Quantitative Analysis – Lesson 1 – Finance Theory Introduction – P1

you so anyway the course I'm going to teach is called financial theory and I'm going to talk about I'm going to teach an actual class I'm gonna spend the first half the class talking about the course and why you might be interested in it and then I'm going to start with the course I'm gonna laugh at many lectures available in the semester so I'm not going to waste this one so the first half the class is going to be about why to study it and the mechanics of the course and the second half of the lecture is gonna be actually the first part of the course they'll give you maybe an idea of whether you'll find the course interesting too so I think I'll turn this I won't have too much PowerPoint here so you should know that finance was not taught until 10 years ago at Yale it was regarded by the deans and the classically minded Faculty of the Arts and Sciences as a vocational subject not worthy of being taught to Yale undergraduates it was growing more and more famous however in the world and there was a band of Business School professors Fischer black Robert Merton William Sharpe Steve Ross Myron Scholes Merton Miller who had a huge following in business schools teaching the subject and whose students went off on to Wall Street and and more or less dominated the investment banking to parts of Wall Street and became extremely successful finance became the most highly paid professional highly paid faculty in the university although they were all in business schools they're more physics PhDs working in finance now than there are working in physics so this merry band of financial theory professors didn't really believe in regulation they believe markets left unfettered work best of all they believed in what they called efficient markets and the idea that asset prices reflect all the available possible information so an implication of that is that if you want to find out whether a company's doing well or not you don't have to take the trouble to read all their financial reports just look at their stock price if you want to know whether a country is doing well or not you don't have to study its entire political system and you know current events just look at the general stock market of the country and that'll tell you they believe that you could make as good returns in the market as a lay person as you could as an expert because all the experts were competing to try and get the best possible price and so the price itself reflected all their knowledge and wisdom and opinions and so the lay person could take advantage of that by buying stocks everybody should be an investor they felt a monkey throwing darts at a dartboard would do as well as any of the greatest experts now their own theory was basically contradicted by their own experience because all of them seemed to go out into the world and and invest in almost all the mating extraordinary returns and made a huge amount of money all of which made them even less popular in the Faculty of Arts and Sciences so a critical part of their theory was that the markets are so efficient driven by people like them who are competing to exploit every advantage and therefore compete away every advantage and by doing that put all the information they have into the prices the implication of that theory is that there's an extraordinarily clever way of computing the value of most investment assets and about deciding when a financial decision is a good thing to do or not and that was the heart of what they taught in these business schools these algorithms for valuing assets and making optimal financial decisions one striking thing is that the people they studied the business school the the business people and the investment bankers they studied adopted their language so this had never happened in academia before I mean anthropologists study you know primitive tribes and different kinds of people all the time and not one of them I venture to say has ever taken over all the language invented by anthropologists to behave themselves in their own societies but the business people that these professors were studying ended up using exactly the language created in academia now Yale was very different there was no divide between economists and finance people all these other you know Business School finance people at Yale the greatest economist in Yale's history were actually very interested in finance maybe there were financial economists to begin with so the greatest of Yale economist of the first half of the 20th century was Irving Fisher will you hear a lot about he wrote possibly the first economics PhD at Yale there was no economist to teach him so he had to write his PhD with Gibbs the great maybe the greatest American physicist of the time there's a building as you know on Science Hill named after Gibbs and you'll you'll hear more about his dissertation in the 1890s but he was a mathematical economist and econometrician but he invented almost all of his economics in order to study finance the most famous yellow economist of the second half of the 20th century was James Tobin a famous macro economist the most famous macro economist possibly of the 22nd half of the 20th century after Keynes a great Keynesian but he got the Nobel Prize for work he did on finance and economics finance was incredibly interesting to him so Bob Shiller and I went to Yale we basically said to the dean's there's a long tradition of finance and economics hand-in-hand at Yale and so it's not a vocational subject it's actually central to economics and central to understanding the economy and central to understanding the global economy so we'd like to teach it to Yale undergraduates and we believe a few of them will actually take the course and so they agreed to let us do it and so we've been teaching it now for the for the last ten years so as you know Shiller is very has been very critical of the business efficient markets tradition he feels that these finance professors left something essential out of the whole story what they left out was psychology they left out the idea of fads and rumors and narratives which they thought which he thinks has as big an effect on prices as the hard information about profits that the business school professors imagine drove profits I myself have been quite critical of financial theory I started off as a straight pure mathematical economist to me economics is almost a branch of logic and philosophy that happened to tell you something about the world so I got my PhD with Ken arrow who you hear a lot about very shortly and I came to Yale I'd been a Yale undergraduate I came back to Yale and I joined the Cowles foundation the Cowles foundations motto was basically can we make economics more mathematical economics social science ought to be amenable to mathematical analysis just like physics or chemistry is and people didn't believe this at first and the Cold's foundation which you'll hear a lot about in these lectures led the revolution in economics transforming it from a a verbal subject political economy into a mathematical subject well I decided around 1989 that since I did mathematical economics and there are all these finance people doing all kinds of mathematical things on Wall Street and doing it very successfully you know I thought I might just check out what they were doing so it might be fun to see what they were up to so I went to to Wall Street and I joined most people I knew fact professors on you went to goldman sachs there was a famous finance professor who i mentioned before i named Fisher black who was there at the time and he attracted a lot of people and so that was the traditional thing to do but I decided to go to a little or firm called Kidder Peabody and one thing it was the seventh biggest investment bank at the time and one thing led to another and they decided that they wanted to reorganize their research department in fixed income and since I was a professor there and I did mathematical economics and I was there for the whole year somebody said the director of fixed income department said why don't you take charge of it and hire a new fixed income research department for me so I did and ultimately there were 75 people in the department all the time I was a professor at Yale and after five years Kidder Peabody even though 135 years old formed by a famous family the name should sound Peabody familiar to you it closed down after 135 years five years after I got there I had to invite the 75 people I'd hired into my office and say you're fired and then I went next door to the office next to mind and the guy there said you're fired and so how's my first taste of Wall Street and after that six of us founded a hedge fund called Ellington Capital Management which is a mortgage hedge fund and we had I'll tell you a lot about about it it started after the Kidder closing as a rather small hedge fund but it grew into a very big mortgage hedge fund in fact the biggest mortgage hedge fund in the country although recently we found out that practically everybody who trades mortgages is basically a hedge fund Fannie Mae Freddie Mac they're all basically hedge funds so it doesn't mean anything anymore to say that you're a big mortgage hedge fund but anyway we almost went out of business in 98 a subject a story I'll tell you a great length and then we just suffered through this disastrous last year or two but we're still here so these experiences of course have colored my understanding of Wall Street and my approach to the subject so I took on in my theoretical work finance an economic theory on its own terms I didn't think like Shiller to introduce psychology into economics I just take it on in its own terms on its own mathematical terms and what I found was that there are two things missing in the standard theory one is that it basically it implicitly assumes you can buy insurance for everything it's the assumption that's called complete markets and secondly it leaves out collateral entirely so you'll never see almost in any single economics textbook the idea of collateral or leverage and those I think the idea that you can't get insurance for everything and that you need collateral you have to be able to convince someone you're gonna pay him back if you borrow money and collateral is the most convincing way of persuading him he's going to be paid back the lender those two things were missing from the standard theory so I built a around incomplete markets and leverage which it's which is a critique of the standard theory so in a way Schiller and I have been vindicated by the crash I mean so let me just show you a picture here well maybe I will you know how bad the crash was so let's look at the Dow Jones the Dow Jones the Dow Jones is an average of 30 stocks and what their value is we'll talk more about it later but here it is back to 1913 moving along reasonably going up and up and up you know there are a few blips which we'll come to later like this one okay 1929 and then but look what happened lately look at that died out Jones was up at 14,000 and a drop to you know 6500 something like that I'm more than a 50% drop and now it's gone 50% up again so if you believe these finance professors you'll have you'd have to say that everybody realized that prop future profits in America were going to be less than half what they thought they were going to be before and that's why the stock market dropped and then miraculously when it hit a bottom everybody figured oh my gosh we misunderstood things actually it's not nearly that bad and things are 50% higher because now people think that profits really weren't gonna go you know didn't drop in half the only didn't drop by 50% they only dropped by 25% and that would be the only way according to the old theory to explain what happened now fit Shiller would just say well everybody's you know they're crazy they got this into their head that the world was just going to be great and then you know some rumor started and things were so high and people still the narrative change and they thought things were terrible and you know that's his story and I'm not sure how he gets it to go up again they changed their mind again but okay so alright now by the way it's a little bit better to look at the Dow in um sorry correcting for inflation and then you see that you know the 1929 crash looks and this is on a log scale so the same apps you know remember before the depression you know the stock market was so low it's grown so much over a hundred years that had hardly seemed like anything was happening well now in log scale you know going up two of these is multiplying by ten you see that the in the depression in 1929 through the early thirties the stock market fell you know I don't remember what it is it looks like it's almost two things it look like it's eighty or ninety percent and the fall this time has been you know much smaller fifty percent not ninety percent so it's a whole thing down but not two not two things down okay so it's not a whole thing downs less than that if you know a whole thing down will be the square root of ten or a three you know a third it didn't go down two thirds it went down less than two thirds and went down fifty percent so the actual percentage drop was much worse in the depression than it is now okay but now we're gonna come back to all these things what else can we get out of these numbers I just want you to notice a couple other things suppose you look for these numbers are all very interesting if your mathematical these are sort of the sorts of things you pay attention to so these efficient markets guys they looked at the change in price every month so there's a lot to say for their theory they said look it goes up and down randomly in fact we'll see that there all kinds of tests about whether you can predict it's going to go up tomorrow on the basis of how it would did yesterday and the answer is no it's very difficult to predict whether the stock market's going up or down seems to be random well it's random and they used to think it was normally distributed a lot of people argued it was normally distributed but you know it's hard you never get these gigantic outliers if things are normally distributed they're just way too unlikely to happen so Mandelbrot was who was a Yale professor who retired a couple years ago although he wasn't when he formed his theories the inventor of fractals he said this couldn't possibly be a random walk in the traditional Brownian motion sense of the word because you never get these big outliers but he offered no explanation for why they might be there and you know I don't know Schiller has an explanation either I mean isn't that people suddenly get shocked one day and then the next week they change their mind and things aren't so bad after all but you'll see that the theory of collateral and margins does explain these kinds of things okay now let's just look at the Dow not that we just looked at the Dow let's look at another the S&P 500 okay so where's the S&P 500

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