Financial Theory Course Introduction

Overview of the Course

• Course Name: Financial Theory
• Structure:
  • First Half: Discuss the course mechanics and interest in finance.
  • Second Half: Introduction to the core topics of the course.

Historical Context of Finance at Yale

• Finance was not taught at Yale until 10 years ago.
• Early perception: Considered a vocational subject by deans and faculty of arts and sciences.
• Rise in popularity due to notable business school professors:
  • Fisher Black, Robert Merton, William Sharpe, Steve Ross, Myron Scholes, Merton Miller.
• Finance's success: Dominated Wall Street with high earnings.

Key Figures in Financial Theory

• Irving Fisher: A significant economist at Yale, wrote early economic theories focused on finance.
• James Tobin: Noted for work on finance and economics, won a Nobel Prize.
• Bob Shiller: Critical of the efficient market hypothesis; emphasizes psychology in finance.

Efficient Market Hypothesis

• Market prices reflect all available information.
• Suggests that:
  • Stock prices indicate a company's performance without needing to read reports.
  • Stock market reflects a country's economic condition.
• Argument: Laypersons can invest as well as experts, citing randomness in stock price changes.
• Contradictory experiences among finance professors who often achieved high returns.

Critique of Standard Financial Theory

• Missing elements in traditional finance:
  • Insurance: The assumption of complete markets.
  • Collateral: Often overlooked in financial decisions.
• New Theory: Focus on incomplete markets and leverage.
• Acknowledgment of the financial crash as a validation of alternative theories.

Financial Crises and Market Behavior

• Analysis of Dow Jones Index from 1913, noting major market crashes.
• Importance of examining market behavior during crises.
• Case Study: 2007-2009 financial crisis roots in mortgage market issues.

Course Goals and Content

• Understand the financial system as part of the broader economic system.
• Learn practical valuation techniques and financial decision-making.
• Explore leverage cycles, market valuations, and demographic effects on the economy.
• Discuss implications of financial crises and regulatory responses.

Course Mechanics

• Prerequisites: Mathematical self-confidence; a background in economics is helpful but not required.
• Structure:
  • Two lectures a week.
  • Weekly problem sets due every Tuesday.
  • Two midterms and a final exam (grade distribution focus).
• Required skills:
  • Basic arithmetic, functions, derivatives, probability, and Excel proficiency.

Additional Topics of Interest

• Discussion on Social Security and its economic implications.
• Explore the argument of free markets as beneficial to the economy, including critiques and supporting theories.

Conclusion

• The course aims to provide not only academic knowledge but also practical skills for real-world financial decision-making.
• Encouragement to actively engage with the material and participate in discussions.