**Financial Theory**

**1. Why Finance?**

**YaleCourses**

This lecture 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.

00:00 – Chapter 1. Course Introduction

10:16 – Chapter 2. Collateral in the Standard Theory

17:54 – Chapter 3. Leverage in Housing Prices

33:47 – Chapter 4. Examples of Finance

46:13 – Chapter 5. Why Study Finance?

50:13 – Chapter 6. Logistics

58:22 – Chapter 7. A Experiment of the Financial Market

**2. Utilities, Empowerment and Equilibrium**

This lecture explains what an economic model is, and why it allows for counterfactual reasoning and often yields paradoxical conclusions. Typically, equilibrium is defined as the solution to a system of simultaneous equations. The most important economic model is that of supply and demand in one market, which was understood to some extent by the Ancient Greeks and even by Shakespeare. That model accurately fits the experiment from the last class, as well as many other markets, such as the Paris Bourse, online trading, the commodities pit, and a host of others. The modern theory of general economic equilibrium described in this lecture extends that model to continuous quantities and multiple commodities. It is the bedrock on which we will build the model of financial equilibrium in subsequent lectures.

00:00 – Chapter 1. Introduction

07:04 – Chapter 2. Why Model?

13:30 – Chapter 3. History of Markets

24:41 – Chapter 4. Supply and Demand and General Equilibrium

37:59 – Chapter 5. Marginal Utility

45:20 – Chapter 6. Endowments and Equilibrium

**3. Computing Equilibrium**

Our understanding of the economy will be more tangible and vivid if we can in principle explain all the economic decisions of every agent in the economy. This lecture demonstrates, with two examples, how the theory lets us calculate equilibrium prices and allocations in a simple economy, either by hand or using a computer. In future lectures we shall extend this method so as to compute equilibrium in financial economies with stocks and bonds and other financial assets.

00:00 – Chapter 1. Introduction

02:48 – Chapter 2. Welfare and Utility in Free Markets

16:52 – Chapter 3. Equilibrium amidst Consumption and Endowments

32:43 – Chapter 4. Anticipation of Prices

52:53 – Chapter 5. Log Utilities and Computer Models of Equilibrium

**4. Efficiency, Assets and Time**

Over time, economists’ justifications for why free markets are a good thing have changed. In the first few classes, we saw how under some conditions, the competitive allocation maximizes the sum of agents’ utilities. When it was found that this property didn’t hold generally, the idea of Pareto efficiency was developed. This class reviews two proofs that equilibrium is Pareto efficient, looking at the arguments of economists Edgeworth, and Arrow-Debreu. The lecture suggests that if a broadening of the economic model invalidated the sum of utilities justification of free markets, a further broadening might invalidate the Pareto efficiency justification of unregulated markets. Finally, Professor Geanakoplos discusses how Irving Fisher introduced two crucial ingredients of finance,–time and assets–into the standard economic equilibrium model.

00:00 – Chapter 1. Is the Free Market Good? A Mathematical Perspective

11:20 – Chapter 2. The Pareto Efficiency and Equilibrium

38:42 – Chapter 3. Fundamental Theorem of Economics

46:27 – Chapter 4. Shortcomings of the Fundamental Theorem

52:39 – Chapter 5. History of Mathematical Economics

01:00:21 – Chapter 6. Elements of Financial Models

**5. Present Value Prices and the Real Rate of Interest**

Philosophers and theologians have railed against interest for thousands of years. But that is because they didn’t understand what causes interest. Irving Fisher built a model of financial equilibrium on top of general equilibrium (GE) by introducing time and assets into the GE model. He saw that trade between apples today and apples next year is completely analogous to trade between apples and oranges today. Similarly he saw that in a world without uncertainty, assets like stocks and bonds are significant only for the dividends they pay in the future, just like an endowment of multiple goods. With these insights Fisher was able to show that he could solve his model of financial equilibrium for interest rates, present value prices, asset prices, and allocations with precisely the same techniques we used to solve for general equilibrium. He concluded that the real rate of interest is a relative price, and just like any other relative price, is determined by market participants’ preferences and endowments, an insight that runs counter to the intuitions held by philosophers throughout much of human history. His theory did not explain the nominal rate of interest or inflation, but only their ratio.

00:00 – Chapter 1. Implications of General Equilibrium

03:08 – Chapter 2. Interest Rates and Stock Prices

22:06 – Chapter 3. Defining Financial Equilibrium

33:41 – Chapter 4. Inflation and Arbitrage

43:35 – Chapter 5. Present Value Prices

57:44 – Chapter 6. Real and Nominal Interest Rates

**6. Irving Fisher’s Impatience Theory of Interest**

Building on the general equilibrium setup solved in the last week, this lecture looks in depth at the relationships between productivity, patience, prices, allocations, and nominal and real interest rates. The solutions to three of Fisher’s famous examples are given: What happens to interest rates when people become more or less patient? What happens when they expect to receive windfall riches sometime in the future? And, what happens when wealth in an economy is redistributed from the poor to the rich?

00:00 – Chapter 1. From Financial to General Equilbrium

06:44 – Chapter 2. Applying the Principle of No Arbitrage

23:50 – Chapter 3. The Fundamental Theorem of Asset Pricing

39:25 – Chapter 4. Effects of Technology in Fisher Economy

51:31 – Chapter 5. The Impatience Theory of Interest

01:06:48 – Chapter 6. Conclusion

**7. Shakespeare’s Merchant of Venice and Collateral, Present Value and Vocabulary for Finance**