Financial Markets (Lecture 1)

1. Behavioral Finance – Theory of Finance mixed with theories of other social sciences
(e.g Psychology, sociology, politics)
2. Subprime – Mortgages that were made over the last 10 years to subprime borrowers
(ppl who has a poor credit history – higher chances of default)
3. If you buy the house and don’t pay the mortgage, you will lose the contract and the
house
4. Technology –
- Finance is a technology (a way of doing things)
- Fintech … an engineering device (mathematical theories that lead us to device
financial structures)
5. Subprime crisis could be a result of technological advancement
6. Well-developed financial institution is key to a country’s success
7. There is a moral dilemma that undermines all our economic lives – and that could be
the same as that in Finance
8. Part of Finance is Philanthropy (giving money to initiate economic projects
9. Financial Invention involves experimentation (just like Scientific research)
10. Efficient Market Theory – Financial Markets work very well and incorporate info very
well. Encouraged by the observation that financial markets respond in great speed to
new info and eventual pricing and readjustments of the market prices.
- Prediction Markets (e,g predict election results)
11. Markets are not efficient in the global sense. Human psychology drives the markets
12. Debt consist of the promise to pay back the amount owed. ST and LT debt
instruments
- ST: Federal Funds Rate in US (1 day)
- LT: 30 /100 yr govt bonds
13. Investment Banks – Not a bank that accepts deposits (does not deal with general
public). It deals with financial institutions, and gets involved in underwriting of
securities for these institutions
14. Froward Contract - A contract made between 2 parties for execution in the future.
Over the counter contract (not arranged through the exchanges)
15. Future Contracts – First invented in Japan (Rice Market)
- Stock Index Futures Mkt
- Oil Prices Future Mkt etc
16. Option – A contract that says how many shares of a company you can buy
 Risk and Crises (Lecture 2)
1. Crises begin with bubbles (which drives the prices really high)
2. They happen in cycles (housing market and stock markets)
3. 2007 - Failure in financial institutions that invest in mortgages
4. Crises that we got into happens from the accumulation of events that further
accumulate by the law of probability theory
5. 2 popular assumptions that underlie financial theory
- Failure of independence
- Tendency of outliers or fat-tail distribution
6. Probability theory is a conceptual framework that evolved to be a powerful way of
thinking (invented by Mathematicians)
7. There is only a certain time frame that we can possibly predict a crisis
8. Formulas for Return:
- Return = [Price(t+1)-Price(t)+Dividend(t)]/P(t)
- Gross Return = 1 + Return
*Returns can be positive and negative.
.
9. Formula for Expected Value, Mean, Avg
- () =  = i=1 prob( = )i
- () =  =- f()  d
10. Formula for Variance and Standard Deviation
- Var() = ni=1prob( = 1) (1 - )2
- S2x = ni=1(1 – xmean)2/n
11. Formula for Covariance
- cov(x, y) = ni=1(x - xmean)(y - ymean)/n
12. Correlation
- A scale measure of how much two variables move together
- 1 = correlates to each other, -1 means they behave opp of each other, 0 =
independent
- -1   1
 = cov(x, y)/ (sxsy)
13. Variance of Sum
- Var(x + y) = var(x) + var(y) + 2cov(x, y)
14. Are the shocks affecting the stock markets independent of each other, or are they
correlated?
15. VaR (Value at Risk) – A measure of risk of a company’s activities (e.g Company A: we
have calculated a 5% prob we will lose $10M in a year)
- However, VaR calculated may be too optimistic which increase the risk of
bringing about a crisis (smaller VaR calculated)
16. Law of Large Numbers – Having a large pool of random numbers and brings us closer
to the average (like stocks, the variance of the average pf n random variable that are
all independent and identically distributed goes to 0 as the number of elements in
the average goes to )
17. Fundamental concept of insurance lies in Probability
18. CoVar is an alternative to VaR (CoVar is employed to recognize that portfolios can co-
vary more than we thought (episodes of things going wrong simultaneously, sending
the value of CoVar to rise)
 19. Returni = market return + idiosyncratic return
20. One of the false assumption in our financial history, is that random shocks to the
economy is randomly distributed (BUT it is not!) – Partly intuitive partly wrong
21. Fat-tail distribution (aka Cauchy Distribution)

Technology and Invention in Finance (Lecture 3)

1. News changes the prices of stock markets every day. They provide information that
drives investors’ decisions to buy / sell
2. Central Limit Theorem – A fundamental theorem from probability theory
- If you have independent identical random distributed variable, and if it has a
finite variance, then the distribution of an average of this variable converges to
this normal distribution, as the number of elements in the average increases
- Normal distributions do not have fat-tail. After 3-4 standard deviations they will
be almost zero
3. No option exchanges, no financial futures, no swaps in the 1970s
4. A core part of intuition that underlies financial inventions is the idea of
independence
- If risks are independent of each other, then they can be pulled away
5. Modern finance is about risk management, and it creates opportunity for people
6. Two concepts to ponder over;
- Risk theme
- Framing theme (framing a scheme as a psychologically appealing game)
7. An important invention in Finance – Limited Liability
- Limited Liability Corporation is one that guarantees you as a shareholder will not
be liable to the debts of the company (…ltd)
- E.g if a company is sued and they can’t pay, they can’t go after the stockholders
- A clear right of the shareholder
8. Stocks appeal to the masses because of the potential gains as a shareholder.
Investors pool money in to the company and this drives capital to where it is needed
to be
9. Another innovation in finance – Inflation Indexation
- Value of money changes through time. Inflation changes the value of a person’s
money and consequently affects the amount of consumer good they can
purchase over time
- Inflation Risk stemming from uncertainty of prices
- Most debts are in nominal terms (written in currency units)
10. Indexed bond (invented in 1780, Massachusetts)
- Amt of money in you get in pounds (back then British Pounds were used to
compute) will increase if inflation were to start
- First identifying an index of commodities that you would purchase, and that
index is used to input a formula that created inflation correction to the bonds
11. Psychologically salient, another invention in Finance that originate from Chile, and
overcoming framing issues, is the Unit Development
- A unit of account that is indexed to inflation
 - If you sign a contract written in UFs, you can be protected from the possibility of
your money being worthless due to the inflation (see Chile – Peso case study)
12. Another financial invention is the Swap
- Swap is a financial contract (invented by David Swensen) between two parties to
exchange cash flow (a simple swap is the currency swap)
- One party changes dollar to euro, and the other party changes euro to dollars
- Useful for risk management purposes
13. Some inventions above only appeared recently and not long time ago… could be due
to regulatory and legal uncertainty
14. Credit Default Swap – A contract between two parties that has to do with the risk of
a credit event.
- A protection buyer (pay the seller regular flow of money)
- A protection seller
- Until something bad happens, the protection seller has to pay the buyer
- It’s like an insurance
15. Credit insurance – An insurance against default of a company

Insurance, the Archetypal Risk Management Institution, its Opportunities and

Vulnerabilities (Lecture 5)
1. Mean-variance risk management problem and the asset pricing model
- Basic idea is pooling of risks and preventing people from being subjected to
extreme risk (via risk pooling)
2. AIG (biggest international insurance group) – one of the biggest bailout in the
subprime crisis ($182 billion)
- After CEO Greenberg left in 2005, AIG became exposed to real estate risk
- The idea their risk modelers had was that it doesn’t matter we take risk that
home prices might fall, because they can never fall everywhere. The company
was writing credit default swaps (insuring against defaults of companies whose
credit depended on real estate market). They also invested directly in securities
(MBS), that depended on the real estate market for their success. Hence when
everything failed at once, AIG was on the brink of failure.
- The reason for their bailout was because of the concern of systemic risks
3. Regulation of insurance (insurance companies subjected to govt regulations)
4. Insurance
- Used to be door to door sales
- It’s about preventing horrible catastrophe from ruining our lives
- Uses mathematical concept of risk pooling
5. Insurance came in during the 1600s. The oldest concept of insurance goes back to
the Count Oldenberg (1689)
- ‘ Why don’t we start a fund in which people pay 1% of the value of their homes
every year into the fund and use that fund to replace the house if there’s a fire?’
- n-events (each with a probability of occurring = p), then the s.d of the proportion
of events that occur is [p x (1 – p) / n]1/2 (assuming independence)
6. Type of insurance
- Life insurance
- Health insurance
 - Car insurance
- Property insurance
- Medical insurance
- Casualty insurance
- Other investment-oriented products (e.g annuities)
7. Making insurance work reliably involves a lot of detail
- Needs a contract design that specifies risks and excludes risks that are
inappropriate.
- An issue that insurance companies reach is moral hazard
- Moral Hazard: effects of insurance on people’s behavior that are undesirable
8. Insurance excludes risks that are vulnerable to moral hazard (i.e exclude certain
causes of death that look like suicide / insure more than what the house is worth)
9. Another design of the insurance contract is to prevent moral hazard from becoming
excessive (selection bias)
- Selection bias occurs when people who sign up for the insurance contract knows
that they are higher risk, which implies they would pay higher premiums
10. Another aspect of insurance (having precise definitions of the loss and what
constitutes proof of the loss)
- Failure could lead to confusions and legal wrangling
11. Insurance requires a collection of statistics
- 1600s (collection of mortality tables)
- A form for the company (who owns it)
12. Insurance also require a government design so that the govt verifies the problem
with insurance companies (govt insurance regulators)
13. Deposit insurance
14. State insurance guarantee funds (oldest being the 1941 SIGF) that protect insurance
companies. These protect individuals if they take out an insurance policy and the
insurance company blow up
15. McCarren Ferguson Act (1945) – which specifies that the insurance regulation act
was entirely for the federal govt
16. National Association of Insurance Commissioner – An association w/o any
constitutional or govt definition
17. China insurance protection fund – similar to us state guarantee fund
- However, it has a limit insurance capped at only $6000, compared to $500000 in
US
18. The biggest category of insurance privately offered is life insurance (2009 - $5
trillion)
19. In 2010, the US govt pass a landmark pair of bills to address the selection bias and
moral hazard problems and reducing the number of uninsured people.
- They set up new insurance exchanges that will offer insurance to be purchased
by the general public (placing a tax penalty if you don’t buy the insurance)
- It solves the selection bias problem as insurance companies no longer have the
problem that only sick ppl sign up (hence they can lower their premiums)
20. Catastrophe bond – a bond that is used to finance the management of large risks
Efficient Markets (Lecture 6)
1. Efficient Market Hypothesis (first coined by Harry Roberts): The theory that you
cannot beat the market, as every new piece of information gets priced into the
market, and following that, the markets react to them instantly to reach a new
equilibrium
George Gibson (1889):
‘When shares become publicly known in an open market, the value which they
acquire there may be regarded as the judgment of the best intelligence concerning
them’

You cannot expect one to routinely profit from information that’s already out there.
If you want to profit you will need to come up with something faster

Brealey and Myers:

‘Security prices accurately reflect available information and respond rapidly to new
information as soon as it becomes available’
2. Getting a high Sharpe ratio (fooling investors into thinking you have a high s. ratio):
- To sell of the tails of the distribution of your returns (selling calls out -of-the
money calls, doing so by writing-of-the-money puts)
3. Integral Investment Management (Hedge Fund)
4. Doing subtler things as a portfolio manager to get your Sharpe ratio up:
- Instead of manipulating with special derivatives positions, you could buy
companies that have large left tails (small probability of mass losses)
5. The law in US and other countries states that an investment manager must not fail to
disclose relevant info about a security (and it has to be more than boilerplate
disclosure) – i.e if there are information that in any way make your statistics look
misleading, you need to disclose that info and explain it to them
6. Technical analysis:
- The analysis of stock prices and some other speculative prices by looking at
charts of the prices and looking for patterns that suggest movements in prices
- Resistance level (a psychological barrier – e.g that the Dow cannot be worth
more than 1000 points and thus investors will sell when nearing 1000… thus the
Dow will just float around that value)
- Support level
- Head and Shoulders
7. Random Walk
- The idea that if the stock prices are really efficient, then any change from day to
day has to be due only to news, which are unforecastable. Thus, stock prices
have to do a random walk through time (any future movement is unpredictable)
- t  t – 1 + t (t is noise)
- The theory says that stock prices are not mean reverting (where they go from
today is all random)
Theory of Debt, Its Proper Role, Leverage Cycles (Lecture 7)

1. Interest Rates I/r (the percent that you own earn on a loan or pay on a loan)
- Eugen Von Bohm Bawerk (on why I/r is 2 / 3 / 4% a year… as in the value)
 Technical Progress (As the economy gets more scientific information on how
to do things, they get more productive – The value of I/r could be indicative
of how fast tech is improving
 Advantages to roundaboutness (More roundabout production is more
productive. The notion behind roundaboutness is:
 If you have to complete a task immediately, you would find the fastest way to
achieve it. However, if you are given ample of time to complete it, you might
devise a plan or way to efficiently complete it in a more effective or productive
way
(I/r is a measure of the advantages to roundaboutness)
 Time preference (people prefer the present over the future (akin to instant
gratification) (I/r is indicative of time preference)
2. Irving Fisher (1930 – Theory of Interest)
- (Fabozzi’s distillation of Irving Fisher): I/r is the intersection of demand and
supply curve for savings
 A graph of I/r against saving (along with the DD/SS curve)
3. Loan instruments
- Discount Bond – pays a fixed amount at a future date, and it sells at a discount
today. It pays no interest (it merely specifies that this particular bond is worth so
many dollars or euros as of a future date)
 E.g Discount Bond
 $100, Annual Compound Interest, T years to maturity
 Price today P = 100/(1+r)T
 r is also called yield to maturity, and maturity is T, which is the time when the
discount bond matures
Fabozzi’s formula for discount bonds:
P= 100/(1+r)t, where t = 2T (Applicable only to every 6 month interval)
4. Present Discounted Value (PDV)
- If you have a payment in T years or 2T (six months), then the PDV of a payment in
T years is PDV = x/(1+r)T = x/(1+z)t (if you are compounding every 6 months)
5. Continuous Compounding, balance = erT, where r is the continuously compounded I/r
∞
Xt
6. ∑ PDV for annual compounding of annual payment
T =1 ( 1+r ) ∗¿ t
7. A console (perpetuity) is an instrument that pays the same payment every period
forever
8. An annuity pays a fixed payment each period until maturity
9. Corporate (Conventional) Bond is a combination of annuity and discount bond
10. The concept of forward I/r (Sir John Wicks 1939)
11. Expectations theory says that the forward rate = expected spot rate
Corporate Stocks (Lecture 8)
1. Corporate stocks are claims on the profits of corporations
2. E,g in Germany:
- AG – Aktiengesellschaft (Public equity i.e traded in the stock exchange)
- GmbH – Gesellschaft mit beschraenkter Haftung (Family company – Private
Equity – Not traded in the stock exchange)
3. The idea of a Corporation (from the Latin word Corpus) is like a legal person
4. A corporation is owned by most shareholders and in most corporations, the
shareholders are equal.
- Each shareholder vote to elect a board member – Shareholder Democracy
- Board of directors provide wisdom to the company. CEOs are not always the
chairman of the board – separate entity
 CEO runs the company
 Board of director – a group of people who are externally hired or elected by
shareholders, can be there to give their perspective and insights to the CEO
5. Two types of Corporation
1. For – Profit (e.g Google, Amazon)
2. NonProfit (Universities)
6. Majority of what happen in corporations is determined by the sociology of the
organisational structure
7. The value of a share = Total value of a company / number of shares in the company
8. Market Cap = Number of shares X prevailing value of the share
9. Dividends – The distribution of profits to the shareholders
- Paid to shareholders when the board of directors decided on it (Subject to their
discretion)
- Could be seen as the reflection of the true value of the entire company
- Point of contention: Value of a stock ought to be the present value of the
expected future dividend
10. Prices of stocks fall when a dividend is paid out since the company is now worth less
after dividend payout
- Price fall = Total dividend payout / number of shares in the company
11. Pecking Order Theory (Stewart Myer’s theory): In essence, companies do not want to
issue new shares (This theory was contended by an article written by Eugene Fama
and Karl French in the Journal of Financial Economics 2005)
12. Buyback of shares (Companies repurchase their shares)
- Could be due to tax returns (if a company issues dividend, that goes in as income
to the shareholders and its taxed (usually get at higher rates than capital gains),
thus there is an advantage to repurchase shares
13. Share dilution and repurchase are neither bad, depending on circumstances
14. Common Stock is the real ownership in the company (you take all the profits)
15. Preferred Stock has a set dividend (and the board does not pay it)
16. Litner model
Dividendt – Dividendt-1 = ( x EPS – DPSt-1) + noise, where 0 <  < 1, EPS =
Earnings per share, DPS: Dividends per share
17. Shareholder equity vs Market Capitalisation (if your MC < SE, you are in danger of
liquidation)