Financial Theory Lecture Summary

Course Overview

• Course Title: Financial Theory
• Lecture Structure:
  • First half: Course introduction and mechanics
  • Second half: Initial concepts of Financial Theory

Historical Context

• Finance at Yale was not taught until 10 years ago, viewed as vocational
• Business school professors had significant influence on the rise of finance
• Key figures in finance:
  • Fisher Black
  • Robert Merton
  • William Sharpe
  • Steve Ross
  • Myron Scholes
  • Merton Miller
• Finance grew to be a highly lucrative field, attracting many physicists

Beliefs of Financial Theory Professors

• Belief in efficient markets:
  • Asset prices reflect all available information
  • Stock prices can indicate a company's health without needing to read reports
• Market efficiency implies laypersons can invest successfully
• Contradiction in practice: Professors had great personal success in investing

Critique of Traditional Finance

• Noted absence of psychology in financial markets by figures like Bob Shiller
• Key concepts missing:
  • Collateral
  • Leverage
  • Incomplete markets theory
• Personal experience led to a broader critique of financial theory and its assumptions

Personal Experience & Career

• Joined Wall Street after years in academia, primarily focused on mathematical economics
• Worked at Kidder Peabody, then co-founded Ellington Capital Management (a mortgage hedge fund)
• Encountered several market crises that influenced theoretical approach

Market Dynamics and Crises

• Leverage Cycle:
  • Importance of collateral and leverage in financial decision-making
  • Events like the 2007-2009 financial crisis highlighted these dynamics
• Theories discussed include:
  • Irrational exuberance (Shiller) vs. Leverage cycle (presenter's view)

Course Structure and Content

• Topics to be Covered:
  • Standard financial theory
  • Mortgage market dynamics
  • Invisible hand argument in economics
  • Social Security analysis and reform
• Students will be expected to engage in problem-solving with a strong mathematical focus

Prerequisites for Students

• Mathematical self-confidence is crucial; simple but relentless math focus
• Course will include problem sets, two midterms, and a final exam

Closing Thoughts

• Purpose of studying finance:
  • Understand the financial system's role in the economy
  • Make informed economic choices and decisions
  • Engage with complex puzzles related to value and pricing
• Key Skills Developed:
  • Problem-solving in financial contexts
  • Understanding economic theories and their real-world applications

Lecture Experiment

• A live auction experiment demonstrated market dynamics:
  • Participants acted as buyers and sellers of football tickets, revealing market efficiency
  • Result: Prices converged to reflect true values despite chaos

Conclusion

• Importance of finance as a discipline not only for theoretical knowledge but for practical application.