Course*  Financial Theory
*
 Course Level: Freshman
This course attempts to explain the role and the importance of the financial system in the global economy. Rather than separating off the financial world from the rest of the economy, financial equilibrium is studied as an extension of economic equilibrium. The course also gives a picture of the kind of thinking and analysis done by hedge funds.
*
The lectures in this course are broken down into "Concepts"
Prerequisites
Tweet

Lecture 19  History of the Mortgage Market; A Personal NarrativeLecture 19 History of the Mortgage Market; A Personal NarrativeProfessor Geanakoplos explains how, as a mathematical economist, he became interested in the practical world of mortgage securities, and how he became the Head of Fixed Income Securities at Kidder Peabody, and then one of six founding partners of Ellington Capital Management. During that time Kidder Peabody became the biggest issuer of collateralized mortgage obligations, and Ellington became the biggest mortgage hedge fund. He describes securitization and tranching of mortgage pools, the role of investment banks and hedge funds, and the evolution of the prime and subprime mortgage markets. He also discusses agent based models of prepayments in the mortgage market.*ConceptsConcept 1  Fannie Mae, Freddie Mac, and the Mortgage Securities MarketConcept 2  Collateralized Mortgage ObligationsConcept 3  Modeling Prepayment Tendencies at Kidder PeabodyConcept 4  The Rise of Ellington Capital Management and the Role of Hedge FundsConcept 5  The Leverage Cycle and the Subprime Mortgage MarketConcept 6  The Credit Default SwapConcept 7  Conclusion

Lecture 22  Risk Aversion and the Capital Asset Pricing TheoremLecture 22 Risk Aversion and the Capital Asset Pricing TheoremUntil now we have ignored risk aversion. The Bernoulli brothers were the first to suggest a tractable way of representing risk aversion. They pointed out that an explanation of the St. Petersburg paradox might be that people care about expected utility instead of expected income, where utility is some concave function, such as the logarithm. One of the most famous and important models in financial economics is the Capital Asset Pricing Model, which can be derived from the hypothesis that every agent has a (different) quadratic utility. Much of the modern mutual fund industry is based on the implications of this model. The model describes what happens to prices and asset holdings in general equilibrium when the underlying risks can't be hedged in the aggregate. It turns out that the tools we developed in the beginning of this course provide an answer to this question.*ConceptsConcept 1  Risk AversionConcept 2  The Bernoulli Explanation of RiskConcept 3  Foundations of the Capital Asset Pricing ModelConcept 4  Accounting for Risk in Prices and Asset Holdings in General EquilibriumConcept 5  Implications of Risk in HedgingConcept 6  Diversification in Equilibrium and Conclusion

Lecture 23  The Mutual Fund Theorem and Covariance Pricing TheoremsLecture 23 The Mutual Fund Theorem and Covariance Pricing TheoremsThis lecture continues the analysis of the Capital Asset Pricing Model, building up to two key results. One, the Mutual Fund Theorem proved by Tobin, describes the optimal portfolios for agents in the economy. It turns out that every investor should try to maximize the Sharpe ratio of his portfolio, and this is achieved by a combination of money in the bank and money invested in the "market" basket of all existing assets. The market basket can be thought of as one giant index fund or mutual fund. This theorem precisely defines optimal diversification. It led to the extraordinary growth of mutual funds like Vanguard. The second key result of CAPM is called the covariance pricing theorem because it shows that the price of an asset should be its discounted expected payoff less a multiple of its covariance with the market. The riskiness of an asset is therefore measured by its covariance with the market, rather than by its variance. We conclude with the shocking answer to a puzzle posed during the first class, about the relative valuations of a large industrial firm and a risky pharmaceutical startup.*ConceptsConcept 1  The Mutual Fund TheoremConcept 2  Covariance Pricing Theorem and DiversificationConcept 3  Deriving Elements of the Capital Asset Pricing ModelConcept 4  Mutual Fund Theorem in Math and Its SignificanceConcept 5  The Sharpe Ratio and Independent RisksConcept 6  Price Dependence on Covariance, Not Variance

Lecture 24  Risk, Return, and Social SecurityLecture 24 Risk, Return, and Social SecurityThis lecture addresses some final points about the CAPM. How would one test the theory? Given the theory, what's the right way to think about evaluating fund managers' performance? Should the manager of a hedge fund and the manager of a university endowment be judged by the same performance criteria? More generally, how should we think about the return differential between stocks and bonds? Lastly, looking back to the lectures on Social Security earlier in the semester, how should the CAPM inform our thinking about the role of stocks and bonds in Social Security? Can the views of Democrats and Republicans be reconciled? What if Social Security were privatized, but workers were forced to hold their assets in a new kind of asset called PAAWS, which pay the holder more if the wage of young workers is higher?*ConceptsConcept 1  Testing the Capital Asset Pricing ModelConcept 2  Evaluation of Fund Management Performance using CAPMConcept 3  Reassessing Assets within Social SecurityConcept 4  Reconciling Democratic and Republican Views on Social SecurityConcept 5  Geanakoplos's Personal Annuitized Average Wage SecuritiesConcept 6  The BlackScholes Model

Lecture 25  The Leverage Cycle and the Subprime Mortgage CrisisLecture 25 The Leverage Cycle and the Subprime Mortgage CrisisStandard financial theory left us woefully unprepared for the financial crisis of 200709. Something is missing in the theory. In the majority of loans the borrower must agree on an interest rate and also on how much collateral he will put up to guarantee repayment. The standard theory presented in all the textbooks ignores collateral. The next two lectures introduce a theory of the Leverage Cycle, in which default and collateral are endogenously determined. The main implication of the theory is that when collateral requirements get looser and leverage increases, asset prices rise, but then when collateral requirements get tougher and leverage decreases, asset prices fall. This stands in stark contrast to the fundamental value theory of asset pricing we taught so far. We'll look at a number of facts about the subprime mortgage crisis, and see whether the new theory offers convincing explanations.*ConceptsConcept 1  Assumptions on Loans in the Subprime Mortgage MarketConcept 2  Market Weaknesses Revealed in the 207209 Financial CrisisConcept 3  Collateral and Introduction to the Leverage CycleConcept 4  Contrasts between the Leverage Cycle and CAPMConcept 5  Leverage Cycle Theory in Recent Financial HistoryConcept 6  Negative Implications of the Leverage CycleConcept 7  Conclusion