WEBVTT 00:00.380 --> 00:07.220 Professor Robert Shiller: This is Economics 252, 00:07.223 --> 00:12.423 Financial Markets, and I'm Bob Shiller. 00:12.420 --> 00:18.120 Let me begin by introducing the teaching fellows for this 00:18.123 --> 00:22.323 course; and so I have them up here. 00:22.320 --> 00:30.100 We have five teaching fellows at this time and they're from 00:30.103 --> 00:33.793 all over. I like to put their pictures up 00:33.786 --> 00:35.846 so you'll know who they are. 00:35.850 --> 00:40.580 The teaching fellows are very international and that reflects 00:40.582 --> 00:44.602 my intention to make this a course that is also very 00:44.604 --> 00:49.574 international because finance is something about the whole world 00:49.573 --> 00:52.503 today, not just the United States. 00:52.500 --> 00:56.220 So we cover the world very well with our T.A.'s. 00:56.220 --> 01:02.110 Usman Ali is from Pakistan, Lahore, and he graduated from 01:02.112 --> 01:07.692 the LUMS, Lahore University of Management Sciences. 01:07.689 --> 01:12.079 He's a PhD candidate now in Economics and he's doing his 01:12.076 --> 01:16.776 doctoral dissertation on stock analysts' recommendations and 01:16.781 --> 01:20.611 the relation to returns in the stock market. 01:20.610 --> 01:23.510 He's also interested in behavioral finance, 01:23.509 --> 01:27.099 which is the application of psychology to finance. 01:27.099 --> 01:30.239 The second teaching assistant--I see him right 01:30.240 --> 01:34.010 there, if you could raise your hand--Santosh Anagol, 01:34.010 --> 01:38.140 who is a representative of the United States, 01:38.135 --> 01:43.475 although he seems to have connections to India as well. 01:43.480 --> 01:48.120 He actually has a publication already in the American Economic 01:48.124 --> 01:51.554 Review on the Return to Capital with Ghana. 01:51.550 --> 01:55.830 He did this jointly with the Chairman of the Economics 01:55.826 --> 01:59.296 Department here, Chris Udry and he has spent 01:59.295 --> 02:03.405 time in India looking at the village economies. 02:03.409 --> 02:06.979 You were going to be giving away cows, did you do that? 02:06.980 --> 02:09.290 Student: No, I'm still working on cows but 02:09.292 --> 02:10.692 we're not giving them away. 02:10.689 --> 02:12.029 Professor Robert Shiller: Okay, 02:12.030 --> 02:14.240 that's the last time you'll hear about cows in this course. 02:14.240 --> 02:17.650 The idea was to give cows away to village farmers and to 02:17.647 --> 02:19.007 observe the outcome. 02:19.009 --> 02:22.589 It's a big change in some of these very poor villages to get 02:22.594 --> 02:25.724 a cow. Christian Awuku-Budu is from 02:25.715 --> 02:28.255 Ghana, Accra, but he, again, 02:28.257 --> 02:33.997 went to college in the United States at Morehouse College. 02:34.000 --> 02:39.460 He is also a PhD candidate in Economics at Yale and he's been 02:39.459 --> 02:45.099 doing research on financial markets in developing countries. 02:45.100 --> 02:51.580 Yaxin Duan is from China. 02:51.580 --> 02:55.970 She got her undergraduate degree from Nanjing University. 02:55.970 --> 02:57.870 No? You are from Nanjing, 02:57.873 --> 02:59.143 did I get a detail wrong? 02:59.140 --> 03:00.720 Where did you go to college? 03:00.720 --> 03:09.320 Okay, well I'm sorry about that. 03:09.319 --> 03:13.789 She is also a PhD candidate in Economics and is doing research 03:13.786 --> 03:17.806 on the behavior of options prices in a phenomenon called 03:17.812 --> 03:22.632 the "options smile," as she's smiling at me right 03:22.633 --> 03:24.883 now. She is also interested in 03:24.883 --> 03:28.093 behavioral finance, which is great to me because 03:28.085 --> 03:30.125 that's one of my interests. 03:30.129 --> 03:35.229 She is shown here standing precariously on a cliff. 03:35.229 --> 03:41.249 It makes me nervous to look at it overlooking Machu Picchu in 03:41.247 --> 03:43.957 Peru. She also loves astronomy, 03:43.964 --> 03:47.594 which is incidentally an interest of mine too, 03:47.590 --> 03:51.780 but you won't hear about it again in this course. 03:51.780 --> 03:58.450 Finally, Xiaolan Zhou is our fifth teaching assistant and 03:58.447 --> 04:03.207 she's also from China, Hubei Province. 04:03.210 --> 04:07.310 She graduated from Wuhan University and is a PhD 04:07.310 --> 04:10.190 candidate in Economics at Yale. 04:10.189 --> 04:13.619 She is doing research on bank mergers. 04:13.620 --> 04:18.790 04:18.790 --> 04:25.930 Let me say, I've been teaching this course now for over twenty 04:25.929 --> 04:31.429 years and I'm very proud of all of my alumni. 04:31.430 --> 04:34.920 Many of them are in the field of finance. 04:34.920 --> 04:38.770 In fact, I like sometimes when I give--I give a lot of public 04:38.767 --> 04:40.887 talks. When I give a talk on Wall 04:40.890 --> 04:44.610 Street or even somewhere else in the world I sometimes ask my 04:44.606 --> 04:46.956 audience, "Did you take my course?" 04:46.959 --> 04:50.809 It's not infrequent that I'll get one or even two people 04:50.814 --> 04:54.884 raising their hand that they took Economics 252 from me. 04:54.879 --> 05:00.509 But I'm also proud of my alumni in this course who are not in 05:00.511 --> 05:02.671 the world of finance. 05:02.670 --> 05:07.990 I think this course goes beyond--It's not just for people 05:07.985 --> 05:13.205 who are planning careers in finance because finance is a 05:13.205 --> 05:18.515 very important technology and it's very important to know 05:18.520 --> 05:24.120 finance to understand what happens in the real world. 05:24.120 --> 05:28.960 Just about any human endeavor involves finance. 05:28.959 --> 05:31.659 Now, you might say, "I could be a poet and what 05:31.659 --> 05:33.829 does that have to do with finance?" 05:33.829 --> 05:36.969 Well, it probably ends up having something to do with 05:36.968 --> 05:40.468 finance because as a poet you probably want to publish your 05:40.469 --> 05:43.849 poetry and you're going to be talking to publishers. 05:43.850 --> 05:46.500 Before you know it, they're going to be talking 05:46.499 --> 05:49.839 about their financial situation and how you fit into it. 05:49.839 --> 05:52.939 I believe it's fundamental and very important. 05:52.940 --> 05:58.180 I think you will find this course as not a vocational 05:58.177 --> 06:03.007 course--not primarily a vocational course--but an 06:03.011 --> 06:08.351 intellectual course about how things really work. 06:08.350 --> 06:11.690 I see finance as the underpinning of so much that 06:11.685 --> 06:14.085 happens. It's a powerful force that goes 06:14.088 --> 06:17.118 behind the scene and I hope we can draw that out in this 06:17.118 --> 06:19.808 course. There is another course--we 06:19.805 --> 06:24.075 have two basic courses in finance for undergraduates at 06:24.077 --> 06:28.467 Yale. The other one is Economics 251, 06:28.474 --> 06:32.224 Financial Theory; this is Financial Markets, 06:32.220 --> 06:34.020 that one is Financial Theory. 06:34.019 --> 06:37.799 Last year it was taught by Rafael Romeu, 06:37.803 --> 06:42.073 because John, Geanakoplos who usually teaches 06:42.071 --> 06:48.281 the course, was on leave and so we had to find someone else. 06:48.279 --> 06:54.589 I assume that next fall John Geanakoplos will be teaching 251 06:54.588 --> 06:56.318 again. So what happened? 06:56.319 --> 06:58.119 Why do we have these two courses? 06:58.120 --> 07:03.610 Well it was something like eight years ago that we reached 07:03.610 --> 07:08.330 the present situation with two finance courses. 07:08.329 --> 07:12.429 John Geanakoplos and I had a meeting and we tried to divide 07:12.432 --> 07:16.112 up the subject matter of finance into two courses. 07:16.110 --> 07:19.620 We thought Financial Theory and Financial Markets would be the 07:19.615 --> 07:22.985 two. But the problem was that both 07:22.988 --> 07:29.148 John and I are interested in both theory and applications. 07:29.149 --> 07:33.749 John Geanakoplos is actually Chief Economist for a large 07:33.752 --> 07:38.022 investment called Ellington Capital in Greenwich, 07:38.019 --> 07:39.959 Connecticut, which you'll see a lot in the 07:39.958 --> 07:41.608 news. It has been very successful. 07:41.610 --> 07:47.120 He is very much interested in the real world and I am 07:47.122 --> 07:52.762 interested in financial theory, so we find it--we decided, 07:52.764 --> 07:57.144 after talking about it, that we really can't divide up 07:57.136 --> 08:02.086 the subject matter of finance into separate courses on theory 08:02.085 --> 08:06.315 and practice. If you tried to do one alone it 08:06.322 --> 08:10.232 would not work, so we decided to divide it up 08:10.228 --> 08:15.468 imperfectly and there may be some repetition between our two 08:15.465 --> 08:19.995 courses. Both of them are self-contained 08:20.002 --> 08:24.802 courses, so you could take either 251 or 252, 08:24.803 --> 08:27.643 or you could take both. 08:27.639 --> 08:31.299 I think maybe the best option is to take both if you're really 08:31.300 --> 08:33.400 interested in the subject matter. 08:33.400 --> 08:38.010 08:38.009 --> 08:43.259 It is true though that his course is more tuned into 08:43.259 --> 08:46.449 theoretical detail than mine. 08:46.450 --> 08:51.390 John is a mathematical economist and we both love 08:51.393 --> 08:57.473 mathematics, but maybe John is going to do more of it than I 08:57.469 --> 09:01.149 am. This course actually will not 09:01.148 --> 09:04.718 use a heavy amount of mathematics. 09:04.720 --> 09:12.630 I try to keep it so that people who are not comfortable with a 09:12.632 --> 09:20.682 lot of math can take this course and I wanted to emphasize that 09:20.675 --> 09:28.715 this is--I've said that it's--I think this course is vocational 09:28.718 --> 09:32.478 preparation in a sense. 09:32.480 --> 09:36.350 I pride myself on the fact that people who have taken this 09:36.352 --> 09:39.752 course find it useful in their subsequent lives, 09:39.750 --> 09:44.420 but on the other hand, I think that it's really 09:44.418 --> 09:47.548 interesting. At least I find it really 09:47.547 --> 09:50.617 interesting and so I hope that you will too. 09:50.620 --> 09:52.890 Now I don't know, I may be different than other 09:52.885 --> 09:55.935 people, but I think organic chemistry is really interesting. 09:55.940 --> 09:58.310 How many of you have that feeling? 09:58.309 --> 10:02.619 Can I get a show of hands, who is interested in organic 10:02.621 --> 10:06.151 chemistry? I'm not getting a lot of hands 10:06.145 --> 10:07.985 raised. Unfortunately, 10:07.988 --> 10:12.868 I've never taken a course in it, but I've started reading it 10:12.872 --> 10:17.262 lately out of just my broad intellectual interest. 10:17.259 --> 10:20.199 That is a course that has a bad reputation, doesn't it? 10:20.200 --> 10:23.930 Because people say I've got to take that if I want to be 10:23.931 --> 10:26.021 pre-med. But, you know, 10:26.022 --> 10:31.272 to me there's a lot of detail in organic chemistry. 10:31.269 --> 10:35.559 To me, when you read the detail you're getting into something 10:35.557 --> 10:40.057 deep and important about the way everything works and so I start 10:40.060 --> 10:41.990 to find it interesting. 10:41.990 --> 10:45.170 So I don't know how people feel about taking--maybe I'm turning 10:45.170 --> 10:48.300 you off by saying this--There's going to be a lot of detail in 10:48.299 --> 10:51.129 this course. Maybe I made a big mistake by 10:51.133 --> 10:54.953 likening it to an organic chemistry course--I don't mean 10:54.951 --> 10:58.661 to turn you off. The idea in this course is that 10:58.659 --> 11:03.279 by being a financial markets course, you have to know how the 11:03.283 --> 11:06.153 world works. We're going to be thinking 11:06.145 --> 11:09.155 about that in connection with Financial Theory, 11:09.162 --> 11:11.722 but we have to get into the details; 11:11.720 --> 11:18.740 so we are going to be learning about facts. 11:18.740 --> 11:22.260 11:22.259 --> 11:27.419 Let me start by talking about the textbook. 11:27.419 --> 11:35.489 So the principal textbook is Frank Fabozzi, 11:35.487 --> 11:42.207 the other authors are Modigliani, 11:42.210 --> 11:47.010 Jones and Ferri, Foundations of Financial 11:47.009 --> 11:50.469 Markets and Institutions. 11:50.470 --> 11:57.210 This textbook is very detailed and it may be--I've had some 11:57.210 --> 12:03.370 reaction by students--more than you wanted to know. 12:03.370 --> 12:07.740 12:07.740 --> 12:10.470 I actually had a great experience reading it. 12:10.470 --> 12:13.680 Actually, it was an earlier edition, when I first assigned 12:13.675 --> 12:17.045 this book in the year 2000, I took it with me on vacation. 12:17.049 --> 12:20.479 I was going to the Bahamas with my family and with Jeremy 12:20.480 --> 12:24.400 Siegel's family--we'll come back to Jeremy Siegel in a minute. 12:24.399 --> 12:28.759 I sat down by the pool with this book. 12:28.759 --> 12:32.359 Other people were reading novels and I don't know what 12:32.360 --> 12:34.670 else, but I was reading Fabozzi. 12:34.669 --> 12:39.419 I had such a great time with it, so I'm telling you my 12:39.415 --> 12:41.875 experience. Maybe it was because it was 12:41.884 --> 12:44.304 filling in gaps in my knowledge--things I've always 12:44.299 --> 12:46.569 wanted to know and was always curious about. 12:46.570 --> 12:50.430 That's partly what you have to develop when you get interested 12:50.431 --> 12:54.231 in a field: some sense of curiosity about all the details. 12:54.230 --> 12:59.430 So I read the whole book, 650 pages, maybe I kind of read 12:59.431 --> 13:02.591 fast because I knew a lot of it. 13:02.590 --> 13:05.940 It might take you a little longer to get through it, 13:05.941 --> 13:09.031 but I wanted you to have the same experience. 13:09.029 --> 13:13.829 I've been assigning this book, now it's in another edition 13:13.825 --> 13:18.115 and--Fabozzi is working on a fourth or next edition, 13:18.116 --> 13:20.216 I forget what number. 13:20.220 --> 13:24.670 I've been assigning--I've gotten some complaints from 13:24.668 --> 13:29.888 students that this book is tough going because there's so much 13:29.887 --> 13:31.767 information in it. 13:31.769 --> 13:34.129 I used to tell people, " I'm assigning the whole book 13:34.133 --> 13:36.273 and you have to know everything in the book." 13:36.270 --> 13:39.400 13:39.400 --> 13:40.580 That's a little ambitious. 13:40.580 --> 13:44.390 I finally backed down because I met a man on Wall Street, 13:44.392 --> 13:46.982 a very prominent Wall Street person, 13:46.980 --> 13:49.290 and he said, "You know, my son started to 13:49.293 --> 13:50.453 take your course." 13:50.450 --> 13:54.180 I said, "What do you mean started the course?" 13:54.179 --> 13:57.119 He said, "Well, he dropped out when he saw this 13:57.117 --> 13:58.967 book and the requirements." 13:58.970 --> 14:00.430 I didn't like that. 14:00.429 --> 14:02.089 I don't want students to drop out. 14:02.090 --> 14:07.070 So what I decided is that you need to know the whole book in 14:07.070 --> 14:12.050 the sense that you need to know all of the key terms and key 14:12.051 --> 14:14.181 points. Now if you look at the 14:14.179 --> 14:16.959 structure of this book, it has sections that say Key 14:16.961 --> 14:18.271 Points and Key Terms. 14:18.269 --> 14:24.029 Anything that's mentioned there is fair game for me in an exam 14:24.029 --> 14:27.239 and that's the way I've done it. 14:27.240 --> 14:29.470 There are key points and key terms. 14:29.470 --> 14:35.200 Also, anything in my lecture is of course fair game for the 14:35.198 --> 14:38.108 exam. Let me also add that I have a 14:38.106 --> 14:42.616 reading list that has clickable things on it and also things 14:42.615 --> 14:45.515 that are on reserve in the library. 14:45.519 --> 14:48.409 Anything that's clickable is required reading. 14:48.409 --> 14:51.999 I don't expect you go to the library, however, 14:52.003 --> 14:56.323 because I think that we're moving into an age where you 14:56.315 --> 14:59.265 tend to want to be online, right? 14:59.269 --> 15:04.839 So the library books are all optional background. 15:04.840 --> 15:10.460 Fabozzi, a faculty member here at Yale, has offered to give 15:10.460 --> 15:16.660 me--we have at least one chapter from the new edition that hasn't 15:16.662 --> 15:20.702 come out yet. I'm going to put that on 15:20.700 --> 15:25.040 reserve in the library; but again, I think that the 15:25.040 --> 15:28.800 edition that you have is reasonably up to date and so 15:28.798 --> 15:32.048 that's all that I'm expecting you to read. 15:32.049 --> 15:36.879 The other author, Franco Modigliani--in the book, 15:36.881 --> 15:41.211 the second author--was my teacher at MIT. 15:41.210 --> 15:46.810 He died in 2003. He is also a Nobel Prize winner 15:46.813 --> 15:50.253 and I think has a remarkable intellect. 15:50.250 --> 15:53.830 So this book, Fabozzi, et al.--Fabozzi, 15:53.826 --> 15:58.906 Modigliani, Jones and Ferri--is a very solid book about 15:58.909 --> 16:00.979 financial markets. 16:00.980 --> 16:08.310 The second book that I'm assigning is Jeremy Siegel, 16:08.308 --> 16:13.048 Stocks for the Long Run. 16:13.050 --> 16:17.050 16:17.050 --> 16:19.060 This is an old friend of mine. 16:19.060 --> 16:20.860 I met him in graduate school. 16:20.860 --> 16:24.060 Funny story, I met him because at MIT they 16:24.055 --> 16:28.335 signed us all up for chest x-rays alphabetically--that's 16:28.341 --> 16:31.771 the way MIT does things, an orderly way. 16:31.769 --> 16:35.469 Shiller and Siegel are next to each other in the alphabet, 16:35.467 --> 16:39.487 so I was standing in line with him for an x-ray and was talking 16:39.490 --> 16:42.280 with him and I've known him ever since. 16:42.279 --> 16:46.179 A funny coincidence is that since our names are close in the 16:46.177 --> 16:49.547 alphabet--you often find our books right together in 16:49.547 --> 16:53.307 bookstores because Shiller and Siegel--if they're shelving 16:53.313 --> 16:56.223 alphabetically--would end up together. 16:56.220 --> 16:59.940 He wrote a book called Stocks for the Long Run, 16:59.937 --> 17:01.267 starting in 1993. 17:01.269 --> 17:07.199 It just came out with the fourth edition and that book was 17:07.204 --> 17:10.244 a best seller. I think it sold over a half 17:10.238 --> 17:13.478 million copies. I'm not sure where it is now 17:13.478 --> 17:15.818 but it has done very well. 17:15.820 --> 17:17.390 It's been a perennial classic. 17:17.390 --> 17:24.050 It emphasizes the long run performance of the stock market, 17:24.049 --> 17:30.709 but it's really a general treatise of financial markets. 17:30.710 --> 17:35.760 I get a very good reaction from students about this book. 17:35.760 --> 17:37.540 This one is very readable. 17:37.539 --> 17:41.119 It's not as intense as Fabozzi, et al. 17:41.119 --> 17:45.019 Jeremy Siegel holds the unique distinction--Business 17:45.021 --> 17:49.791 Week did a poll asking MBA's about their favorite professor. 17:49.790 --> 17:51.620 This was about ten years ago. 17:51.619 --> 17:54.949 They ranked business school professors according to their 17:54.947 --> 17:57.477 popularity. He came out number one in the 17:57.475 --> 18:00.135 United States as business school professor. 18:00.140 --> 18:02.840 I think you'll like this book. 18:02.839 --> 18:06.929 The next book is my own and called Irrational 18:06.930 --> 18:08.410 Exuberance. 18:08.410 --> 18:14.540 This is the last book--That's a phrase that was coined by Allen 18:14.538 --> 18:20.668 Greenspan in 1996 and it refers to the stock market boom of the 18:20.666 --> 18:26.886 2000s--of the 1990s and the boom and the bust--well I think it's 18:26.893 --> 18:31.443 related to the bust that came out later, 18:31.440 --> 18:35.430 after 2000. I wrote this book in 2000 right 18:35.430 --> 18:40.990 at the peak of--fortunately right at the peak of the stock 18:40.985 --> 18:43.845 market. But what I'm assigning to you 18:43.853 --> 18:46.793 is the second edition, which came out in 2005, 18:46.791 --> 18:49.991 pretty much at the peak of the housing market. 18:49.990 --> 18:55.510 We're going to talk about both the housing market and the stock 18:55.511 --> 18:58.541 market in these different books. 18:58.539 --> 19:02.419 These books are all on sale at Labyrinth Books, 19:02.417 --> 19:06.967 which is an independent bookstore here in New Haven. 19:06.970 --> 19:11.110 I put it there because, well, I think the major chain 19:11.108 --> 19:15.718 bookstores fulfill an important function but I also like to 19:15.724 --> 19:18.514 support independent bookstores. 19:18.509 --> 19:21.719 I don't know if you know the story, but Labyrinth Books is 19:21.718 --> 19:25.138 independent, it's not a chain, and independent bookstores are 19:25.136 --> 19:27.126 trying–struggling--to survive. 19:27.130 --> 19:29.500 This is finance. In the book business, 19:29.504 --> 19:33.704 there's something difficult about maintaining an independent 19:33.704 --> 19:36.484 operation. Labyrinth was at Columbia 19:36.477 --> 19:38.027 University and Yale. 19:38.029 --> 19:42.179 For some reason they shut down their Columbia bookstore, 19:42.183 --> 19:45.283 but they've opened up now in Princeton. 19:45.279 --> 19:48.459 There was this famous bookstore in Princeton on Nassau Street 19:48.456 --> 19:51.206 called Micawber's, which is a wonderful bookstore. 19:51.210 --> 19:53.550 I've been in there a number of times. 19:53.549 --> 19:55.159 But they just went out of business. 19:55.160 --> 19:58.230 Labyrinth has moved in to take their place. 19:58.230 --> 20:06.890 Anyway, that's where all the books are and they are available 20:06.893 --> 20:07.763 now. 20:07.760 --> 20:19.600 20:19.599 --> 20:21.589 We're going to have these lectures on Mondays and 20:21.590 --> 20:23.390 Wednesdays. We're going to have T.A. 20:23.390 --> 20:26.250 sections in the second part of the week. 20:26.250 --> 20:30.120 We're going to ask you to look at your schedule sometime before 20:30.117 --> 20:34.047 our next lecture and think about when you can come to a teaching 20:34.047 --> 20:35.417 assistant section. 20:35.420 --> 20:39.050 They will be Wednesday, Thursday, and Friday and we 20:39.048 --> 20:40.788 have six problem sets. 20:40.789 --> 20:47.179 The six problem sets are due generally on Mondays and we'll 20:47.177 --> 20:52.567 go over the problem sets in the teaching sections, 20:52.574 --> 20:56.984 several days after you turn them in. 20:56.980 --> 21:00.050 This is one of the biggest classes at Yale, 21:00.045 --> 21:04.345 but I think we've got it so it will be a good and satisfying 21:04.351 --> 21:06.031 experience for you. 21:06.029 --> 21:10.319 We have very qualified--I'm very impressed with our teaching 21:10.323 --> 21:13.793 assistants. The important thing is for you 21:13.786 --> 21:18.396 to stay with them and get to know them and I urge you to 21:18.400 --> 21:20.750 attend the T.A. sections. 21:20.750 --> 21:22.600 The course is going to be graded. 21:22.599 --> 21:27.639 We have two mid-terms and one final. 21:27.640 --> 21:32.740 The in class mid-terms--the grades will be roughly 10% 21:32.736 --> 21:35.806 problem sets, 20% first mid-term, 21:35.814 --> 21:39.184 30% second mid-term, 40% final. 21:39.180 --> 21:43.540 But we will also use judgment and I'm going to appeal to the 21:43.541 --> 21:46.721 T.A.'s to help me on judging the grading. 21:46.720 --> 21:53.500 21:53.500 --> 21:56.550 Also, I ask the teaching assistants to give me little 21:56.551 --> 21:59.721 capsule descriptions of you so that if in ten years, 21:59.720 --> 22:03.030 or 20 years from now, I get a call from a reporter 22:03.031 --> 22:07.291 asking about this illustrious person who was once my student, 22:07.289 --> 22:10.119 I can have something to prod my memory. 22:10.119 --> 22:13.559 That's why I hope you'll stay with--you'll each find a 22:13.562 --> 22:16.942 teaching assistant and will stay with that person. 22:16.940 --> 22:21.320 22:21.319 --> 22:28.579 I want to say something about a particular interest of mine 22:28.579 --> 22:35.709 because it is part of this course, although not the entire 22:35.713 --> 22:39.643 course. Behavioral finance refers to a 22:39.635 --> 22:44.895 revolution in finance that has occurred over the last ten or 20 22:44.895 --> 22:49.045 years and that is incorporated--Behavioral finance 22:49.052 --> 22:54.062 is the theory of finance mixed in with the theories of other 22:54.058 --> 22:57.898 social sciences, notably psychology, 22:57.901 --> 23:02.681 sociology, political science, and anthropology. 23:02.680 --> 23:08.870 I think it's the most important revolution in finance of the 23:08.871 --> 23:11.181 last couple decades. 23:11.180 --> 23:14.220 Maybe I'm biased because I've been very much involved in it. 23:14.220 --> 23:18.430 I've been organizing workshops in behavioral finance at the 23:18.433 --> 23:22.573 National Bureau for Economic Research since 1991 with Dick 23:22.574 --> 23:25.484 Thaler at the University of Chicago. 23:25.480 --> 23:28.940 We think that we're avant-garde of a major revolution. 23:28.940 --> 23:34.000 The unity of the social sciences is, I think, 23:34.003 --> 23:37.853 very important. It's a mistake to try to 23:37.853 --> 23:40.303 consider finance in isolation. 23:40.299 --> 23:45.669 There is a whole array of other information related to finance. 23:45.670 --> 23:49.680 This will be a theme of my course and also a theme of this 23:49.678 --> 23:52.278 book, Irrational Exuberance. 23:52.279 --> 23:58.529 That's what exuberance refers to--it's a psychological term. 23:58.529 --> 24:05.159 So that's an important element of this course. 24:05.160 --> 24:10.960 Another thing that I will be talking about is less important 24:10.964 --> 24:15.004 to this course but you have heard of this: 24:14.998 --> 24:17.358 the subprime crisis. 24:17.359 --> 24:22.749 This is the big financial event that is hitting the United 24:22.754 --> 24:26.544 States and the entire world right now. 24:26.539 --> 24:30.599 I'm actually writing another book about this. 24:30.599 --> 24:35.129 It's not done in time for you to read but I think I will have 24:35.128 --> 24:38.448 it done at some time during this semester. 24:38.450 --> 24:41.170 What does it mean? 24:41.170 --> 24:48.780 "Subprime" refers to the mortgages that were made mostly 24:48.784 --> 24:56.264 over the last ten years or so to subprime borrowers. 24:56.259 --> 25:01.049 A "subprime borrower" is somebody who has a poor credit 25:01.050 --> 25:06.370 history or some other indication that would suggest that they 25:06.372 --> 25:12.052 might not be able to repay the mortgage--they might default. 25:12.049 --> 25:15.139 The industry, subprime lending, 25:15.144 --> 25:20.304 has grown dramatically over the last ten years and, 25:20.302 --> 25:25.462 as you probably know, it's in big trouble now. 25:25.460 --> 25:29.930 What's happening is the housing market is dropping, 25:29.932 --> 25:34.852 home prices are falling, people are defaulting in record 25:34.852 --> 25:38.432 numbers, and there are foreclosures. 25:38.430 --> 25:40.230 What happens if you don't pay your mortgage? 25:40.230 --> 25:43.580 If you buy a house and you don't pay the mortgage, 25:43.575 --> 25:47.805 the contract says you lose the house--you're out--you've got to 25:47.808 --> 25:51.288 pay or it goes back to the mortgage originator. 25:51.289 --> 25:57.319 This crisis is very interesting to me because it's had so many 25:57.316 --> 26:01.956 ramifications throughout the financial world. 26:01.960 --> 26:06.030 It's exposing defects in many of our biggest financial 26:06.027 --> 26:10.707 institutions and every day we see more news about failures, 26:10.710 --> 26:13.090 huge losses, resignations, 26:13.093 --> 26:16.433 or firings of top finance people. 26:16.430 --> 26:19.720 So it's a very interesting time in finance. 26:19.720 --> 26:25.380 These things happen from time to time, but they happen with 26:25.379 --> 26:30.939 enough regularity that there's something we really want to 26:30.941 --> 26:35.041 understand as a systematic phenomenon. 26:35.039 --> 26:38.109 So that's another thing that I will be talking about. 26:38.109 --> 26:42.119 Let me make another point about technology. 26:42.120 --> 26:46.950 26:46.950 --> 26:53.020 Finance, I believe, is a technology and that means 26:53.016 --> 26:56.726 it is a way of doing things. 26:56.730 --> 26:59.460 It has a lot of detail. 26:59.460 --> 27:07.450 A financial instrument is like an engineering device. 27:07.450 --> 27:11.410 Here I'm tying to the engineering--Is anyone here from 27:11.405 --> 27:13.385 engineering? A couple of you, 27:13.390 --> 27:16.800 well this could be--In fact, some engineering schools offer 27:16.799 --> 27:19.209 courses in finance, did you know that? 27:19.210 --> 27:23.360 Engineers find it congenial because they have a way of 27:23.360 --> 27:27.590 thinking constructively about the world that is kind of 27:27.590 --> 27:29.470 parallel to finance. 27:29.470 --> 27:37.910 We have theories--mathematical theories--that lead us to devise 27:37.909 --> 27:44.039 financial structures, which are complicated devices 27:44.042 --> 27:48.082 just like engines or nuclear reactors. 27:48.079 --> 27:51.539 They have a lot of components and they have to work right. 27:51.539 --> 27:55.579 When people first devise some new financial instrument it 27:55.578 --> 27:57.308 typically has trouble. 27:57.309 --> 28:00.709 Like when they devised the first engines or the first 28:00.709 --> 28:03.849 nuclear reactors, it didn't work so well at first 28:03.847 --> 28:07.897 and then from the experience of many people working on it, 28:07.900 --> 28:11.430 over many years, a body of knowledge emerges and 28:11.430 --> 28:13.910 that's what we call technology. 28:13.910 --> 28:18.430 So technology is a powerful force in our society and I 28:18.434 --> 28:20.914 respect power of this kind. 28:20.910 --> 28:23.270 That's why I like to follow it up. 28:23.269 --> 28:26.889 But technology is also dangerous. 28:26.890 --> 28:28.870 Nuclear power, for example, 28:28.869 --> 28:33.439 may be our salvation when we run out of oil--or virtually run 28:33.437 --> 28:37.777 out of oil--it seems to be coming up over the next several 28:37.777 --> 28:41.277 decades--we're going to have to do that, 28:41.279 --> 28:43.319 we're going to need nuclear power. 28:43.319 --> 28:45.849 But it's also dangerous, as you know. 28:45.849 --> 28:49.649 The same thing is true about finance. 28:49.650 --> 28:52.920 I think that, in a sense, the subprime crisis 28:52.920 --> 28:57.530 that we have is an example of the dangers of new technology. 28:57.529 --> 29:02.789 We have been seeing financial technology advance in recent 29:02.792 --> 29:08.242 years and this advancement of technology has brought us some 29:08.239 --> 29:11.189 problems. Some people want to go back, 29:11.187 --> 29:14.807 some people think there's a lot of anger about the subprime 29:14.808 --> 29:18.548 prices and there's some anger expressed against the financial 29:18.553 --> 29:22.023 community. I think that we should be very 29:22.017 --> 29:26.987 careful not to let that deflect us from the recognition that 29:26.986 --> 29:32.036 this is important technology and that it's not the technology 29:32.041 --> 29:35.451 that's at fault; we have to get it right and 29:35.450 --> 29:37.030 then it will be powerful. 29:37.029 --> 29:42.989 I've had some experience giving talks in less developed 29:42.994 --> 29:46.374 countries. I'm not a development economist. 29:46.369 --> 29:50.039 Now a development economist--that's Santosh's 29:50.039 --> 29:54.709 field--Development economics is a very important field in 29:54.709 --> 29:59.879 economics that is helping less developed countries emerge. 29:59.880 --> 30:04.310 I'm very proud to say that Yale has a strong department at the 30:04.305 --> 30:07.275 Growth Center on development economics. 30:07.280 --> 30:10.010 I'm not a development economist. 30:10.009 --> 30:12.479 Nonetheless, when I've spoken in less 30:12.480 --> 30:15.640 developed countries, I find that they're really 30:15.636 --> 30:17.416 interested in finance. 30:17.420 --> 30:21.220 I think that's because there's a growing recognition that 30:21.221 --> 30:25.231 that's what you need to know and that the countries that are 30:25.227 --> 30:28.957 emerging successfully are those that have well developed 30:28.960 --> 30:33.170 financial institutions that are adopting the technology. 30:33.170 --> 30:35.940 They have to adapt it to their own situation, 30:35.942 --> 30:38.842 but in many ways they're copying technology. 30:38.839 --> 30:41.409 There's nothing bad about copying technology, 30:41.407 --> 30:43.097 that's what everybody does. 30:43.099 --> 30:46.379 When somebody invented the automobile, before you knew it 30:46.379 --> 30:50.069 everyone was driving automobiles and they all looked pretty much 30:50.068 --> 30:52.208 the same. When someone invented the 30:52.210 --> 30:55.360 airplane, before you knew it every country had an airplane 30:55.357 --> 30:57.397 because there was a best practice, 30:57.400 --> 31:01.090 there was a best technology and it was not unique to any one 31:01.085 --> 31:05.485 country. So that's why I view this 31:05.489 --> 31:11.839 course as fundamentally about technology. 31:11.840 --> 31:19.960 31:19.960 --> 31:24.380 I want to say something about morality and about mixed 31:24.378 --> 31:27.878 feelings that people have about finance. 31:27.880 --> 31:35.610 31:35.609 --> 31:38.139 I know that undergraduates--I don't know how you feel about 31:38.143 --> 31:40.833 finance. Some people have a reaction--If 31:40.833 --> 31:44.983 you say you're taking a course in finance, they think that 31:44.977 --> 31:49.117 maybe you're selling out or maybe you value money too much 31:49.121 --> 31:53.121 and that you should really be in some other field. 31:53.119 --> 32:00.459 This is a longstanding conflict in our thinking. 32:00.460 --> 32:05.660 There is some contempt for finance, I believe, 32:05.663 --> 32:11.333 because it makes so much money for many people. 32:11.329 --> 32:13.389 Many of our students go into finance. 32:13.390 --> 32:16.520 Yale is very strong in providing people to the 32:16.518 --> 32:19.158 financial community and, I have to say, 32:19.160 --> 32:20.690 they do very well. 32:20.690 --> 32:23.900 My first advice is if you want to make money, 32:23.904 --> 32:28.144 which I don't particularly advise, but if you do it's not a 32:28.142 --> 32:30.482 bad idea to go into finance. 32:30.480 --> 32:32.600 Just as, you know, you can make a lot of money 32:32.596 --> 32:33.956 with organic chemistry too. 32:33.960 --> 32:38.360 I think that what you have to do as a young person is develop 32:38.358 --> 32:42.828 your human capital and that means knowing how to do things. 32:42.829 --> 32:51.959 But there is hostility toward finance that I think is very 32:51.961 --> 32:58.211 fundamental to a lot of our thinking. 32:58.210 --> 33:00.350 I wanted to say something about that. 33:00.349 --> 33:07.939 Part of it is that some people in finance get so rich. 33:07.940 --> 33:11.410 If you look at the list of the richest people, 33:11.410 --> 33:14.650 they're all connected to finance, right? 33:14.650 --> 33:17.270 I mean they understand it. 33:17.269 --> 33:20.429 Maybe they're not–-Maybe they're in publishing or some 33:20.426 --> 33:23.636 other field but they understand finance and a lot of them are 33:23.636 --> 33:24.916 directly in finance. 33:24.920 --> 33:27.120 So what do we make of that? 33:27.119 --> 33:33.269 Well part of it is that we get very--We get a sort of jealousy 33:33.266 --> 33:39.106 of these people because why should someone have billions of 33:39.110 --> 33:42.550 dollars? Did they really deserve that? 33:42.549 --> 33:46.899 Some people who make a lot of money get 33:46.895 --> 33:53.755 self-important–who make a lot of money--and they end up 33:53.755 --> 33:59.125 not making a lot of friends in the process. 33:59.130 --> 34:04.150 The Yale University Press is publishing a new book by Steve 34:04.152 --> 34:06.492 Fraser about Wall Street. 34:06.490 --> 34:11.350 He gives examples in this book about hostility toward--it goes 34:11.346 --> 34:16.116 way back--In Fraser's book he gives an example of--I've never 34:16.122 --> 34:20.852 heard of this person before, but William Durr, 34:20.845 --> 34:27.495 who was a financier in colonial America in the 1700s, 34:27.501 --> 34:35.441 made a lot of money and helped finance the Revolutionary War in 34:35.436 --> 34:38.376 the United States. 34:38.380 --> 34:43.360 He ended up being chased down the street by an angry mob. 34:43.360 --> 34:46.360 People hated him and why was that? 34:46.360 --> 34:50.950 Well it was partly because he got so rich and he started 34:50.945 --> 34:52.775 wanting to show off. 34:52.780 --> 34:57.380 He had what they called "livery servants," not just servants, 34:57.376 --> 35:02.276 but servants who were wearing livery, like a military uniform. 35:02.280 --> 35:09.140 It looked like aristocracy coming back in the form of rich 35:09.136 --> 35:14.546 financial successes and we don't like that. 35:14.550 --> 35:16.680 There is a feeling of hostility toward that. 35:16.679 --> 35:22.959 There has been a long discussion about what people owe 35:22.960 --> 35:29.240 each other and how okay it is to try to make money. 35:29.239 --> 35:38.349 I don't know if you remember--I have to start erasing here--one 35:38.347 --> 35:46.427 of the most well known Yale professors of the nineteenth 35:46.427 --> 35:52.007 century was William Graham Sumner, 35:52.010 --> 35:56.390 who wrote a famous piece called, What Social Classes 35:56.385 --> 35:58.325 Owe to Each Other. 35:58.329 --> 36:03.719 Sumner graduated from Yale in 1863. 36:03.719 --> 36:06.909 He was a member of Skull and Bones--have you heard of that? 36:06.910 --> 36:08.650 You know that group? 36:08.650 --> 36:12.620 He spent his entire career at Yale and he wrote--He was Head 36:12.624 --> 36:15.054 of our social sciences department, 36:15.050 --> 36:18.880 before we had separate departments of economics and 36:18.880 --> 36:22.730 psychology, etc. He was a very prominent 36:22.728 --> 36:29.058 exponent of the idea that people should go out for their own 36:29.061 --> 36:33.171 interest. One social class does not owe 36:33.174 --> 36:38.434 anything to another and we should not feel guilty about 36:38.433 --> 36:41.553 pursuing financial interests. 36:41.550 --> 36:47.750 That led to an attitude among a good segment of our society that 36:47.750 --> 36:53.650 it's okay to go out and make money because making money means 36:53.654 --> 36:59.564 doing productive things for the economy and ultimately it's a 36:59.559 --> 37:02.019 benefit to society. 37:02.020 --> 37:05.470 37:05.469 --> 37:07.529 But we have some discomfort with that. 37:07.530 --> 37:13.530 37:13.530 --> 37:17.790 Another book, which I haven't put on reserve 37:17.789 --> 37:21.649 yet but I'm going to, is by Peter Unger, 37:21.653 --> 37:24.133 who is a philosopher. 37:24.130 --> 37:29.060 It's a remarkable book called Living High and Letting 37:29.062 --> 37:34.352 Die that refers to a more broad philosophical issue that 37:34.353 --> 37:38.383 we have. It is that most of us are 37:38.377 --> 37:44.387 really making money for ourselves--that's what we do 37:44.389 --> 37:50.519 with our lives--and whether or not that is moral. 37:50.519 --> 37:57.679 It's not just rich people who do that--the rest of us do it 37:57.678 --> 38:04.588 also--and in Peter Unger's book he--On the first page, 38:04.590 --> 38:09.730 he has an address and it's an address for UNICEF, 38:09.732 --> 38:14.662 which is the United Nations Children's Fund, 38:14.659 --> 38:19.819 and he starts out his book with that address where you could 38:19.820 --> 38:21.920 send money right away. 38:21.920 --> 38:25.160 I thought it was very impressive that he put that on 38:25.162 --> 38:28.792 page one of the book because it puts the reader in a moral 38:28.786 --> 38:31.716 dilemma. He points out that it's 38:31.715 --> 38:36.045 estimated that for every $3 you send to UNICEF, 38:36.045 --> 38:38.205 you can save a life. 38:38.210 --> 38:42.950 That's because there are people in this world who are not 38:42.945 --> 38:44.885 getting medical care. 38:44.889 --> 38:49.959 There are people who are dying of diseases for which there are 38:49.957 --> 38:54.607 known cures because they don't have the best medicine, 38:54.610 --> 38:57.350 which are often not even expensive but they're living in 38:57.352 --> 39:01.852 such poverty. So he says, why don't you stop 39:01.852 --> 39:06.232 right now and send $100 to UNICEF. 39:06.230 --> 39:11.120 It was very impactful to start a book that way because I doubt 39:11.123 --> 39:16.263 that hardly any readers actually write out a check on the spot to 39:16.257 --> 39:18.377 UNICEF; but if you don't, 39:18.377 --> 39:22.447 then you are in some sense responsible for the loss of 30 39:22.454 --> 39:25.894 lives. It's quite striking and it 39:25.891 --> 39:32.311 helps you to reflect on what makes us behave the way we do. 39:32.309 --> 39:37.759 By the way, when you go back to your computer, 39:37.763 --> 39:43.223 Google UNICEF, and you can give $100 to UNICEF 39:43.216 --> 39:47.646 within the hour. Maybe I could ask for a show of 39:47.645 --> 39:49.905 hands of how many people did that. 39:49.909 --> 39:54.439 I expect that not many of you will and I don't think that 39:54.443 --> 39:58.093 proves that you are bad people--this is a very 39:58.086 --> 40:02.536 interesting philosophical question--but what it means is 40:02.538 --> 40:07.318 that there is a moral dilemma underlying all of our economic 40:07.315 --> 40:12.165 lives and I think this moral dilemma is the same as the moral 40:12.172 --> 40:14.522 dilemma in finance. 40:14.519 --> 40:19.089 It's just that people in finance are sometimes very 40:19.085 --> 40:24.925 successful and they could give a lot more than $100 to UNICEF. 40:24.929 --> 40:31.259 One thing that I wanted to emphasize in this course, 40:31.261 --> 40:36.971 or try to emphasize, is that part of finance is 40:36.972 --> 40:40.202 actually philanthropy. 40:40.199 --> 40:45.399 The most important--The most successful people in finance, 40:45.401 --> 40:50.691 I believe, end up giving the money away and that means--you 40:50.694 --> 40:53.984 can't consume a billion dollars. 40:53.980 --> 40:56.450 There's no way that you can do that. 40:56.449 --> 41:00.239 You can only drive one car at a time and if you have five 41:00.239 --> 41:04.099 cars--well I mean that's kind of--all right you could have 41:04.097 --> 41:08.087 five cars and you could drive a different one everyday, 41:08.090 --> 41:10.970 but it's starting to seem a little ridiculous, 41:10.968 --> 41:12.188 right? At any rate, 41:12.190 --> 41:15.390 you're not using them and they're going to end up being 41:15.389 --> 41:16.869 used by somebody else. 41:16.869 --> 41:22.659 So I think the outcome should be philanthropy and those of you 41:22.656 --> 41:27.396 who are successful really ought to give it away. 41:27.400 --> 41:32.150 I'm bringing in outside speakers as part of this course 41:32.152 --> 41:36.022 and, among them, I'm going to bring in people 41:36.023 --> 41:39.723 who I think have been philanthropists. 41:39.719 --> 41:45.069 That's the mode of thinking that is most attractive when you 41:45.068 --> 41:47.968 think about financial markets. 41:47.969 --> 41:51.779 So let me tell you about--I have slots now for four outside 41:51.777 --> 41:54.477 speakers. I've lined up two of them and 41:54.476 --> 41:58.426 let me tell you about the two that I've already lined up. 41:58.429 --> 42:02.719 The first one is our own David Swensen. 42:02.719 --> 42:09.979 David Swensen came to Yale University in 1985 from Wall 42:09.976 --> 42:15.616 Street, although he was a Yale graduate. 42:15.619 --> 42:23.049 At that time the Yale endowment was actually slightly under one 42:23.052 --> 42:27.162 billion dollars. What is the endowment of Yale? 42:27.159 --> 42:31.639 The endowment is defined as the financial assets that Yale 42:31.636 --> 42:34.446 University owns. Yale also has an art 42:34.454 --> 42:38.604 collection, which is worth many billions, but we don't count 42:38.597 --> 42:42.807 that as part of the endowment because they will never sell it 42:42.810 --> 42:45.690 so it doesn't provide income for us. 42:45.690 --> 42:49.080 Yale also has a physical plant, like this beautiful building 42:49.077 --> 42:51.367 that we're in, but that's not part of the 42:51.374 --> 42:52.584 endowment either. 42:52.579 --> 42:56.029 The financial assets that Yale had, at that time, 42:56.034 --> 42:58.414 were about one billion dollars. 42:58.409 --> 43:05.469 Since then, David Swensen has invested or has managed the 43:05.472 --> 43:13.672 investment of this endowment and it has done phenomenally well. 43:13.670 --> 43:18.730 Yale now has over twenty-two billion dollars in its 43:18.734 --> 43:26.434 endowment. The return he got from 1996 to 43:26.427 --> 43:34.197 2006 was 17% a year on investments. 43:34.199 --> 43:41.199 Last year the return on the Yale portfolio was 28% in one 43:41.195 --> 43:43.945 year. Now I don't know how impressed 43:43.945 --> 43:47.315 you are, the year before that it was 22% in one year. 43:47.320 --> 43:51.650 Now some of this might be luck but I don't think it's all luck 43:51.652 --> 43:55.632 because he's done this consistently for so many years. 43:55.630 --> 43:58.970 If you look up around this campus now, you'll see a lot of 43:58.971 --> 44:01.201 construction, a lot of things are being 44:01.198 --> 44:02.838 spruced up and improved. 44:02.840 --> 44:07.960 I think David Swensen has had a big hand in doing that because 44:07.960 --> 44:11.570 we have the money that makes it possible. 44:11.570 --> 44:15.180 44:15.179 --> 44:17.949 The endowment at Yale is something like two million 44:17.950 --> 44:21.390 dollars per student now that's just sitting there as money that 44:21.387 --> 44:22.437 could be spent. 44:22.440 --> 44:26.140 44:26.140 --> 44:27.640 How did he do this? 44:27.639 --> 44:29.229 That's one of the amazing things. 44:29.230 --> 44:33.440 It seems to have something to do, I think, with academic 44:33.444 --> 44:37.424 understanding. That being part of a university 44:37.417 --> 44:42.647 community is a good thing for investing and you can see some 44:42.647 --> 44:44.417 evidence in that. 44:44.420 --> 44:46.670 Harvard University, Princeton University, 44:46.674 --> 44:49.774 and other universities have done extremely well on their 44:49.774 --> 44:52.664 endowments; however, not quite as well as 44:52.658 --> 44:53.928 Yale. Yale, I think, 44:53.933 --> 44:57.713 is the number one performer so it's very interesting that we're 44:57.713 --> 45:01.863 able--it's very significant that we're able to get David Swensen. 45:01.860 --> 45:06.660 He doesn't do a lot of public speaking but he is willing, 45:06.659 --> 45:11.289 for young people like you, to do this--so that's one of 45:11.287 --> 45:13.427 our outside speakers. 45:13.429 --> 45:17.269 He also has two books about investing that we'll talk about. 45:17.269 --> 45:22.549 The second person I have set up now to come--although the date 45:22.545 --> 45:27.295 on the syllabus online is going to be changed--is Andrew 45:27.302 --> 45:31.782 Redleaf, who is also a Yale graduate and 45:31.776 --> 45:37.316 who set up a hedge fund called Whitebox Advisors. 45:37.320 --> 45:41.560 It has done phenomenally well in investing. 45:41.560 --> 45:46.580 45:46.579 --> 45:51.019 I think--I have on the syllabus a New York Times article about 45:51.022 --> 45:53.262 him. He's a very original and 45:53.263 --> 45:57.853 creative thinker who looks at things from a unique perspective 45:57.847 --> 46:01.677 and I find it very interesting talking with him. 46:01.679 --> 46:04.779 To do well in investing you have to have your own 46:04.784 --> 46:08.544 independent view of things and really be thinking about how 46:08.535 --> 46:11.635 things work and he is someone who does that. 46:11.639 --> 46:14.829 Incidentally, the New York Times had another 46:14.833 --> 46:18.623 article about Redleaf, saying that he was really one 46:18.621 --> 46:23.081 of the first persons to clearly delineate the subprime crisis 46:23.077 --> 46:24.857 that we're now in. 46:24.860 --> 46:27.420 He saw it coming and, I have to say, 46:27.420 --> 46:28.810 profited from it. 46:28.809 --> 46:32.469 If you know the subprime crisis is coming, then there's always a 46:32.471 --> 46:35.321 way to profit from that and that's what he did. 46:35.320 --> 46:41.660 But he also has a philanthropic side so it all comes out very 46:41.660 --> 46:47.160 well. I think in the remaining time I 46:47.158 --> 46:56.678 will just go through an outline of the course and that means go 46:56.676 --> 47:05.116 through the topics of the various lectures and then I'll 47:05.118 --> 47:09.108 let you go for today. 47:09.110 --> 47:13.920 So the way this course is divided up is different than the 47:13.924 --> 47:16.124 Financial Theory course. 47:16.119 --> 47:19.639 If you look at John Geanakoplos's course on 47:19.639 --> 47:23.489 Financial Theory, his mathematical concepts are 47:23.494 --> 47:26.934 central to his outline of the course; 47:26.929 --> 47:30.129 but this being a Financial Markets course, 47:30.127 --> 47:33.707 I'm dividing it up more in terms of markets and 47:33.714 --> 47:37.764 institutions. I still want to start with some 47:37.758 --> 47:42.758 theory and I thought that--well I will--I plan to start by 47:42.757 --> 47:48.017 talking about the most basic concepts of risk management, 47:48.020 --> 47:49.580 which underlie finance. 47:49.579 --> 47:54.019 That will be Wednesday's lecture. 47:54.019 --> 47:57.209 I call it the universal principle of risk management 47:57.206 --> 47:59.326 pooling and the hedging of risk. 47:59.329 --> 48:03.099 I think it's the most important theoretical concept that 48:03.100 --> 48:07.280 underlies finance and insurance, which we'll also talk about a 48:07.283 --> 48:09.343 little bit in this course. 48:09.340 --> 48:14.040 The idea is that if you spread risks they don't disappear, 48:14.037 --> 48:17.767 they're still there, but they're spread out over 48:17.765 --> 48:21.805 many people and the impact on any one person is reduced. 48:21.809 --> 48:26.489 So a basic principle of insurance is that if each person 48:26.488 --> 48:30.218 or each family suffers the risk, for example, 48:30.224 --> 48:32.414 that a parent, father or mother, 48:32.407 --> 48:36.207 might die then it is a terrible blow to the family; 48:36.210 --> 48:39.670 but it's not a blow to society as a whole because people die 48:39.671 --> 48:42.371 and it has a certain statistical regularity. 48:42.369 --> 48:47.059 It makes sense that we pay families who have lost a father 48:47.062 --> 48:50.522 or a mother so that they can keep going. 48:50.519 --> 48:55.829 It benefits everyone to have a situation in place for that. 48:55.829 --> 48:59.329 I wanted to talk about that with a little bit of reference 48:59.326 --> 49:03.126 to probability theory and so that's what I will be covering. 49:03.130 --> 49:06.420 The next lecture will be among the more mathematical, 49:06.423 --> 49:08.453 although it's very elementary. 49:08.449 --> 49:11.869 If you had a course in probability and statistics, 49:11.871 --> 49:15.921 then you'll find it easy to follow, but it's self-contained 49:15.921 --> 49:18.831 again. I feel like I have to introduce 49:18.826 --> 49:22.806 concepts like variance and co-variance and correlation in 49:22.813 --> 49:27.393 order to talk about finance; so that's what we'll do in 49:27.386 --> 49:31.106 Lecture Two. The following lecture--I want 49:31.106 --> 49:35.296 to come back to some basic themes that--the third 49:35.304 --> 49:40.734 lecture--about technology and it relates to another book that I 49:40.727 --> 49:44.127 wrote. I'm not assigning it, 49:44.125 --> 49:50.385 but I wrote a book called New Financial Order in 49:50.388 --> 49:54.678 2003 about technology and finance. 49:54.679 --> 49:58.619 A theme of that book was that--I've already said this to 49:58.616 --> 50:02.906 you, but it's a very important point--financial technology is 50:02.910 --> 50:07.200 evolving and improving just the way engineering technology or 50:07.204 --> 50:10.214 biochemical technology is improving. 50:10.210 --> 50:16.190 It's getting better year by year and the course of finance 50:16.192 --> 50:20.182 over your lifetime will be dramatic, 50:20.179 --> 50:23.839 so the financial institutions that we have ten years from now 50:23.838 --> 50:27.068 will look very different from the ones we have now. 50:27.070 --> 50:31.500 50:31.500 --> 50:35.500 We have to understand--in understanding the progress of 50:35.496 --> 50:39.266 financial technology--is its fundamental relation to 50:39.271 --> 50:41.271 information technology. 50:41.269 --> 50:44.909 Computers, the Internet, and communication devices are 50:44.909 --> 50:48.549 fundamental to financial progress and they make things 50:48.550 --> 50:52.190 possible that wouldn't have been possible before. 50:52.190 --> 50:55.710 Oftentimes, inventions that seem, in the abstract, 50:55.705 --> 50:59.355 to be good ideas may be impossible because something 50:59.363 --> 51:03.673 that you have to do to make it actually come into practice is 51:03.668 --> 51:07.398 too expensive and so it's not economic to produce the 51:07.398 --> 51:11.538 invention. But then developments in other 51:11.539 --> 51:17.429 fields can change the relative prices and suddenly make an idea 51:17.427 --> 51:23.407 that had been hypothetical and unapplied suddenly work well. 51:23.409 --> 51:28.879 So financial inventions also involve experimentation. 51:28.880 --> 51:32.430 Like in any other invention, nobody knows what will work and 51:32.425 --> 51:35.245 abstract theory doesn't guide you completely. 51:35.250 --> 51:39.890 51:39.889 --> 51:44.779 Once an invention is seen to work it is rapidly copied around 51:44.781 --> 51:48.171 the world. We can see various breaks in 51:48.170 --> 51:52.910 financial history when some new idea was suddenly proven 51:52.906 --> 51:54.836 workable. Traditionally, 51:54.841 --> 51:58.131 financial inventions were not granted patent rights, 51:58.126 --> 52:01.476 but now in the United States and in a number of other 52:01.475 --> 52:05.915 countries it has become possible to patent financial inventions. 52:05.920 --> 52:13.060 I know I've done that in my life and so I think it gives a 52:13.057 --> 52:17.437 different perspective on finance. 52:17.440 --> 52:21.720 Then I want to talk about insurance. 52:21.720 --> 52:27.160 52:27.159 --> 52:31.859 The institution of insurance is something that really came 52:31.859 --> 52:36.479 in--it's one of the earliest--I consider it a division of 52:36.476 --> 52:41.086 finance--really came in the 1600s when probability theory 52:41.093 --> 52:44.383 was invented. The mathematical theory of 52:44.384 --> 52:48.304 probability was unknown until that time and you can see that 52:48.298 --> 52:51.878 insurance suddenly made an appearance at that time. 52:51.880 --> 52:58.620 52:58.619 --> 53:03.519 This will be an historical as well as a theoretical discussion 53:03.524 --> 53:07.714 of insurance. Then I will move to portfolio 53:07.709 --> 53:13.359 diversification and supporting financial institutions. 53:13.360 --> 53:17.910 This is again a more theoretical lecture. 53:17.909 --> 53:20.889 It will be about the capital asset pricing model. 53:20.889 --> 53:26.379 It will be about the securities market line, about the beta, 53:26.381 --> 53:31.261 about the mutual fund theorem, and it will also be about 53:31.258 --> 53:35.968 institutions that we have--about investment companies and their 53:35.966 --> 53:38.616 management. So it's really parallel to an 53:38.622 --> 53:39.832 insurance discussion. 53:39.829 --> 53:45.879 Insurance pools risks like life risks or fire risks by writing 53:45.875 --> 53:49.735 policies to individual policyholders. 53:49.739 --> 53:54.039 Portfolio management pools risks in a different way: 53:54.040 --> 53:58.930 by assembling a diversified portfolio or a portfolio that's 53:58.931 --> 54:03.571 negatively correlated with a risk that someone has. 54:03.570 --> 54:08.440 Then I want to go to the efficient markets theory. 54:08.440 --> 54:16.120 "Efficient markets" is a theory about--well it came in about 54:16.117 --> 54:20.787 three decades ago, maybe it's closer to four 54:20.787 --> 54:25.997 decades ago--it's a theory that financial markets work very well 54:25.998 --> 54:29.388 and incorporate information very well. 54:29.389 --> 54:32.049 The efficient markets hypothesis was 54:32.051 --> 54:36.541 encouraged--actually the idea goes back over 100 years--it's 54:36.537 --> 54:41.017 encouraged by the observation that financial markets seem to 54:41.023 --> 54:45.133 respond with great speed to new information and, 54:45.130 --> 54:48.560 when new information appears, prices will suddenly adjust in 54:48.563 --> 54:49.963 the financial markets. 54:49.960 --> 54:52.790 Certain kinds of financial markets called "prediction 54:52.793 --> 54:54.703 markets," which may, for example, 54:54.699 --> 54:58.369 predict the outcome of an election have been seen to be 54:58.366 --> 55:03.066 very accurate predictors, often better than pollsters can 55:03.069 --> 55:06.969 manage. So there seems to be some deep 55:06.965 --> 55:09.275 wisdom of the market. 55:09.280 --> 55:13.020 I think that "efficient markets" is an important 55:13.023 --> 55:16.703 concept. On the other hand--and this is 55:16.695 --> 55:21.675 something that I want to emphasize--you don't want to 55:21.680 --> 55:26.860 carry that too far and one of the lessons of behavioral 55:26.857 --> 55:32.507 finance is that markets are not really efficient in a global 55:32.513 --> 55:36.463 sense. Human psychology drives markets 55:36.460 --> 55:39.650 a great deal. If markets were perfectly 55:39.646 --> 55:44.206 efficient, David Swensen could not have done what he did. 55:44.210 --> 55:49.860 It would not be possible to make excess returns in finance. 55:49.860 --> 55:54.250 I believe it's clear that it is and that people who do so are 55:54.252 --> 55:58.422 people who understand more than the core efficient markets 55:58.424 --> 56:01.414 theory. They understand something about 56:01.412 --> 56:05.002 human nature and how human nature interacts with our 56:05.003 --> 56:08.383 institutions. The next lecture is about 56:08.382 --> 56:13.612 behavioral finance and I want to talk in that lecture about 56:13.607 --> 56:17.907 research and psychology, things that come out of another 56:17.908 --> 56:20.558 department here, the psychology department, 56:20.559 --> 56:25.719 which has traditionally been ignored in economics and finance 56:25.722 --> 56:27.532 but is coming back. 56:27.530 --> 56:32.640 I want to talk about Kahneman and Tversky's Prospect Theory, 56:32.639 --> 56:38.009 which is a very important and a little technical--psychologists 56:38.009 --> 56:42.339 can become mathematical and technical as well. 56:42.340 --> 56:45.660 It'll be an important part of our understanding of financial 56:45.657 --> 56:48.937 markets. Then I want to talk in the next 56:48.935 --> 56:53.045 lecture about regulation, which means government 56:53.053 --> 56:57.703 oversight of financial markets and not just government 56:57.695 --> 57:01.045 oversight, there are also the so-called 57:01.050 --> 57:04.840 self-regulatory organizations that are created in the 57:04.838 --> 57:07.678 financial industry to self regulate. 57:07.679 --> 57:10.479 So, for example, FINRA, which used to be called 57:10.479 --> 57:13.399 The National Association for Security Dealers, 57:13.400 --> 57:17.880 is a membership organization of people in the financial 57:17.884 --> 57:21.874 community and it imposes rules on its members. 57:21.869 --> 57:24.849 It's not a government organization but it is a 57:24.846 --> 57:25.636 regulator. 57:25.640 --> 57:28.770 57:28.769 --> 57:33.489 The problem is that not everyone is nice and not 57:33.491 --> 57:39.121 everyone is high-minded so financial markets--the success 57:39.117 --> 57:43.237 of financial markets is, in many ways, 57:43.236 --> 57:45.746 a success of regulation. 57:45.750 --> 57:49.520 Governments establish regulators who set down rules 57:49.519 --> 57:53.969 for participants in financial markets and these rules may be 57:53.966 --> 57:58.256 perceived as onerous and costly to people in the financial 57:58.263 --> 58:01.183 community, but ultimately it's their 58:01.183 --> 58:04.683 salvation and it's what makes everything possible. 58:04.679 --> 58:11.019 After that, I want to talk about the debt markets. 58:11.019 --> 58:16.489 Debt is the simplest of financial instruments. 58:16.489 --> 58:22.059 It consists of a promise to pay, usually denominated in 58:22.055 --> 58:27.925 currency, and there are both long-term and short-term debt 58:27.930 --> 58:31.010 instruments. The shortest term debt 58:31.008 --> 58:34.838 instrument in the United States is the Federal Funds Rate, 58:34.840 --> 58:40.090 which is an overnight rate--one day maturity--and the longest 58:40.094 --> 58:45.354 issued by the Government is a thirty-year government bond, 58:45.349 --> 58:49.509 which will be repaid three decades in the future. 58:49.510 --> 58:53.020 There have also been one hundred-year bonds and there 58:53.017 --> 58:56.117 have also been perpetuities that--in the UK, 58:56.119 --> 58:58.799 for example, the British Consoles--have no 58:58.796 --> 59:02.056 expiration date and they have infinite maturity. 59:02.059 --> 59:08.659 So the debt market is something worthy of studying because it 59:08.659 --> 59:13.609 really represents a market for time itself. 59:13.610 --> 59:16.450 What is it that we're talking about when we talk about the 59:16.445 --> 59:17.385 rate of interest? 59:17.389 --> 59:21.459 It has units of time, it represents the price of 59:21.462 --> 59:26.312 time, and it is something that fluctuates through time in 59:26.313 --> 59:28.483 interesting patterns. 59:28.480 --> 59:34.880 They are very important drivers of our economy and our lives. 59:34.880 --> 59:41.330 The theory of the term structure is the theory of how 59:41.326 --> 59:48.016 interest rates differ according to maturity or term. 59:48.019 --> 59:52.939 There are not only debt instruments that are payable in 59:52.941 --> 59:58.141 currency, but there are also indexed debt instruments that 59:58.136 --> 1:00:03.696 are indexed to the price level so that they give real interest 1:00:03.696 --> 1:00:06.506 rates. We've had episodes in our 1:00:06.509 --> 1:00:10.839 history when real interest rates have made major moves and these 1:00:10.842 --> 1:00:15.452 movements are very important for what is happening in our lives. 1:00:15.449 --> 1:00:20.479 Most recently--A few years ago, we were living in a regime of 1:00:20.480 --> 1:00:25.080 negative real interest rates, when the Fed was pursuing a 1:00:25.082 --> 1:00:27.532 very aggressive monetary policy. 1:00:27.530 --> 1:00:31.530 I suspect that with the subprime crisis the Fed will be 1:00:31.532 --> 1:00:36.282 pushing real interest rates down dramatically again and we may be 1:00:36.277 --> 1:00:40.277 in a period of negative real interest rates again. 1:00:40.280 --> 1:00:43.740 After that I want to talk about the stock market and I want 1:00:43.741 --> 1:00:45.771 to--there's a lot to talk about. 1:00:45.769 --> 1:00:52.009 Of course, stocks are shares in companies and they're traded on 1:00:52.010 --> 1:00:57.750 stock exchanges and they're interesting to analyze because 1:00:57.748 --> 1:01:03.688 there's sort of an ambiguity about stocks that is not widely 1:01:03.686 --> 1:01:07.206 perceived by a lot of people. 1:01:07.210 --> 1:01:12.770 That is, share repurchase can change the units of measurement 1:01:12.772 --> 1:01:18.242 in a security and companies have to decide how leveraged the 1:01:18.241 --> 1:01:21.421 stock will be, which changes the stock 1:01:21.424 --> 1:01:24.124 price--leverage, meaning how much debt the 1:01:24.123 --> 1:01:25.443 company takes on. 1:01:25.440 --> 1:01:29.970 Moreover, companies have to decide how much dividends to pay 1:01:29.968 --> 1:01:32.718 on the stock. That's a decision of the 1:01:32.717 --> 1:01:36.977 management of the company and we have to understand how they make 1:01:36.979 --> 1:01:40.839 that decision and what that means to people who are valuing 1:01:40.841 --> 1:01:43.281 stocks. It's a very simple idea. 1:01:43.280 --> 1:01:46.750 The idea of dividing a company up into shares and selling them 1:01:46.748 --> 1:01:49.988 off, but in practice it involves a lot of complexities. 1:01:49.989 --> 1:01:54.079 We'll be talking about the Modigliani-Miller Theorem and 1:01:54.076 --> 1:01:58.526 related issues in this lecture as well as something about the 1:01:58.533 --> 1:02:02.843 behavior of the stock market and its tendency to go through 1:02:02.842 --> 1:02:04.702 dramatic movements. 1:02:04.699 --> 1:02:07.669 For example, like it has done recently if 1:02:07.669 --> 1:02:11.009 you've been following it earlier this year. 1:02:11.010 --> 1:02:15.980 The next lecture will be about real estate and that brings us 1:02:15.976 --> 1:02:20.936 into the subprime crisis and connects with interests that are 1:02:20.943 --> 1:02:23.513 central to my own thinking. 1:02:23.510 --> 1:02:27.860 The housing market is a huge market. 1:02:27.860 --> 1:02:33.270 Right now the total value of single-family homes in the 1:02:33.273 --> 1:02:39.293 United States is about twenty trillion dollars and the market 1:02:39.288 --> 1:02:43.998 has been becoming increasingly speculative. 1:02:44.000 --> 1:02:47.600 Home prices have become unstable. 1:02:47.599 --> 1:02:53.889 Nationally, home prices in the United States rose 85% between 1:02:53.889 --> 1:03:00.179 1997 and 2006 in real terms--in inflation-corrected terms. 1:03:00.179 --> 1:03:04.099 We've seen almost a doubling in the price of the average home in 1:03:04.096 --> 1:03:05.336 the United States. 1:03:05.340 --> 1:03:06.790 Why did that happen? 1:03:06.789 --> 1:03:12.299 Now they are falling and in real terms home prices have 1:03:12.301 --> 1:03:16.691 fallen almost 10% since the peak in 2006. 1:03:16.690 --> 1:03:18.690 This is not just a U.S. 1:03:18.687 --> 1:03:22.567 phenomenon; many countries around the world 1:03:22.569 --> 1:03:27.969 are experiencing home price booms and the beginnings of what 1:03:27.972 --> 1:03:30.722 might be a home price bust. 1:03:30.719 --> 1:03:37.019 I want to consider the market for homes and the market for 1:03:37.019 --> 1:03:43.429 mortgages, which are the instruments that finance homes. 1:03:43.429 --> 1:03:48.299 To what extent was the housing boom that we saw in recent years 1:03:48.302 --> 1:03:52.312 the result of revolution in financial technology? 1:03:52.309 --> 1:03:56.109 There have been many changes in our mortgage institutions that 1:03:56.108 --> 1:03:59.718 might be part of the reason for the boom in home prices. 1:03:59.719 --> 1:04:03.819 There's also a question of psychology. 1:04:03.820 --> 1:04:09.470 The following lecture will be about banking, 1:04:09.467 --> 1:04:15.637 the supply of money and the money multiplier. 1:04:15.639 --> 1:04:19.159 It's also about: how banks operate; 1:04:19.159 --> 1:04:21.129 what their function is in our society; 1:04:21.130 --> 1:04:24.880 and, why they are such important institutions that have 1:04:24.883 --> 1:04:28.433 gone back for hundreds of years and remain powerful, 1:04:28.427 --> 1:04:30.927 central features in our economy. 1:04:30.929 --> 1:04:35.219 It's also about bank regulation, such as the Basel 1:04:35.223 --> 1:04:37.943 Accord, Basel I and Basel II. 1:04:37.940 --> 1:04:42.390 I also want to talk about the impact of information and 1:04:42.391 --> 1:04:44.371 technology on banking. 1:04:44.369 --> 1:04:47.519 The following lecture is about monetary policy. 1:04:47.520 --> 1:04:50.500 What do central banks do? 1:04:50.500 --> 1:04:52.980 In the United States, the central bank is called the 1:04:52.983 --> 1:04:55.133 Federal Reserve. In the United Kingdom, 1:04:55.129 --> 1:04:56.629 it's the Bank of England. 1:04:56.630 --> 1:04:58.470 In Japan, it's the Bank of Japan. 1:04:58.469 --> 1:05:02.979 And in Europe, it's the European Central Bank. 1:05:02.980 --> 1:05:07.760 All of these banks are really in control of short-term 1:05:07.757 --> 1:05:12.617 interest rates and these interest rates are used to try 1:05:12.624 --> 1:05:16.234 to manage and stabilize the economy. 1:05:16.230 --> 1:05:19.420 In response to the subprime crisis that we are now in, 1:05:19.421 --> 1:05:21.831 our central bank, the Federal Reserve, 1:05:21.829 --> 1:05:25.289 has been cutting interest rates aggressively to try to save the 1:05:25.286 --> 1:05:27.456 economy that appears to be declining. 1:05:27.460 --> 1:05:33.210 I want to try to understand in that lecture--help us to 1:05:33.208 --> 1:05:38.098 understand how this works and how we're getting 1:05:38.104 --> 1:05:43.644 solutions--possible solutions to these problems. 1:05:43.639 --> 1:05:46.209 Then I want to talk about investment banking. 1:05:46.210 --> 1:05:49.060 An investment bank is a different kind of bank. 1:05:49.059 --> 1:05:51.609 I was talking, up to this point, 1:05:51.606 --> 1:05:53.656 about commercial banks. 1:05:53.659 --> 1:05:57.879 An investment bank is not a bank that accepts deposits; 1:05:57.880 --> 1:06:00.850 it doesn't deal with the general public. 1:06:00.849 --> 1:06:04.939 Instead it deals with financial institutions and it gets 1:06:04.938 --> 1:06:08.508 involved in underwriting securities for financial 1:06:08.506 --> 1:06:11.916 institutions. It's a very important industry 1:06:11.923 --> 1:06:16.593 and it's also one in which many of our students have found jobs, 1:06:16.590 --> 1:06:20.530 so I think it's important for us to try to understand the 1:06:20.529 --> 1:06:24.599 history of investment banks, the role they have in our 1:06:24.598 --> 1:06:28.358 financial community, and how they're regulated. 1:06:28.360 --> 1:06:32.590 Then I want to talk about money managers--professional money 1:06:32.587 --> 1:06:35.307 managers--people like David Swensen. 1:06:35.309 --> 1:06:39.939 This is a community of people in a different segment of the 1:06:39.935 --> 1:06:41.605 financial industry. 1:06:41.610 --> 1:06:43.280 These are people who manage portfolios. 1:06:43.280 --> 1:06:49.440 1:06:49.440 --> 1:06:53.610 We want to think about what kinds of forces operate on them 1:06:53.611 --> 1:06:58.211 and what kind of--I'm interested in viewing them partly as people 1:06:58.214 --> 1:07:02.534 who are experts in a certain kind of technology who live in a 1:07:02.530 --> 1:07:06.920 very competitive environment and try to understand why some of 1:07:06.917 --> 1:07:10.007 them succeed much more than others. 1:07:10.010 --> 1:07:12.680 It also relates to behavioral finance. 1:07:12.679 --> 1:07:18.029 That is, ultimately they are human beings like anyone else 1:07:18.030 --> 1:07:23.850 and some of their differences in success or failure may have to 1:07:23.850 --> 1:07:28.260 do with their own interconnections and their own 1:07:28.262 --> 1:07:32.582 psychology and interpersonal psychology. 1:07:32.579 --> 1:07:35.029 Then I want to talk about brokerages. 1:07:35.030 --> 1:07:40.120 Those are institutions that arrange for or manage the buying 1:07:40.117 --> 1:07:45.117 and selling of financial assets, such as the New York Stock 1:07:45.119 --> 1:07:48.359 Exchange. Now the brokerage industry--The 1:07:48.361 --> 1:07:51.921 New York Stock Exchange goes back into the eighteenth 1:07:51.920 --> 1:07:53.700 century, it's very old. 1:07:53.699 --> 1:07:57.979 In fact, the idea of the stock exchange goes back to the 1:07:57.976 --> 1:08:01.666 fourteenth century, when in Flanders the first 1:08:01.672 --> 1:08:05.642 stock exchange called The Bourse was established. 1:08:05.639 --> 1:08:09.619 So it goes back many hundreds of years but it's in rapid 1:08:09.624 --> 1:08:13.034 change now because of information technology. 1:08:13.030 --> 1:08:18.710 It's one of the most rapidly changing, hard to keep up with 1:08:18.708 --> 1:08:24.968 areas because someone can set up an electronic exchange overnight 1:08:24.973 --> 1:08:30.953 and suddenly become a base for trading trillions of dollars of 1:08:30.945 --> 1:08:34.995 securities. It fits in well with the theme 1:08:34.995 --> 1:08:39.915 of this course about technology because in understanding what's 1:08:39.924 --> 1:08:43.414 happening with brokerages, our technology, 1:08:43.407 --> 1:08:46.857 the new information technology, is central. 1:08:46.859 --> 1:08:52.549 Then I want to move to futures markets and forward markets. 1:08:52.550 --> 1:08:57.370 A forward contract is a contract made between two 1:08:57.366 --> 1:09:01.176 parties for execution in the future. 1:09:01.180 --> 1:09:04.980 Generally these are called over-the-counter contracts 1:09:04.984 --> 1:09:08.574 because they're not arranged through exchanges. 1:09:08.569 --> 1:09:12.779 We also have standardized contracts that are traded on 1:09:12.784 --> 1:09:16.684 exchanges and they're called futures contracts. 1:09:16.680 --> 1:09:21.410 The futures contracts were invented in Japan in the 1600s 1:09:21.412 --> 1:09:26.822 at Osaka and they were developed for the rice market in Japan. 1:09:26.819 --> 1:09:30.469 They were uniquely Japanese until pretty much the nineteenth 1:09:30.472 --> 1:09:33.882 century and then they were copied all over the world and 1:09:33.878 --> 1:09:35.548 are now very important. 1:09:35.550 --> 1:09:40.060 I'm going to talk about one futures market that I have been 1:09:40.056 --> 1:09:42.306 instrumental in developing. 1:09:42.310 --> 1:09:45.460 I've been working with the Chicago Mercantile Exchange to 1:09:45.458 --> 1:09:48.268 create a futures market for single-family homes, 1:09:48.270 --> 1:09:51.310 which is sort of my connection to the futures industry. 1:09:51.310 --> 1:09:54.770 Of course, there are many futures markets that we'll talk 1:09:54.774 --> 1:09:57.274 about. They're very interesting to me 1:09:57.266 --> 1:10:01.126 and I wonder why the business community isn't more aware of 1:10:01.127 --> 1:10:03.327 them. A futures market has a 1:10:03.326 --> 1:10:07.486 prediction going out years into the future of what every 1:10:07.492 --> 1:10:10.222 financial variable will be doing, 1:10:10.220 --> 1:10:13.450 so you can see the future in a sense through the futures 1:10:13.451 --> 1:10:15.491 prices. It's not always correct to 1:10:15.487 --> 1:10:19.077 think of it that way--we have to get into the theory of futures 1:10:19.082 --> 1:10:21.882 markets. In many cases that is not the 1:10:21.881 --> 1:10:26.201 right way to think about futures prices, but there are very 1:10:26.203 --> 1:10:30.453 important futures markets that--In the next lecture I want 1:10:30.452 --> 1:10:35.522 to talk about the various kinds of futures markets that matter. 1:10:35.520 --> 1:10:39.230 We have a stock index futures market and notably we have an 1:10:39.234 --> 1:10:40.584 oil futures market. 1:10:40.579 --> 1:10:46.009 The oil futures market is very significant because it 1:10:46.011 --> 1:10:52.071 represents the price of energy on dates into the future. 1:10:52.069 --> 1:10:56.169 We can now see the price of oil going out years into the future. 1:10:56.170 --> 1:10:59.440 We've just hit $100 barrel price of oil, 1:10:59.439 --> 1:11:01.619 but what does that mean? 1:11:01.619 --> 1:11:05.519 Does that mean we're going to live in a world with $100 oil? 1:11:05.520 --> 1:11:08.450 Well not if you look at the futures market, 1:11:08.449 --> 1:11:12.639 which is in backwardation now and it's predicting major drops 1:11:12.635 --> 1:11:14.305 in the price of oil. 1:11:14.310 --> 1:11:17.200 Then I want to talk about options markets--this is getting 1:11:17.204 --> 1:11:18.884 close to the end of the course. 1:11:18.880 --> 1:11:22.340 An option is the right to buy something. 1:11:22.340 --> 1:11:24.520 Typically, we think of it as a stock option. 1:11:24.520 --> 1:11:30.550 An option is a contract that says you can buy so many shares 1:11:30.547 --> 1:11:34.327 of a company. The options have been traded 1:11:34.328 --> 1:11:38.418 for several decades, starting with the Chicago Board 1:11:38.423 --> 1:11:40.033 Options Exchange. 1:11:40.029 --> 1:11:42.139 But now there are many options exchanges. 1:11:42.140 --> 1:11:47.180 We have prices of options that change minute by minute. 1:11:47.180 --> 1:11:50.030 Now what do these changes and these prices mean? 1:11:50.029 --> 1:11:56.219 The options are a very useful technology for managing risks 1:11:56.219 --> 1:12:01.769 and I think that we'll see a rapid--Over the next few 1:12:01.769 --> 1:12:04.959 decades, we'll see rapid expansion in 1:12:04.960 --> 1:12:08.780 the scope of options contracts traded on the exchanges. 1:12:08.779 --> 1:12:12.559 Finally, for the last lecture for this semester, 1:12:12.556 --> 1:12:17.376 I want to pull this together and talk about one of the themes 1:12:17.378 --> 1:12:21.638 that is summarized in terms of a theme of this course: 1:12:21.636 --> 1:12:24.606 the democratization of finance. 1:12:24.609 --> 1:12:30.009 Finance used to be a very esoteric field that only a few 1:12:30.007 --> 1:12:34.817 people in London and Paris and other world centers 1:12:34.815 --> 1:12:40.015 understood--Amsterdam and other places where financial 1:12:40.016 --> 1:12:45.606 technology emerged--but it's becoming democratized. 1:12:45.609 --> 1:12:50.289 With each year that goes by the concepts of finance are being 1:12:50.293 --> 1:12:54.823 applied more broadly and involving more and more people. 1:12:54.819 --> 1:12:59.199 With electronic technology, it's becoming more economical 1:12:59.199 --> 1:13:03.579 to offer sophisticated financial services to everyone. 1:13:03.579 --> 1:13:05.939 This is something that we're seeing. 1:13:05.939 --> 1:13:10.229 I think the subprime crisis that is the current financial 1:13:10.229 --> 1:13:12.909 crisis highlights this very well. 1:13:12.910 --> 1:13:15.310 What does subprime mean? 1:13:15.310 --> 1:13:19.780 Well I think it stands for the general population. 1:13:19.779 --> 1:13:23.909 The subprime mortgage market was bringing people into the 1:13:23.906 --> 1:13:27.956 mortgage market who in prior decades would not have been 1:13:27.960 --> 1:13:31.350 involved--would not have had any mortgage. 1:13:31.350 --> 1:13:33.420 The problem, of course, with the 1:13:33.424 --> 1:13:36.774 democratization of finance is that if you raise the 1:13:36.770 --> 1:13:39.380 participation in financial markets, 1:13:39.380 --> 1:13:41.640 then you bring in people who are: less and less 1:13:41.642 --> 1:13:44.382 knowledgeable; less and less understanding of 1:13:44.382 --> 1:13:48.162 concepts of finance; and less capable and more 1:13:48.155 --> 1:13:50.845 vulnerable to exploitation. 1:13:50.850 --> 1:13:53.850 So the democratization of finance is, I think, 1:13:53.853 --> 1:13:57.863 the ultimate mission of--I find central to this course but it 1:13:57.858 --> 1:14:01.658 brings with it dangerous hazards and we have to think very 1:14:01.663 --> 1:14:04.003 carefully about how we do it.