Title: Uncertainty and the Rational Expectations Hypothesis: Applications toPredicting Stock Prices, Default Probabilities, and Hyperbolic Discounting

Overview:
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 today. In one famous test of this hypothesis, it was found that detailed weather forecasts could not be used to improve on contemporaneous orange prices as a predictor of future orange prices, but that orange prices could improve contemporaneous weather forecasts. Under the rational expectations hypothesis you can infer more about the odds of corporate or sovereign bonds defaulting by looking at their prices than by reading about the financial condition of their issuers.On the other hand, when discount rates rather than payoffs are uncertain, today's one year rate grossly overestimates the long run annualized rate. If today's one year interest rate is 4%, and if the one year interest rate follows a geometric random walk, then the value today of one dollar in T years is described in the long run by the hyperbolic function 1/ √T, which is much larger than the exponential function 1/(1.04)T, no matter what the constant K. Hyperbolic discounting is the term used to describe the tendency of animals and humans to value the distant future much more than would be implied by (exponentially) discounting at a constant rate such as 4%. Hyperbolic discounting can justify expenses taken today to improve the environment in 500 years that could not be justified under exponential discounting.

1. Why Finance?
2. Utilities, Endowments, and Equilibrium
3. Computing Equilibrium
4. Efficiency, Assets, and Time
5. Present Value Prices and the Real Rate of Interest
6. Irving Fisher's Impatience Theory of Interest
7. Shakespeare's Merchant of Venice, Collateral. Present Value and the Vocabulary of Finance
8. How a Long-Lived Institution Figures an Annual Budget. Yield
9. Yield Curve Arbitrage
10. Dynamic Present Value
11. Social Security
12. Overlapping Generations Models of the Economy
13. Demography and Asset Pricing: Will the Stock Market Decline when the Baby Boomers Retire?
14. Quantifying Uncertainty and Risk
15. Uncertainty and the Rational Expectations Hypothesis
16. Backward Induction and Optimal Stopping Times
17. Callable Bonds and the Mortgage Prepayment Option
18. Modeling Mortgage Prepayments and Valuing Mortgages
19. History of the Mortgage Market: A Personal Narrative
20. Dynamic Hedging
21. Dynamic Hedging and Average Life
22. Risk Aversion and the Capital Asset Pricing Theorem
23. The Mutual Fund Theorem and Covariance Pricing Theorems
24. Risk, Return, and Social Security
25. The Leverage Cycle and the Subprime Mortgage Crisis
26. The Leverage Cycle and Crashes

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.