is called Financial Theory.

I'm going to teach an actual class.

I'm going to spend the first half of the class talking about

the course and why you might be interested in it,

and then I'm going to start with the course.

There are not that many lectures available in the

semester so I'm not going to waste this one.

So the first half of 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 going to be actually

the first part of the course.

It'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 ten 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 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.

So this merry band of financial theory professors didn't really

believe in regulation.

They believed markets left unfettered worked 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 wanted to know whether a country's doing well or not you

don't have to study its entire political system and current

events, just look at the general stock

market of the country and that'll tell you.

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, a critical part of their theory was that the markets were

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's 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 people and the investment bankers they studied

adopted their language.

So this had never happened in academia before.

I mean, anthropologists study 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,

the business school finance people.

At Yale the greatest economists in Yale's history were actually

very interested in finance.

Maybe they were financial economists to begin with.

So the greatest Yale economist of the first half of the

twentieth century was Irving Fisher who 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, maybe the greatest American physicist of the time.

There's a building, as you know,

on Science Hill named after Gibbs,

and you'll hear more about his dissertation in the 1890s,

but he was a mathematical economist,

an econometrician but he invented almost all of this

economics in order to study finance.

The most famous Yale economist of the second half of the

twentieth century was James Tobin,

a famous macroeconomist, the most famous macroeconomist,

possibly, of the second half of the twentieth century after

Keynes, a great Keynesian.

But he got the Nobel Prize for work he did on finance in

economics.

Finance was incredibly interesting to him.

So Bob Shiller and I went to Yale and we basically said to

the deans, "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 last ten years.

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.

I myself have been quite critical of the financial

theory.

I started off as a straight pure mathematical economist.

To me economics was 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'll 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.

And the Cowles Foundation's motto was basically,

"Can we make economics more mathematical?

Economics, a 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 Cowles Foundation, which you'll hear a lot about

in these lectures, led the revolution in economics

transforming it from a verbal subject,

political economy, into a mathematical subject.

Well, I decided around 1989 that since I did mathematical

economics, and there were all these

finance people doing all kinds of mathematical things on Wall

Street and doing it very successfully,

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 Wall Street and I joined--most people I knew,

in fact, professors I knew went to Goldman Sachs.

There was a famous finance professor, who I had mentioned

before, named Fischer 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 littler firm called Kidder

Peabody, and 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 the 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 seventy-five people in the

department.

All the time I was a professor at Yale.

And after five years Kidder Peabody,

even though it was a hundred thirty-five years old,

formed by a famous family, the name should sound--

Peabody--familiar to you, it closed down after a hundred

thirty-five years, five years after I got there.

I had to invite the seventy-five people I'd hired

into my office and say, "You're fired."

And then I went next door to the office next to mine and the

guy there said, "You're fired."

And so that was my first taste of Wall Street.

And after that six of us founded a hedge fund called

Ellington Capital Management, which was a mortgage hedge

fund, and we had-- I'll tell you a lot 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'll 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 at 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 and 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,

in its own mathematical terms.

And what I found was that there are two things missing in the

Standard Theory.

One is that 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 know, you have to be able to convince someone you're going

to pay them 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 theory around incomplete markets and leverage,

which is a critique of the Standard Theory.

So in a way Shiller 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 is an average of thirty stocks and what their

value is.

We'll talk more about it later.