Financial Theory Yale

[Malcolm Lozada]

Thislecture gives a brief history of the young field of financial theory, which began in business schools quite separate from economics, and of my growing interest in the field and in Wall Street. A cornerstone of standard financial theory is the efficient markets hypothesis, but that has been discredited by the financial crisis of 2007-09. This lecture describes the kinds of questions standard financial theory nevertheless answers well. It also introduces the leverage cycle as a critique of standard financial theory and as an explanation of the crisis. The lecture ends with a class experiment illustrating a situation in which the efficient markets hypothesis works surprisingly well.

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 to Wall Street, and more or less dominated the investment banking parts of Wall Street, and became extremely successful. Finance became the most highly paid profession. It became the most highly paid faculty in the university, although they were all in business schools. There are more physics PhDs working in finance now than there are working in physics.

They believed 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 dart board 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 invest, and almost all of them made 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 as you know Shiller 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 he thinks has as big an effect on prices as the hard information about profits that the business school professors imagined drove profits.

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Financial economics encompasses a broad area of topics and issues, including corporate investments and financing policy, security valuation, portfolio management, the behavior of prices in speculative markets, financial institutions, and intermediation.

The PhD specialization in finance is designed to give the student a strong background for study and research in both theoretical and empirical work in finance and related areas. Emphasis is placed on understanding the important concepts and models. Students normally take several graduate courses in the Department of Economics, particularly in microeconomics and macroeconomic theory, the economics of uncertainty, and econometrics.

The program offers two courses specifically in financial theory and its applications. In addition, the faculty and doctoral students attend a seminar that features speakers from around the country. However, the specialization is built primarily around individual study and research under the guidance of the faculty.

Professor Robert Shiller: This is Economics 252, Financial Markets, and I'm Bob Shiller. Let me begin by introducing the teaching fellows for this course; and so I have them up here. We have five teaching fellows at this time and they're from all over. I like to put their pictures up so you'll know who they are. The teaching fellows are very international and that reflects my intention to make this a course that is also very international because finance is something about the whole world today, not just the United States. So we cover the world very well with our T.A.'s.

Usman Ali is from Pakistan, Lahore, and he graduated from the LUMS, Lahore University of Management Sciences. He's a PhD candidate now in Economics and he's doing his doctoral dissertation on stock analysts' recommendations and the relation to returns in the stock market. He's also interested in behavioral finance, which is the application of psychology to finance. The second teaching assistant--I see him right there, if you could raise your hand--Santosh Anagol, who is a representative of the United States, although he seems to have connections to India as well. He actually has a publication already in the American Economic Review on the Return to Capital with Ghana. He did this jointly with the Chairman of the Economics Department here, Chris Udry and he has spent time in India looking at the village economies. You were going to be giving away cows, did you do that?

Professor Robert Shiller: Okay, that's the last time you'll hear about cows in this course. The idea was to give cows away to village farmers and to observe the outcome. It's a big change in some of these very poor villages to get a cow.

Christian Awuku-Budu is from Ghana, Accra, but he, again, went to college in the United States at Morehouse College. He is also a PhD candidate in Economics at Yale and he's been doing research on financial markets in developing countries.

Yaxin Duan is from China. She got her undergraduate degree from Nanjing University. No? You are from Nanjing, did I get a detail wrong? Where did you go to college? Okay, well I'm sorry about that. She is also a PhD candidate in Economics and is doing research on the behavior of options prices in a phenomenon called the "options smile," as she's smiling at me right now. She is also interested in behavioral finance, which is great to me because that's one of my interests. She is shown here standing precariously on a cliff. It makes me nervous to look at it overlooking Machu Picchu in Peru. She also loves astronomy, which is incidentally an interest of mine too, but you won't hear about it again in this course.

Finally, Xiaolan Zhou is our fifth teaching assistant and she's also from China, Hubei Province. She graduated from Wuhan University and is a PhD candidate in Economics at Yale. She is doing research on bank mergers.

Let me say, I've been teaching this course now for over twenty years and I'm very proud of all of my alumni. Many of them are in the field of finance. In fact, I like sometimes when I give--I give a lot of public talks. When I give a talk on Wall Street or even somewhere else in the world I sometimes ask my audience, "Did you take my course?" It's not infrequent that I'll get one or even two people raising their hand that they took Economics 252 from me. But I'm also proud of my alumni in this course who are not in the world of finance. I think this course goes beyond--It's not just for people who are planning careers in finance because finance is a very important technology and it's very important to know finance to understand what happens in the real world. Just about any human endeavor involves finance. Now, you might say, "I could be a poet and what does that have to do with finance?" Well, it probably ends up having something to do with finance because as a poet you probably want to publish your poetry and you're going to be talking to publishers. Before you know it, they're going to be talking about their financial situation and how you fit into it.

I believe it's fundamental and very important. I think you will find this course as not a vocational course--not primarily a vocational course--but an intellectual course about how things really work. I see finance as the underpinning of so much that happens. It's a powerful force that goes behind the scene and I hope we can draw that out in this course. There is another course--we have two basic courses in finance for undergraduates at Yale. The other one is Economics 251, Financial Theory; this is Financial Markets, that one is Financial Theory. Last year it was taught by Rafael Romeu, because John, Geanakoplos who usually teaches the course, was on leave and so we had to find someone else. I assume that next fall John Geanakoplos will be teaching 251 again.

So what happened? Why do we have these two courses? Well it was something like eight years ago that we reached the present situation with two finance courses. John Geanakoplos and I had a meeting and we tried to divide up the subject matter of finance into two courses. We thought Financial Theory and Financial Markets would be the two. But the problem was that both John and I are interested in both theory and applications. John Geanakoplos is actually Chief Economist for a large investment called Ellington Capital in Greenwich, Connecticut, which you'll see a lot in the news. It has been very successful. He is very much interested in the real world and I am interested in financial theory, so we find it--we decided, after talking about it, that we really can't divide up the subject matter of finance into separate courses on theory and practice. If you tried to do one alone it would not work, so we decided to divide it up imperfectly and there may be some repetition between our two courses. Both of them are self-contained courses, so you could take either 251 or 252, or you could take both. I think maybe the best option is to take both if you're really interested in the subject matter. It is true though that his course is more tuned into theoretical detail than mine. John is a mathematical economist and we both love mathematics, but maybe John is going to do more of it than I am.

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