Course: Financial Theory with John Geanakoplos Dnatube

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Lec 1- Why Finance?

"Lec 1- Why Finance?" Financial Theory (ECON 251) 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....
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Lec 2- Utilities, Endowments, and Equili ...

"Lec 2- Utilities, Endowments, and Equilibrium" Financial Theory (ECON 251) 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...
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Lec 3 - Computing Equilibrium

"Lec 3 - Computing Equilibrium" Financial Theory (ECON 251) 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...
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Lec 4- Efficiency, Assets, and Time

"Lec 4- Efficiency, Assets, and Time" Financial Theory (ECON 251) 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...
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Lec 5- Present Value Prices and the Real ...

"Lec 5- Present Value Prices and the Real Rate of Interest" Financial Theory (ECON 251) 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...
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Lec 6 - Irving Fisher's Impatience Theor ...

"Lec 6 - Irving Fisher's Impatience Theory of Interest" Financial Theory (ECON 251) 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...
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Lec 7 - Shakespeare's Merchant of Venice ...

"Lec 7 - Shakespeare's Merchant of Venice and Collateral, Present Value and the Vocabulary of Finance" Financial Theory (ECON 251) While economists didn't have a good theory of interest until Irving Fisher came along, and didn't understand the role of collateral until even later, Shakespeare understood many of these things hundreds of years earlier. The first half of this lecture examines...
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Lec 8 - How a Long-Lived Institution Fig ...

"Lec 8 - How a Long-Lived Institution Figures an Annual Budget. Yield" Financial Theory (ECON 251) In the 1990s, Yale discovered that it was faced with a deferred maintenance problem: the university hadn't properly planned for important renovations in many buildings. A large, one-time expenditure would be needed. How should Yale have covered these expenses? This lecture begins by applying...
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Lec 9 - Yield Curve Arbitrage

"Lec 9 - Yield Curve Arbitrage " Financial Theory (ECON 251) Where can you find the market rates of interest (or equivalently the zero coupon bond prices) for every maturity? This lecture shows how to infer them from the prices of Treasury bonds of every maturity, first using the method of replication, and again using the principle of duality. Treasury bond prices, or at least Treasury...
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Lec 10 - Dynamic Present Value

"Lec 10 - Dynamic Present Value" Financial Theory (ECON 251) In this lecture we move from present values to dynamic present values. If interest rates evolve along the forward curve, then the present value of the remaining cash flows of any instrument will evolve in a predictable trajectory. The fastest way to compute these is by backward induction. Dynamic present values help us understand...
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Lec 11 - Social Security

"Lec 11 - Social Security" Financial Theory (ECON 251) This lecture continues the analysis of Social Security started at the end of the last class. We describe the creation of the system in 1938 by Franklin Roosevelt and Frances Perkins and its current financial troubles. For many democrats Social Security is the most successful government program ever devised and for many Republicans...
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Lec 12 - Overlapping Generations Models ...

"Lec 12 - Overlapping Generations Models of the Economy" Financial Theory (ECON 251) In order for Social Security to work, people have to believe there's some possibility that the world will last forever, so that each old generation will have a young generation to support it. The overlapping generations model, invented by Allais and Samuelson but here augmented with land, represents such a...
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Lec 13 - Demography and Asset Pricing: W ...

"Lec 13 - Demography and Asset Pricing: Will the Stock Market Decline when the Baby Boomers Retire?" Financial Theory (ECON 251) In this lecture, we use the overlapping generations model from the previous class to see, mathematically, how demographic changes can influence interest rates and asset prices. We evaluate Tobin's statement that a perpetually growing population could solve the...
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Lec 14 - Quantifying Uncertainty and Risk

"Lec 14 - Quantifying Uncertainty and Risk" Financial Theory (ECON 251) Until now, the models we've used in this course have focused on the case where everyone can perfectly forecast future economic conditions. Clearly, to understand financial markets, we have to incorporate uncertainty into these models. The first half of this lecture continues reviewing the key statistical concepts that...
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Lec 15 - Uncertainty and the Rational Ex ...

"Lec 15 - Uncertainty and the Rational Expectations Hypothesis" Financial Theory (ECON 251) According to the rational expectations hypothesis, traders know the probabilities of future events, and value uncertain future payoffs by discounting their expected value at the riskless rate of interest. Under this hypothesis the best predictor of a firm's valuation in the future is its stock price...
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Lec 16 - Backward Induction and Optimal ...

"Lec 16 - Backward Induction and Optimal Stopping Times" Financial Theory (ECON 251) In the first part of the lecture we wrap up the previous discussion of implied default probabilities, showing how to calculate them quickly by using the same duality trick we used to compute forward interest rates, and showing how to interpret them as spreads in the forward rates. The main part of the...
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Lec 17 - Callable Bonds and the Mortgage ...

"Lec 17 - Callable Bonds and the Mortgage Prepayment Option" Financial Theory (ECON 251) This lecture is about optimal exercise strategies for callable bonds, which are bonds bundled with an option that allows the borrower to pay back the loan early, if she chooses. Using backward induction, we calculate the borrower's optimal strategy and the value of the option. As with the simple...
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Lec 18 - Modeling Mortgage Prepayments a ...

"Lec 18 - Modeling Mortgage Prepayments and Valuing Mortgages" Financial Theory (ECON 251) A mortgage involves making a promise, backing it with collateral, and defining a way to dissolve the promise at prearranged terms in case you want to end it by prepaying. The option to prepay, the refinancing option, makes the mortgage much more complicated than a coupon bond, and therefore something...
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Lec 19 - History of the Mortgage Market: ...

"Lec 19 - History of the Mortgage Market: A Personal Narrative" Financial Theory (ECON 251) Professor 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...
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Lec 20 - Dynamic Hedging

"Lec 20 - Dynamic Hedging" Financial Theory (ECON 251) Suppose you have a perfect model of contingent mortgage prepayments, like the one built in the previous lecture. You are willing to bet on your prepayment forecasts, but not on which way interest rates will move. Hedging lets you mitigate the extra risk, so that you only have to rely on being right about what you know. The trouble with...
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Lec 21 - Dynamic Hedging and Average Life

"Lec 21 - Dynamic Hedging and Average Life" Financial Theory (ECON 251) This lecture reviews the intuition from the previous class, where the idea of dynamic hedging was introduced. We learn why the crucial idea of dynamic hedging is marking to market: even when there are millions of possible scenarios that could come to pass over time, by hedging a little bit each step of the way, the...
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Lec 22 - Risk Aversion and the Capital A ...

"Lec 22 - Risk Aversion and the Capital Asset Pricing Theorem" Financial Theory (ECON 251) Until 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...
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Lec 23 - The Mutual Fund Theorem and Cov ...

"Lec 23 - The Mutual Fund Theorem and Covariance Pricing Theorems" Financial Theory (ECON 251) This 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...
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Lec 24 - Risk, Return, and Social Security

"Lec 24 - Risk, Return, and Social Security" Financial Theory (ECON 251) This 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,...
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Lec 25 - The Leverage Cycle and the Subp ...

"Lec 25 - The Leverage Cycle and the Subprime Mortgage Crisis" Financial Theory (ECON 251) Standard financial theory left us woefully unprepared for the financial crisis of 2007-09. 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...
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Lec Last - The Leverage Cycle and Crashes

"Lec Last - The Leverage Cycle and Crashes" Financial Theory (ECON 251) In order to understand the precise predictions of the Leverage Cycle theory, in this last class we explicitly solve two mathematical examples of leverage cycles. We show how supply and demand determine leverage as well as the interest rate, and how impatience and volatility play crucial roles in setting the interest...

Financial Theory with John Geanakoplos


Source of these courses is Yale 
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.
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COURSE NAME: Financial Theory with John Geanakoplos

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