
Lecture Description
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 rate and the leverage. Mathematically, the model helps us identify the three key elements of a crisis. First, scary bad news increases uncertainty. Second, leverage collapses. Lastly, the most optimistic people get crushed, so the new marginal buyers are far less sanguine about the economy. The result is that the drop in asset prices is amplified far beyond what any market participant would expect from the news alone. If we want to mitigate the fallout from a crisis, the place to begin is in controlling those three elements. If we want to prevent leverage cycle crashes, we must monitor leverage and regulate it, the same way we monitor and adjust interest rates.
Course Index
- Why Finance?
- Utilities, Endowments, and Equilibrium
- Computing Equilibrium
- Efficiency, Assets, and Time
- Present Value Prices and the Real Rate of Interest
- Irving Fisher's Impatience Theory of Interest
- Shakespeare's Merchant of Venice, Collateral. Present Value and the Vocabulary of Finance
- How a Long-Lived Institution Figures an Annual Budget. Yield
- Yield Curve Arbitrage
- Dynamic Present Value
- Social Security
- Overlapping Generations Models of the Economy
- Demography and Asset Pricing: Will the Stock Market Decline when the Baby Boomers Retire?
- Quantifying Uncertainty and Risk
- Uncertainty and the Rational Expectations Hypothesis
- Backward Induction and Optimal Stopping Times
- Callable Bonds and the Mortgage Prepayment Option
- Modeling Mortgage Prepayments and Valuing Mortgages
- History of the Mortgage Market: A Personal Narrative
- Dynamic Hedging
- Dynamic Hedging and Average Life
- Risk Aversion and the Capital Asset Pricing Theorem
- The Mutual Fund Theorem and Covariance Pricing Theorems
- Risk, Return, and Social Security
- The Leverage Cycle and the Subprime Mortgage Crisis
- The Leverage Cycle and Crashes
Course Description
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.
Course Structure:
This Yale College course, taught on campus twice per week for 75 minutes, was recorded for Open Yale Courses in Fall 2009.