haiti a

Less developed country didn't have much of the modern insurance industry so that people were uninsured against risk of collapse of their structure and you didn't have insurance industries going in and policing building codes if the

Insurance company is what is liable to the risk then they go in and say we won't insure you unless you fix this since it didn't happen so many people died I think that Haiti will come along there is already a Caribbean insurance

Initiative that was starting we want to see the developing world get these institutions I want to try to give a sense of the reality of that that we tend to think of Haiti as an opportunity for our charity and a lot of us gave

Money to help these people but you know charity doesn't work on a big enough scale you know going around the people on the street and asking them to give money to help the Haitian earthquake victims it doesn't amount to a lot what

Really becomes big and important is the insurance industry which is doing the same thing as a business model and that's the real world and it matters enormous Lee the sixth lecture is about efficient markets this is about a theory

That developed in the 1960s that financial markets are wonderfully perfect I'm saying I'm a little bit skeptical of this theory of I think it has an element of truth efficient markets theory is the idea

That you really can't make money by trading in financial markets because the markets are so competitive that the price is always pushed to an optimal level that incorporates all information that anyone could ever have about the

Security and the theory has been that it's hopeless to try to invest and beat the market well I think there's an element of truth to that but it's not quite true and people like David Swensen are counter examples that it is possible

For professional money managers to beat the market and that's that's something I want to think about and talk about in that lecture lecture 7 is about debt markets and it's about we we have a lot of money that's lent the Federal Reserve

Manages these markets that tries to tries to coordinate the markets through open market operations and through but now it's called quantitative easing but the markets are huge and international they involve errors that people make a

Lot of people get overly indebted and make mistakes with over their lives but they also offer opportunities that debt markets are fundamental to things we want to do in our lives for example when you are a little bit older many of you

Will want to buy a house right but you won't be in that point in the life cycle when you have the money to buy a house most of you so you would be borrowing it's elementary you take out a mortgage that seems obvious but still today in

Many countries of the world the mortgage market is not very developed and you can't do that so there's a good side to borrowing as well as a bad side I want to put it in in perspective again our review session will talk a little bit of

Some what with our teaching assistant about the mathematics of debt lecture eight will be about the stock market again I think of the stock market not has something that we're going to beat I think it's something that that is an

Invention to motivate people to get people working together so the basic idea of a stock investment you and your friends want to set up a company okay how do you do that well the company needs money to start so somebody's got

To contribute capital well if some of you has more money to contribute than others so you should have a bigger share in the company some of you have no money at all to contribute but you're going to contribute your time and energy so you

Want to give a share in the company to these other people as well in order to incentivize them so you devise a whole scheme to set up a company that involves the creation of stock and then you start trading the stock and then it gets all

The more interesting and then there are options on these stock certificates but it's all for a purpose the purpose is to make some Enterprise happen and it really is important that we have these institutions if you don't have them your

Little group trying to do something is going to fall apart someone's going to get angry and leave it's just not going to work and so I think the stock market is doing these functions now I know Karl Marx said he thought it was a big casino

But we're not communists here this is about modern finance lecture 9 is about real estate and another fascination for me I've been working for years about real estate and in fact I have my own with my colleague Karl case we have our

Own home price indices called the Standard & Poor case-shiller home price indices we'll talk about those but it's really important for this crisis that we've just seen because the financial crisis was caused substantially by a

Bubble in home prices a psychologically in this excitement or euphoria about home prices in the United States and in other countries that collapse around 2006 these bubbles are restarting in other parts of the world right more

Recently and they are the the real estate market is getting very speculative and psychological I believe and the outlook right now for the economy hinges on how these markets behave so that that

Will be a that will be I think an important lecture for this course lecture ten is about behavioral finance it's about psychology and finance I talked about that it's another long-standing interest of mine to try to

Incorporate psychology into our theory so lecture 12 is about banking multiple expansion of credit money multiplier and bank regulation which is something that is fascinating topic because we almost lost our banking system we had to bail

Them out massively we have international Accords now notably a new one just came out called Basel three from Basel which is the city in Switzerland and it was endorsed by the g20 countries at their Korean meeting and Seoul so we're seeing

A change in bank regulation that well we hope prevent another crisis like the one we just went through lecture 13 is about forwards and futures market futures markets well forward markets our markets are for contracts that deliver in the

Future over-the-counter contracts they're called that had done one-on-one between parties with their with the help of an investment bank or futures contracts which are traded on organized organized futures exchange like the

Chicago Mercantile Exchange I have some involvement with this because we worked with the Chicago Mercantile Exchange to create a futures market for single-family homes using the SP Case Shiller index so I'm involved in this

And we have that market functioning at a rather low level but it is functioning and seems to be growing lately look hopeful for that market lecture 14 is about options market these are most typically stock options

Which are contracts that allow you to purchase a share of a stock or the seller share at a pre-specified price these are traded on options exchanges they have a price that goes up and down this is an example of a derivative

Contract that injects a lot of complexity in the financial Theory lecture 16 15 is about monetary policy it's about the central banks of the world for example our central bank called the Federal Reserve in the United

States and it's about what they do and how they help prevent crises like the one we've just seen they did help prevent it I think they saved off disaster lecture 16 is about Investment Banking I know this is of great interest

Because we place a lot of students in good jobs in investment banking companies like Goldman Sachs has most talked about one these help investment bankers help companies raise capital issues securities retire securities and

We want to talk about how they're regulated and I didn't mention dodd-frank by the way but we have a new bill that just passed in July in the United States that changes the regulatory structure for investment

Banks and a whole array of financial institutions and I want to talk about that it's there are other in other countries the European Union the European Parliament has created a number of new laws and organizations that

Somewhat resemble dodd-frank and other countries have also done financial regulation reform that affects investment banking and other aspects of Finance it's extremely complicated and I but I don't want to give you too many

Details but I want to give you some sense of the revolution that we're seeing lecture 17 is about professional money managers like David Swensen people who manage portfolios you don't have to be a billionaire to manage a

Billion-dollar portfolio in fact some of you may be doing it sooner than you realize if you get the right kind of managing the portfolio means managing the risks putting them in the right places and and also you know you think

Of institutional investors big money managers as just trying to make money but when you get into that field you realize that you are deciding on you have power as an institutional investor you can go to when you own a big share

Of some company you can go to the board meeting and talk to these people and you or the stockholders meeting and you'll get heard if you will 10% of the shares of a company then you suddenly realize that you are a steward of the public

Interest and I think institutional investors are recognizing that more and more lecture 18 is about exchanges brokers dealers clearing houses like the New York Stock Exchange or the London Stock Exchange

They are proliferating around the world whereas there were just a few thirty years ago now almost every country has a Stock Exchange and a complicated list of exchanges they're increasingly electronic they have interesting new

Features like microsecond trading that's going on computer is trading with other computers we'll talk about where this is going lecture 19 is about public and nonprofit finance so I think this is very

Important nonprofit finance would include organizations like Yale University or churches and charities and other things like that but I'm also including in this lecture of public finance and that means government's

Financing projects so for example you take it for granted that our city here in New Haven has roads it has schools it has sewers it has water all this kind of comes without your even asking but all of these things

Had to be financed and the city of New Haven like other cities is issuing debt and it's a complicated business I want to get you into some of the details because it matters because this is how you make things happen you can go to

Your city government and you can propose that they issue revenue bonds to start some new product you would know that's what I want you to do is know how these things are done so that it's not just imagination you can make

You can make it happen and also nonprofits I want you to understand that you can set up your own nonprofit and there's a lot of advantages to doing that that's an organization that has a

Financial structure but no shareholders nobody takes home the money it all goes to some cause and finally my last lecture lecture 20 I'm calling it finding your purpose in finance I just want to come back in the last lecture to

The idea that this is a course about not about making money I don't want you to give a billion dollars to your children and grandchildren which they will then squander in conspicuous consumption the idea is a is a moral purpose and that's

One thing I wanted to try to convey partly with outside speakers maybe with other examples that I can give that I think that many people who are wealthy and who have succeeded in finance really don't care about spending the money on

Themselves they really do have a purpose and even if that's not true of many of them there's an interesting book by Robert Frank I don't have it on the reading list called riches Stan who talks about what wealthy people are like

These days and if you read his book sometimes they are disgustingly rich and spending the money on silly things but there is a there is an idea among many of them that they are going to do their good things for the world and I think

That's what I that's because I think many of you will do these things I want to think about the purpose that you'll find in in in in finance so that that's just the closing thought I'll leave you I'll see you again on Wednesday but the

Closing thought is that this is about making your purposes happen

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