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prof: so anyway,the course i'm going to teach is called financial theory. i'm going to teach an actualclass. i'm going to spend the firsthalf of the class talking about the course and why you might beinterested in it, and then i'm going to startwith the course. there are not that manylectures available in the semester so i'm not going towaste this one. so the first half of the classis going to be about why to

study it and the mechanics ofthe course, and the second half of thelecture is going to be actually the first part of the course. it'll give you maybe an idea ofwhether you'll find the course interesting too. so i think i'll turn this--iwon't have too much powerpoint here. so you should know that financewas not taught until ten years ago at yale.

it was regarded by the deansand the classically minded faculty of the arts and sciencesas a vocational subject not worthy of being taught to yaleundergraduates. it was growing more and morefamous, however, in the world and therewas a band of business school professors,fischer black, robert merton,william sharpe, steve ross, myron scholes,merton miller, who had a huge following inbusiness schools teaching the

subject,and whose students went off to wall street,and more or less dominated the investment banking parts of wallstreet, and became extremely successful. finance became the most highlypaid profession. it became the most highly paidfaculty in the university, although they were all inbusiness schools. there are more physics phdsworking in finance now than there are working in physics.

so this merry band of financialtheory professors didn't really believe in regulation. they believed markets leftunfettered worked best of all. they believed in what theycalled efficient markets and the idea that asset prices reflectall the available possible information. so an implication of that isthat if you want to find out whether a company's doing wellor not you don't have to take the trouble to read all theirfinancial reports,

just look at their stock price. if you wanted to know whether acountry's doing well or not you don't have to study its entirepolitical system and current events,just look at the general stock market of the country andthat'll tell you. they believed that you couldmake as good returns in the market as a lay person as youcould as an expert because all the experts were competing totry and get the best possible price,and so the price itself

reflected all their knowledgeand wisdom and opinions and so the lay person could takeadvantage of that by buying stocks. everybody should be aninvestor, they felt. a monkey throwing darts at adart board would do as well as any of the greatest experts. now, their own theory wasbasically contradicted by their own experience because all ofthem seemed to go out into the world and invest,and almost all of them made

extraordinary returns and made ahuge amount of money all of which made them even lesspopular in the faculty of arts and sciences. so, a critical part of theirtheory was that the markets were so efficient,driven by people like them who are competing to exploit everyadvantage, and therefore compete awayevery advantage, and by doing that put all theinformation they have into the prices.

the implication of that theoryis that there's an extraordinarily clever way ofcomputing the value of most investment assets,and about deciding when a financial decision's a goodthing to do or not, and that was the heart of whatthey taught in these business schools,these algorithms for valuing assets and making optimalfinancial decisions. one striking thing is that thepeople they studied, the business people and theinvestment bankers they studied

adopted their language. so this had never happened inacademia before. i mean, anthropologists studyprimitive tribes and different kinds of people all the time andnot one of them, i venture to say,has ever taken over all the language invented byanthropologists to behave themselves in their ownsocieties, but the business people thatthese professors were studying ended up using exactly thelanguage created in academia.

now, yale was very different. there was no divide betweeneconomists and finance people, the business school financepeople. at yale the greatest economistsin yale's history were actually very interested in finance. maybe they were financialeconomists to begin with. so the greatest yale economistof the first half of the twentieth century was irvingfisher who you hear a lot about. he wrote, possibly,the first economics phd at

yale. there was no economist to teachhim so he had to write his phd with gibbs, maybe the greatestamerican physicist of the time. there's a building,as you know, on science hill named aftergibbs, and you'll hear more about hisdissertation in the 1890s, but he was a mathematicaleconomist, an econometrician but heinvented almost all of this economics in order to studyfinance.

the most famous yale economistof the second half of the twentieth century was jamestobin, a famous macroeconomist,the most famous macroeconomist, possibly, of the second half ofthe twentieth century after keynes,a great keynesian. but he got the nobel prize forwork he did on finance in economics. finance was incrediblyinteresting to him. so bob shiller and i went toyale and we basically said to

the deans,"there's a long tradition of finance and economicshand-in-hand at yale, and so it's not a vocationalsubject. it's actually central toeconomics, and central to understanding the economy,and central to understanding the global economy. so we'd like to teach it toyale undergraduates, and we believe a few of themwill actually take the course,"and so they agreed to let us do

it,and so we've been teaching it now for the last ten years. so as you know shiller has beenvery critical of the business efficient markets tradition. he feels that these financeprofessors left something essential out of the wholestory. what they left out waspsychology. they left out the idea of fads,and rumors, and narratives,which he thinks has as big an

effect on prices as the hardinformation about profits that the business school professorsimagined drove profits. i myself have been quitecritical of the financial theory. i started off as a straightpure mathematical economist. to me economics was almost abranch of logic and philosophy that happened to tell yousomething about the world. so i got my phd with ken arrow,who you'll hear a lot about very shortly.

and i came to yale,i'd been a yale undergraduate, i came back to yale and ijoined the cowles foundation. and the cowles foundation'smotto was basically, "can we make economicsmore mathematical? economics, a social science,ought to be amenable to mathematical analysis just likephysics or chemistry is," and people didn't believe thisat first. and the cowles foundation,which you'll hear a lot about in these lectures,led the revolution in economics

transforming it from a verbalsubject, political economy,into a mathematical subject. well, i decided around 1989that since i did mathematical economics,and there were all these finance people doing all kindsof mathematical things on wall street and doing it verysuccessfully, i thought i might just checkout what they were doing. so it might be fun to see whatthey were up to. so i went to wall street and ijoined--most people i knew,

in fact, professors i knew wentto goldman sachs. there was a famous financeprofessor, who i had mentioned before, named fischer black whowas there at the time and he attracted a lot of people. and so that was the traditionalthing to do, but i decided to go to alittler firm called kidder peabody,and it was the seventh biggest investment bank at the time. and one thing led to another,and they decided that they

wanted to reorganize theirresearch department in fixed income. and since i was a professorthere, and i did mathematical economics,and i was there for the whole year somebody said,the director of the fixed income department said,"why don't you take charge of it and hire a new fixedincome research department for me. so i did, and ultimately therewere seventy-five people in the

department. all the time i was a professorat yale. and after five years kidderpeabody, even though it was a hundredthirty-five years old, formed by a famous family,the name should sound-- peabody--familiar to you,it closed down after a hundred thirty-five years,five years after i got there. i had to invite theseventy-five people i'd hired into my office and say,"you're fired."

and then i went next door tothe office next to mine and the guy there said,"you're fired." and so that was my first tasteof wall street. and after that six of usfounded a hedge fund called ellington capital management,which was a mortgage hedge fund, and we had--i'll tell you a lot about it. it started after the kidderclosing as a rather small hedge fund,but it grew into a very big mortgage hedge fund,in fact the biggest mortgage

hedge fund in the country. (although recently we found outthat practically everybody who trades mortgages is basically ahedge fund. fannie mae, freddie mac,they'll all basically hedge funds, so it doesn't meananything anymore to say that you're a big mortgage hedgefund.) but anyway, we almost went outof business in '98 a subject, a story i'll tell you at greatlength, and then we just sufferedthrough this disastrous last

year or two,but we're still here. so these experiences,of course, have colored my understanding of wall street andmy approach to the subject. so i took on,in my theoretical work, finance and economic theory onits own terms. i didn't think like shiller tointroduce psychology into economics i just take it on inits own terms, in its own mathematical terms. and what i found was that thereare two things missing in the

standard theory. one is that it implicitlyassumes you can buy insurance for everything. it's the assumption that'scalled complete markets. and secondly it leaves outcollateral entirely so you'll never see, almost in any singleeconomics textbook, the idea of collateral orleverage. and those, i think,the idea that you can't get insurance for everything andthat you need collateral,

you know, you have to be ableto convince someone you're going to pay them back if you borrowmoney and collateral is the most convincing way of persuading himhe's going to be paid back, the lender. those two things were missingfrom the standard theory, so i built a theory aroundincomplete markets and leverage, which is a critique of thestandard theory. so in a way shiller and i havebeen vindicated by the crash. i mean, so let me just show youa picture here.

well, maybe i will,you know, how bad the crash was. so let's look at the dow jones. the dow jones is an average ofthirty stocks and what their value is. we'll talk more about it later. but here it is back to 1913moving along breezily going up and up and up,you know, there are a few blips which we'll come to later likethis one in 1929,

and then--but look whathappened lately. look at that. the dow jones was up at 14,000and it dropped to 6,500, something like that,more than a fifty percent drop and now it's gone fifty percentup again. so if you believe these financeprofessors you'd have to say that everybody realized thatfuture profits in america were going to be less than half whatthey thought they were going to be before and that's why thestock market dropped.

and then miraculously when ithit a bottom everybody figured, "oh, my gosh,we misunderstood things. actually it's not nearly thatbad and things are fifty percent higher because now people thinkthat profits really weren't going to go,you know, didn't drop in half, didn't drop by fifty percent,they only dropped by twenty-five percent. and that was the only way,according to the old theory, to explain what happened.

now shiller would just say,"well, everybody's--they're crazy. they got this into their headthat the world was just going to be great and then some rumorstarted, and things were so high,and the narrative changed and they thought things wereterrible," and this his story. and i'm not sure how he gets itto go up again. they changed their mind again.

by the way it's a little bitbetter to look at the dow correcting for inflation andthen you see that the 1929 crash looks--and this is on a log scale, remember before the depressionthe stock market was so low. it's grown so much over ahundred years that it hardly seemed like anything washappening. well, now in log scale--goingup two of these is multiplying by ten--you see that in the depression in 1929 through the early '30sthe stock market fell.

i don't remember what it is. it looks like it's almost twothings. it looks like it's eighty orninety percent, and the fall this time has beenmuch smaller, fifty percent,not ninety percent. so it's a whole thing down butnot two things down. it's not a whole thing down. it's less than that. a whole thing down would be thesquare root of ten or a third.

it didn't go down two thirds. it went down less than twothirds. it went down fifty percent,so the actual percentage drop was much worse in the depressionthan it is now. we're going to come back to allthese things. what else can we get out ofthese numbers? i just want you to notice acouple other things. so these numbers are all veryinteresting. if you're mathematical theseare the sorts of things you pay

attention to. so these efficient marketsguys, they looked at the change in price every month. so there's a lot to say fortheir theory. they said, "look,it goes up and down randomly." in fact we'll see that thereare all kinds of tests about whether you can predict it'sgoing to go up tomorrow on the basis of how it did yesterday,and the answer's no.

it's very difficult to predictwhether the stock market is going up or down. it seems to be random. well, it's random and they usedto think it was normally distributed. a lot of people argued it wasnormally distributed, but it's hard. you never get these giganticoutliers if things are normally they're just way too unlikelyto happen.

so mandelbrot,who was a yale professor who retired a couple years ago,although he wasn't when he formed his theories,the inventor of fractals, he said this couldn't possiblybe a random walk in the traditional brownian motionsense of the word because you'd never get these big outliers,but he offered no explanation for why they might be there,and i don't know if shiller has an explanation either. i mean, is it that peoplesuddenly get shocked one day and

then the next week they changetheir mind and things aren't so bad after all? but you'll see that the theoryof collateral and margins does explain these kinds of things. let's just look at the dow. we just looked at the dow. let's look at another,the s&p 500. where's the s&p 500?

here's the s&p 500 data. here's the history of thes&p 500. it looks very similar to thedow, except we have longer history back to 1871,so i just want to point out one more thing in the s&p 500. so this is an average offive-hundred stocks, not just thirty,but it's more or less the same. but let's look at the samething taking the logarithm and check for inflation.

so you see here that there arethese four cycles. things seemed low in 1871. they go up and they go down. then you've got another up anda down. then you've another up and adown. four times the same thing hashappened. now this could be justmeaningless accidents, but it will turn out that thedemography of the country, the baby boom cycle,we haven't had just one baby

boom we've had four of them,so this cycle of stock prices, which they're each time ageneration long, happens to correspond exactlyto the rise, the different age distributionin the population. so another theory of the stockmarket, which wouldn't have beenentertained by these original financial theorists,is that demography has something to do with the stockmarket, not information about profitsand returns but the distribution

of ages in the population. so i'm not saying this theoryis correct, although i was one of theproponents of it, but it shows that there's room,i think, in finance for economic things,for demography to matter, for leverage to matter and notjust for expectations about future profits. so let me show you anotherpicture. so this is a second way inwhich shiller became famous.

he said, "well,look at housing prices," the case shiller housing index. so he's also famous because hehad the idea of collecting housing prices. so it's quite amazing,every town has to record, by law you have to record inthe town directory, and they're often on theinternet, what the price is of every sale of every house. so everybody has it and it'sall publicly available on the

internet, or most of it ispublicly available on the internet. and nobody thought to gatherall this information together and take the average and writedown an index until shiller did it. so here's the shiller index. all right, so you can see thathousing prices were pretty stable throughout the '80s andthen in and around 2000 they started taking off,so this is when the stock

market was taking off too. so shiller says this isirrational exuberance. people just went crazy. they somehow think things cannever go down, and they're just going to keepgoing up, and they keep buying becausethey think things are going to go up,and it's crazy. psychology--eventually a newnarrative is going to start. somebody's going to say,"oh, they've been going up

so long they can't continue togo up. things have to go down,"and things went down. i think there's something topsychology so there was something missing in theoriginal finance story. the finance guys,by the way, they would say, "well, the rise is not sosurprising. look at the mortgage rates. (this is the interest rate youhave to pay if you get a mortgage.)

there's been an incredibledecline in mortgage rates over the years, so it's less costlyto buy housing. if you take the present valueof your expenditures you just have to pay less. you pay over a long period oftime, and so the interest rate isless, so the value of the houses is worth more because you'rediscounting the future benefits at a lower rate. (you'll hear all aboutdiscounting later.)

so there's no mystery." on the other hand nothinghappened to interest rates. they kept getting lower sothere's no reason why the market should have crashed. so, again, this seems like avindication for shiller. now, it also,in a way, is a vindication for my theory which isnon-psychological. so i'm distrustful a little bitof psychology because it can be anything, although i agree it'simportant.

so my theory is when you take aloan you have to negotiate two things, the interest rate andhow much collateral you put up. who's going to trust you to payback? when you buy a house they say,"you can't just borrow the whole value of the house." they say, "well,make a down payment of twenty percent. borrow eighty percent of thevalue of a house." and so what i say is thatinstead of paying all your

attention to the interest ratethink about the collateral rate. why is it twenty percent thatyou have to put down? maybe it should be ten percentor forty percent. well, in fact,that number changes all the time. so here what i've done is--thepink line from 2000 to the future, that pink line isshiller's housing index inverted. so you notice the scale on theright is the housing prices,

but i've inverted it,and on the left i have the down payment percentage. these are non-agency loans. we'll come back to the graphlater-- i don't have time to explainexactly how i got it-- but what you see is that from2000 onwards the down payment people were asked to make to buytheir house got lower, and lower, and lower,and lower and it got down to three percent.

you could put down threepercent of the value of the house and borrow the otherninety-seven percent of the value of the house to buy it. so amazingly the prices go upand down just with what's called the leverage. so why is it called leverage? because the cash you put downpayment, say ten percent,you can lever it up and own an asset that's worth a hundredeven though you put down ten

dollars. so you're leveraged 10:1. if you put down three dollarsand you get a hundred dollar house you've leveraged it 30:1or 33:1. so that's why it's calledleverage. so anyway, the point is thatleverage went way up. the margins kept going down anddown and down and just at the peak of the housing cycle,which is the bottom of that curve, that's when collateralstarted getting tougher and

people started asking for moremoney down again, and sure enough the pricesturned around. so if you look at the prices ofmortgages, again, the inverse on theright, and you look at the margins on the left,not for buying houses but for buying securities--i don't have time to explain this whole graph,but the blue line is the buying securities. so '98 is a big crisis,the margins spike up,

i don't have pricing data backuntil then. that's the blue line. and now from 2007 to 2009 yousee the margins spiking up. so to buy a toxic mortgagesecurity investors don't pay cash, they borrow part of themoney to buy it. they used to put down only fivepercent to buy it. now they have to put downseventy percent to buy it on average. well, what happened to prices?

prices--this is the inverse ofprices--in 2007 they started to collapse. so this going up means pricesare collapsing. so once again,the margins--tougher margins means lower prices and as themargins came down recently the prices have gone up recently. so it's an alternative theory. so what else do i want to showyou? so it doesn't mean that thestandard financial theory is

wrong. after all, i helped run a hedgefund. six of us founded it and we'vebeen in business for fifteen years. we must believe in standardfinancial theory because that's how we've been making a lot ofour money. we exploit all those algorithmsand those are the things i'm going to teach you,so i certainly believe it and it's very important to teach youthat again this semester,

but there's more to the theorythan just that. i want to show you one morething in the dow jones or the s&p which i forgot tomention. and where is this? oh, i can't get it out of that. let's try dow. okay, so dow. where was the peak of the dow? it was right over here.

now what was the date? the date's supposed to flashhere. so it's october 1st 2007. so that's when people startedto realize something was wrong with the world and things headeddown. until then nothing bad seemedto be happening in the world, but suppose that you look notat the dow, suppose you looked--sorry. here's a graph,suppose you looked at the

sub-prime mortgage index. so you see it's a hundred. you'll understand what thesethings are. so a hundred means nobodythinks there's going to be a default. over here january 2007,that's ten months before the stock market starts to godown--before it hits its peak. the stock market is still goingup here. a month later,this is april 2007,

a month later the sub-primeindex starts to collapse. you see it goes from a hundredto sixty. we're already--in february ormarch 2007. so that means the people,those experts trading mortgages, already realizedthere was a calamity about to happen. this was long before anyoneelse perceived anything happening,long before the stock market moved,long before the government did

anything to correct the problem. so just as financial theorysays if you pay attention to the prices you can learn a lot aboutthe world. the people trading thosethings--their life depends on fixing the right prices. probably they know stuff thatyou don't know. the prices are going to reflecttheir opinion. if the price collapsed part ofthe reason it collapsed, maybe margins and something hadsomething to do with it,

but part of the reason itcollapsed was because they knew something bad was happening. so for two and half years we'veknown there's going to be a major catastrophe in themortgage market. to go from a hundred to sixtyand since to twenty is a total calamity. so you know that there are onepoint seven million people who have already been thrown out oftheir houses. another three and a halfmillion aren't paying their

debts and are seriouslydelinquent. probably all of them will bethrown out of their houses, and another four or fivemillion after them might default and have to be thrown out oftheir houses. so it's a major catastrophe andthe market told us and warned us about it two and a half yearsago and nobody's done anything about it,basically, until now as we'll find out. so it's not that i thinkfinancial theory,

the standard financial theoryis wrong i think it's incredibly useful. i just think it has to besupplemented by a more general and richer theory. maybe i should show you how myhedge fund has done just so that you don't think that it was atotal failure. oh dear, where is my returns? here we go, emg returns,it's sort of interesting. so kidder peabody went out ofbusiness in 1994.

there was a tremendous crash inthe market, a low of the leverage cycle. the purple is ellington,that's the hedge fund. you'll see that these are otherinvestment opportunities. the s&p 500 is the greenthing which looked like it was doing great for a while. emerging markets is the blueone, and high yield is the green one,and then there are bunch of other things like treasuries,and this is libor which is what

banks lend to each other at. so this says if you put yourmoney into any of those strategies,in libor, keep lending your money each month to a bank andseeing what interest you get and seeing how much money youaccumulate, or putting your money inellington and looking at the purple,or putting your dollar into the stock market and see whathappens, the s&p 500,this is what happens.

so you see there was a crashhere. you're fired, you're fired. so we start ellington andellington does great, and so we have all these yearswe're doing great. then '98 there's another crash. look what happened. overnight, practically,we lost a huge amount of money. we almost went out of business. long term capital,which, by the way,

was run partly by two nobelprize winners, merton miller,not merton miller, myron scholes and robertmerton, two of the guys i mentioned whowere the leaders of the financial crisis [correction:leading finance academics], they bankrupted their companyand they went out of business. and why did they go out ofbusiness? because they weren't aware ofthe leverage cycle, in my view.

anyway, so the prices collapsed. then look it,all these returns shoot up again and the world seems to bedoing great, the stock market, everybody's doing great. then there's another crisis in2007. everything plummets alltogether this time and then everything is going up again. so it's hard to see this and tolive through that. so i remember in '98,for example,

when there was a margin call. our lenders called and said,"we want more money. we don't believe that theassets are worth as much as they were and so the collateral isnot covering the loan anymore." and we said,"you can't make a margin call. it's not legal. you promised not to change themargins on us for six months.

you can't make a margincall." and they said,"well, blah, blah, blah, we don't reallyknow about that. we're making a margincall." so we called up warren buffettand we said, "this is terrible. they're making a margin call. they can't do this. we have great bonds.

there's nothing wrong with thebonds. they're going to force us tosell all the bonds to pay them the money, and how can theyforce us to do that? they shouldn't force us to dothat. we've got great bonds,it's a great business, it's a great company andthey're going to run us out of business. you can't let this happen. warren buffett why don't youbuy part of the company and save

us and you'll get rich and it'llbe great." he said, "say thatagain." and we said,"well, they're going to force us to sell all the bondson tuesday to meet their margin call and we'll get terribleprices for the bonds and we'll be driven out of business,even though they're great bonds, just because they'remaking a margin call. you can't let this happen to us. buy part of the business andsave us and you'll get rich.

you'll own part of a greatcompany." and he said,"hell, it sounds like i should just show up on tuesdayand buy the bonds." so we survived. i'll tell you more about whatwe did. we survived that,no thanks to warren buffett, although he had a pretty goodidea, and then we survived the last crash. so we survived all thesecrashes, but the fact is things

go up, they crash,they go up, they crash, they go up. could it all be my fault? i decided it can't be all myfault. it's got to be there'ssomething more basic at work and that's why i'm going to tell youabout the leverage cycle. now, of course,i realize that my pet theories may not turn out to be right,although i think more and more people are starting to thinkthere's something to it.

so i'm not going to spend ahuge portion of the course just talking about my pet theories. i mean, i recognize that i haveto teach partly what's standard. so the course is going to bedivided in the following way. i'm going to talk about thestandard no-arbitrage financial theory,and i'm going to talk about it theoretically and mathematicallyand from a practical point of view,because helping to run the hedge fund--lots of the things that i'll be

teaching are things that weactually confronted in the hedge fund. and so you'll get the standardfinancial theory course taught from a hedge fund perspectiveboth theoretically and from a practical point of view. on the other hand,i've lived now through three mortgage crises and so it seemssilly for me not to describe how the mortgage market works,even through you'll find almost none of that in any standardfinance textbooks,

how the mortgage market works,and what's going on, and what happened in thecrises, and how we survived and how other people didn't. and i'll talk about theleverage cycle. i'll also spend some time--ithink it's quite important--on the mathematical logic of theinvisible hand argument. that's the most importantargument in economics that the free market does good for theeconomy and a huge number of people believe it.

and part of that argument andpart of the sort of hazy knowledge of that argument iswhat drives resistance to a lot of government programs. i mean, the government can onlyscrew things up is what people generally believe. is it a prejudice or is theresome actual argument behind that?. well, i want to go over thatargument and show you precisely how it works and how it doesn'twork in the financial sphere.

and then, i want to talk aboutsocial security. that's one more program. that's the biggest program inthe budget. it's as big as defense and thetwo of those are much bigger than everything else,vastly bigger than every other thing in the budget. so i want to talk about socialsecurity and should it be privatized and should it bereformed and why did it go bankrupt.

it's also an interestingmathematical problem because social security criticallyinvolves the belief that things will go on forever,so there's an infinity in it. each generation the young arepaying for the old. nobody would do that if theythought they were going to be the last generation paying tothe old, and when they got old nobody would help them. so social security rests onthis world going on forever which makes it mathematicallyinteresting.

anyway, so i got interested init from a theoretical point of view and then i got put on allthese national academy panels on social security and privatizing. and so i know quite a bit aboutit so i might as well talk about something i know about,so that's why i'm going to talk about that. all right, so this is too hardfor you to read so let's do this. so let me just give you a fewexamples.

uh-oh, i hope i didn't do aterrible thing. no. so let me just give you a fewexamples here of the kinds, just so you realize there'ssomething to the standard theory. there's a lot to it. so i'm going to give you tenexamples very quickly, of the standard theory. so these are things that i'mguessing you'll have,

at least some of them,trouble figuring out how to answer now,but by the end of the course this should be totally obviousto you. so suppose you win the lottery,forty million dollars, it's a hundred million dollars,the lottery. now they always give you thechoice. do you want to take fivemillion a year over twenty years or just get forty milliondollars right now? which would you do and how doyou think about what to do?

so now you get tenure at yaleat the age of 50, say. you're making a hundred fiftythousand dollars a year and you think professors--it's going to go up with the rate of inflation,and that's about it for the next twenty years until youretire. so that's twenty years of thatand then you're going to live another twenty years when you'regoing to be making nothing. so how much of thehundred-fifty-thousand,

and let's say inflation isthree percent, and what you'd like to do isconsume inflation corrected the same amount every year after youretire and before you retire, and so how much of thehundred-fifty-thousand should you spend this year and how muchshould you save? you'll learn very quickly howto do a problem like that. now, president levin wrote afew months ago, the end of last year if youremember, he said that, "well, the crisis was bad.

yale was going to weather it,but yale had lost twenty-five percent, probably,of its endowment. that's five-billion dollarsalmost of the twenty-three-billion dollarendowment. so how much should he choose tocut? it's his decision. how much should yale reducespending every year? the total spending at yale is alittle over two-billion. so the endowment goes down byfive-billion what cuts should

you take to the budget. should faculty salaries be cut,be frozen, should you get three tas instead of four tas? what should you do? how big a cut should you take? now, the same question facedyale in 1996 or so. i've forgotten exactly the year. ten or twelve years ago theprevious president, benno schmidt,he suddenly noticed that there

was deferred maintenance,as he called it, a billion dollars to fix theyale buildings. that's why, incidentally,every year another college gets fixed. they decided there was deferredmaintenance of a billion a hundred million dollars everyyear for ten years had to be spent. the whole endowment then wasthree billion, and now we had a one billiondollar deferred maintenance

problem. the budget was about onebillion then. so how much should you cut theyale budget at that time? so benno schmidt said,"i'm firing fifteen percent of the faculty." he announced he was firingfifteen percent of the faculty. that was on the front page ofthe new york times, "yale to firefaculty." well, did he make the rightdecision?

rick levin took over aspresident three months later, so probably not. what mistake did he make in hiscalculations? what should he have done? what was the right response? we're going to talk about it. it's not that hard a problem. now, let's take a slightly morecomplicated one. you're a bookie.

the world series is coming up. the yankees are playing thedodgers, let's say, and you know thatthe teams are evenly matched and you've got a bunch of friendswho you know every game will be willing to bet at even odds oneither side because they think it's a tossup. well, one of your customerscomes to you and says, he's a yankee fan,he's sure the yankees are going to win the series.

he's willing to put up threehundred thousand dollars to bet on the yankees. so if the yankees win he getstwo hundred thousand, but if the yankees lose heloses three hundred thousand. so 3:2 odds he's willing to beton the yankees winning the series. well, you say,"this guy's sort of a sucker here. i can take big advantage of him.

on the other hand it's a lot ofmoney, two hundred thousand i might lose if i have to pay offand the yankees win. so even though i think that myexpected profit is positive, because he's putting up threehundred thousand to make only two hundred when they're evenodds, in fact--the fact is it's sucha big number i'm a little worried about that." so what do you do? so what can you do?

you've got these friends whoare willing to bet at even odds each game by game,so how much money--presumably the first night you're going tobet with one of your friends. you take the guy's bet,the customer, you take his three hundredthousand. you promise to deliver him fivehundred back if the yankees win and to keep it if the yankeeslose. what should you do with yourfriends? should you bet on the yankeeswith your friends?

should you bet on the dodgerswith your friends and how much should you bet at even odds thefirst night? so the answer is,well, i don't want to give all the answer now,but so there's a way of skillfully betting with yourfriends and not betting two hundred or three hundredthousand the first night with your friends at even odds. you bet some different numberthan that, which you'll figure out howmuch to bet so that if you keep

betting through the course ofthe world series you can never lose a penny. how do you know how much thatis? well, that's the kind of cleverthing that these finance guys developed and you're going toknow how to do. so let's do another examplelike that. i'm running out of time alittle bit, but an example. suppose there's a deck ofcards, twenty-six red and twenty-six black cards.

somebody offers to play a gamewith you. they say, "if you want topick a card and it's black i'll give you a dollar. if it's red you give me adollar." so if i'm picking,i'm in the black, i get a dollar,it's in the red i lose a dollar, i have to throw away thecard after i pick it. the guy says,"by the way, you can quit whenever youwant."

so should you pick the firstcard? it looks like an even chance ofwinning or losing. let's say you pick the firstcard, it's black, you win a dollar. now the guy says,"do you want to do it again?" you picked a black one sothere's twenty-six red left and twenty-five black. so now the deck is stackedagainst you.

should you pick another card? well, it doesn't sound like youshould pick another card. but you should pick anothercard and i can even tell you how many cards to pick. even if you keep getting blacksyou should keep picking and picking. so how could that be? it sounds kind of shocking. well, it's going to turn out tobe very simple for you to solve

half way through the course. so, a more basic question. there are thirty year mortgagesnow you can get for five and three-quarter percent interest. there are fifteen-yearmortgages you can get for less, like five point three percentinterest. one's lower than the other. should you take thefifteen-year mortgage or the thirty year mortgage?

how do you even think aboutthat? why do they offer one at alower price than the other? one more example,suppose you're a bank and you hold a bunch of mortgages. that means the people in thehouses, you've lent them the money, they're promising to payyou back. and you value all thosemortgages at a hundred million the interest rates go down. the government lowers theinterest rates.

half of them take advantage torefinance. they pay you back what they oweand they refinance into a new mortgage. so now you've only got half thepeople left. let's say all the people hadthe same size mortgage and everything. half the people are left. that shrunken pool,half as big as the original pool,is that worth fifty-million,

half of what it was before,or more than fifty-million, or less than fifty-million? how would you decide that? again, this is a question whichmight be a little puzzling now, but actually you should be ableto get the sign of that today even,and we'll start to analyze it. so that's what mortgage tradershave to do. they see interest rates wentdown. a bunch of people acted.

the people who are left in thepool are different from the people who started in the pool. now we've got to revalueeverything and rethink it all, so how should we do that? let's say you run a hedge fundand some investor comes to you and says, "oh,things are terrible. look at all the money you lostfor me last year. i know you're doing great thisyear and you've made it all back that you lost last year,but i don't want to run that

risk. so i want to give you my money,a billion dollars, i want to get these superiorreturns you seem to earn, but you have to guarantee thatyou don't lose me a penny. i don't want to run any risk. i want a principal guarantee(it's called) that when i give you a hundred dollars you'llalways return my hundred dollars,and hopefully much more, but never less than a hundreddollars."

so is there any way to do that? you know that you've got agreat strategy, but of course it's risky. you could lose money. you've lost money a bunch oftimes before. so how can you guarantee theguy that he'll get all his money back and still have room to runyour strategy? well, it sounds like you can'tdo it, but of course a lot of people want to invest that way,so there must be a way to do.

so you'll figure out--we'lllearn how to do that. so, three more short ones. a scientist discovers apotential cure for aids. if it works he's going to makea fortune. he started a company. he's a yale scientist,he's--medical school, started this startup company. yale, of course,is going to take all his profits, but anyway it's hisstartup company and if his thing

really works he's going to makea fortune. if it doesn't work it's goingto be totally zero. you calculate,and let's say you believe your calculation,that the expected profits that he'll make if it works,the probability of it working times the profit,that expected profit is equal to the profits of all of generalelectric. should his company be worthmore than general electric, the same as general electric,or less than general electric

since it's got the same expectedprofits? well, i can tell you the answerto this one because i think most of you would think,first you'd think, "well, maybe thesame." then you'd say,"well, this aids thing it's so risky. it's either going to be way uphere or nothing, and that's so risky,and general electric is so solid,probably general electric is

worth more." but the answer is the aidscompany is worth more. so another question,suppose you believed in this efficient market stuff and yourank all the stocks at the end of this year from top to bottomof which stock had the highest return over the year. it's 2010, let's say 2010,this year's a weird year. so let's say you do it in 2010. all the stocks the highestreturn to the lowest return.

now, suppose you did the samething in 2011 with the same stocks? would you expect to get thesame order, or the reverse order, or random order? now again, if you believe inefficient markets and the market's really functioning,the prices are fair and all, i'll bet most of you will say,you won't know, but you might say it should berandom the next time, because firms only did betteror worse by luck,

but that's not right either. so you're going to know how toanswer that question by the end of the class. one last one,the yale endowment over the last fifteen years has gottensomething like a fifteen percent annualized return. a hedge fund,that i won't name, has gotten eleven percent overthe last fifteen years counting all its losses and stuff likethat.

so is it obvious that the yaleendowment has done better than the hedge fund? would you say that the yalemanager is better than the hedge fund manager? its return was fifteen percent. the hedge fund only got elevenpercent. so i'm asking the question,and i would say that david swensen would think about it thesame way i think about it. so suppose i even told you thatthe yale hedge fund had lower

volatility--the yale hedge fund?--the yale endowment had lower volatilitythan the hedge fund, which it surely does,would that convince you now that the yale endowment had beenmanaged better than the hedge fund? well, we're going to answerthis question again, and you're going to see thatthe answer's a little surprising. it won't be so surprising--iwouldn't have brought it up

otherwise. but anyway, that's the kind ofthing that in finance you're taught to think about. so the crisis of 2007,which we're going to spend a long time talking about,i just want to get back to that subject. so that list of questions werethe kinds of things that i used to teach for years before i wasconfident about my theory of crises,and this is the kind of

questions you have to face allthe time in hedge funds, and decisions you have to make,and things you have to tell investors,and so that's the basic part of the course,but i want to say more. so i want to talk about thecrisis of 2007-2009. it started as a mortgage crisis. now, how could it be thateverything goes wrong in mortgages? i mean, they're four thousandyears old.

the babylonians inventedmortgages. what is a mortgage? you lend somebody money. they put up collateral. they don't pay you take thehouse or you take the guys life, he's a slave or something,but it's the same thing. you borrow money and the guypromises you can confiscate something if he doesn't pay. four thousand years and wescrewed it up.

how could that be? and why should a screw up inthe mortgage market have such a big effect on the rest of theeconomy? were sub-prime mortgages aterrible idea? was there some logic to it? and how did we get out of thecrisis? how is it, that everybody wassaying this is the worst crisis since the depression,may be another depression and things seem to have turnedaround.

what is it that we did to getthings to turn around? i don't think we're out of ityet, but things are a lot better than they were a year ago. so what is it that thegovernment did to turn things around? it didn't do nearly enough,i think, but it did something. what exactly did it do? now, shiller would talk aboutthe whole thing was irrational exuberance.

i'm going to say it's all theleverage cycle, but anyway so that's themortgage crisis. now, are free markets good? i want to talk about theargument. the argument was first made byadam smith about the invisible hand. the modern mathematicalargument is ken arrow's, my thesis advisor. and of course everybody knowsthat monopoly and pollution and

things like that interfere withthe free market and they have to be regulated. but the financial markets,there's no monopoly. as long as there's no monopolyand there's no pollution shouldn't the free marketfunction there? so i want to go over thatargument and show you what was missing in it,as i said before, and then lastly we're going totalk about social security and how could that system be goingbankrupt.

i mean, it just seems shocking. there's a two-trillion dollartrust fund that's going to run out in 2024 or something andafter that the system will be broke. so how did it happen? why is it broke? what can we do to fix it? so george bush said,"well, it's terrible. even if we manage to sort ofget the trust fund rehabilitated

young people like you are goingto get a two percent rate of return. if you put your money in thestock market, even allowing for the lastcrash, over the long haul, the returns have been sixpercent. so it's terrible,social security. something's wrong with thesystem. we should privatize it and letyoung people like you put your money in stocks instead."

well, gore, in the debate in2000 said, "you can't do that becausethen the old people who are expecting their money can't getpaid." and both of them agreed that itwas all the baby-boomers' fault. people like me we're gettingold, we're going to retire. that's why the system's goingto get broke. so that's the conventionalwisdom. all three of those things arewrong, so we're going to find out why.

so in summary,why study finance? it's to understand thefinancial system, which is really part of theeconomic system. it's to make informed choices. is privatizing social securitya good or bad thing? is regulation of financialmarkets a good thing? the language that you learn isthe language that's spoken on wall street, and was created byprofessors and yet practitioners use it.

for me it's incredibly fun,all these little puzzles. as j.p. morgan said,"money's just a way of keeping score." you have to figure out whatsomething's worth in the end and if you get it right you'vesolved the puzzle right and it'll help you make goodfinancial decisions in a pensioned career. that's the standard reason totake finance. now, the prerequisites of thecourse, so i want to make this

clear, you don't really needecon 115. it would be helpful becausethis logic of the free market being good or bad,that was already started in econ 115. that's what they call it now,right? it's still called 115. i used to teach it but ihaven't done it for years. so anyway, what you really needis mathematical self-confidence. it's not going to be high math.

it's going to be simple math,but it's relentless over and over again. and i can tell you that everyyear there's the five percent of you,let's five or ten out of the hundred-twenty are going to justget bored doing problem after problem and you're probably notthat, you know, those ten maybehaven't that much experience doing it,don't feel very confident doing it,stop coming to the class and

then really have no idea what'sgoing on. my sister is probably muchsmarter than i am, but she doesn't like math. she wouldn't take this course. so if you're not confidentdoing little mathematical problems just don't take thecourse. you'll save yourself a lot oftrouble. i don't know how to say thisany better. i want to warn you not to do it.

it's easy math,but it never stops. every week there's going to bea problem set. the exam--there are problemsets. the exam is doing problems justlike the problem sets, but if you don't like that,you know, to me finance is a quantitative subject. what's so beautiful about it inone aspect i really like is that you have these complicateddifferent things you have to weigh,but at the end you have to come

up with one number. what is the price you'rewilling to pay for something? it's very concrete. i'm going to take advantage ofthe concreteness by turning every question into a number. i hate it when you get on theone hand and on the other hand. it's a number. so if you don't like numbersit's not a good course to take. so what are the kinds of thingsyou have to know?

you have to understand thedistributive law of arithmetic (which, i have little kids and isee that's not so easy to understand). anyway, and then you have tounderstand the idea of a function which is a contingentplan. simultaneous equations;that's what we do for equilibrium in arbitrage. taking a derivative,that's marginal utility. the idea of diminishingmarginal utility,

a concave function looks likethat. that's risk aversion. bankers invented the logarithm,compound interest, so you have to know what takinga logarithm and exponential means,and you have to understand how to take probability weightedaverages of things. and we're going to use excelfor a lot of the problems which we'll teach you. by the end of a day you'll bebetter at it than i am.

so my office hours are four tosix. my secretary assistant isrend√£©, there's an accent missing asshe always tells me, wilson. she just started three days agobut i'm sure she'll be great. there are going to be twolectures a week and a ta section. so every tuesday there'll be aproblem set starting this tuesday due the next tuesday.

there will be two midterms. there's a lot of stuff to learnand so i found, everybody i think agrees who'staken the course, if you take the midterm it'llfocus your mind and make it a lot easier,so i give two of them so you only have half the course tostudy. it makes the final much easierto study for. i recognize that some of youwill have problems on one of them,like especially the first

mid-term,and if you do vastly worse on one exam than the rest i'll tendto ignore that, but most people don't,by the way, do vastly worse on one exam than the rest. so the final's forty,the problem set's twenty, and the two midterms are twentypercent. tuesday to thursday,and so all the ta sessions are thursday to monday so they'regoing to start next thursday. so you see the classes aretuesday-thursday then the next

tuesday. there's a long time in-betweenhere so all the ta sessions will meet there. so they're at the same momentin the class. there are all these textbooks,all by the nobel prize winners, all by those financial greats. you can buy any one of them,but i have my own lecture notes because as i say i teach aslightly unconventional course and there's a huge list of bookson the crisis.

some of them are incrediblyinteresting and fun, and so they're all on thereading list you can take a look at. i mean, there's never been amore fun time to read this stuff now. so course improvements, anyway. so that's it. are there any questions abouthow the course runs, or how i will run it,or whether you think you should

take the course,or whether your preparations--so if you haven'ttaken econ 15 it's okay, 115, but you've got to beconfident that you can solve problems,otherwise don't do it. any questions? yes? student: so the firstproblem set will be assigned next tuesday? prof: yeah,so next tuesday it's going to

be due the tuesday after. so i know that's early,but you probably already know whether you're going to take thecourse or not. student: will you teachthis next year? prof: will i teach itnext year? actually i probably won'tbecause i'm going to go on leave, but i might,but probably not. someone else will teach it. yep?

student: which of thebooks do you suggest we buy? prof: they're all good. they're all famous peoplewho've written. they're trying to sell copiesso they're pitched at a quite low level, but they're verygood. anyone of them is good. merton's book is good. steve ross is a friend of mine. he used to teach at yale,so his book is good.

so any one of those is verygood, but they're not quite at the same mathematical levelbecause they're trying to sell thousands of books,and they stick pretty closely to this financial view of theworld that everything is efficient. student: will the tapedlectures be available online? prof: that's a goodquestion. i don't think so. no, they're shaking their head.

so it won't be in time for you,but it will be if you want to look back in your old age,"i was there. i saw the leverage cycle." sorry. student: are the lectureslides posted before or after the lecture? prof: oh,the lecture notes are all posted already before the class. so the first twelve of them arethere, and i'm changing them

each year so there'll be somechanges. so last year's first twelve arethere and they might change a little bit, but you can alreadyget an idea of what they're about. this first lecture is not on,but the rest of them are. any other questions? student: when do we signup for the ta sections? prof: oh,you should be signing up now. i don't know how to do this.

it's online or something, right? you sign up online. yeah, so you should pick yoursections. we might add another section ifall of you stay, but probably you won't,but if we do we'll add another ta section. student: what's thegrade distribution? prof: the gradedistribution? i don't know.

the standard yale junior levelcourse grade distribution which is when i was at yale thingswere much tougher, so it's the standarddistribution. i don't remember it offhand. but i'll tell you all about thedistribution at the midterm. so there will be a midtermbefore--you'll have chance to drop the course after themidterm and then there will be another midterm right at the endof the course. student: what level ofmath and type of math should we

be comfortable with to take thecourse? prof: i was trying tosay that. i'm glad you asked me again. so i went over the things thatyou have to know. if you have 3x-4x^(2) you haveto be able to take the derivative of that which is3-8x. if you've got the log naturalof x you have to take the derivative. it's one over x.

if you've got 3x 5=10 and2x-7=12 you have to be able to solve that simultaneousequation. so that's the kind of thing youhave to do, and you have to be able to do it quickly and withtotal confidence that you're doing it right. and for many of you that's noproblem, but for some of you who aremaybe even smarter than everybody else that's a problem,and so you'll have to judge yourself whether you can do thatcomfortably so you don't have to

worry about the mechanics ofdoing that. you can think conceptuallyabout what the question is asking. when does this end,ten of or quarter of? student: ten of. prof: ten of,so we have 13 minutes. i want to end with oneexperiment. so (teaching assistant),can you help me with this? so this is something we're notgoing to have time to figure out

the answer to. so i need sixteen volunteers. how about the first two rows? why don't you just volunteer. you'll survive,and i know it's a drag but you'll do it. what i'm going to do now is i'mgoing to run an auction. so please stand up and eight ofyou go this side and eight come over here.

that's okay, you'll be okay. i know everyone's reluctant todo this. so i only need sixteen. (ta), help me count them. two, four, six,eight, you guys have to come the other way. the tas aren't going toparticipate. you're not in this, right? two, four, six,eight so we only need eight,

you both sat down. so would you like toparticipate? come on. we could use another woman here. two, four, six,eight, there are eight of them? so can you mix these up? there are going to be eightsellers and eight, we say seller,right? buyer, so shuffle them up andhand one to each.

so we've got eight,and these are the football, they're selling. so we've got eight sellers andeight buyers, and i don't know whether you'veever seen this experiment before, but shuffle them,right? student: they're allsellers though. prof: they're allsellers, but you've got to shuffle them. on the other side there's anumber.

so we've got eight sellers hereand eight buyers. so each seller knows what hisfootball ticket is worth, or hers, so please take one. student: i have a sellerone. prof: oh,you have a seller one? that's bad. student: yes. prof: i'm blind. student: thank you.

prof: buyer, thank you. does this say buyer and buyer? you should be one short. here's an extra. so there are eight sellers andeight buyers. they've got the footballtickets. each of them knows what thefootball ticket is worth to her. there are three women here andonly two, so these are the "hers".

she knows exactly what it'sworth to her. so say it's fifteen. the football ticket's worthfifteen. now if she can sell it for morethan fifteen she's going to do she's going to make a profit. if she sells it for less thanfifteen she's not a very good trader. she's not going to do that. she's going to say,"if i can get more than

the football ticket is worth i'mgoing to sell it. if i can't get more than it'sworth i won't sell it." so everybody knows what thefootball ticket is worth to herself. all these guys,they know what the ticket is worth to them. so say someone thinks it'sworth thirty that guy's going to say,"if i can get it for less than thirty,like for fifteen,

i'm going to get it. that'll give me a profit offifteen. if i can only get it for fortyi'm sure not going to do that because i'm paying more than ithink it's worth. so you all got that? you have a reservation valueyourself. you don't want to pay more thanit's worth because then you're losing money,and they want to sell it for more than they think it's worthbecause then they're making

money. so nobody knows anybody else'svaluation. the information is distributedcompletely randomly across the class. now this is a famous experiment. i'm not the first one to runit, although i've done it for ten years. i do it in my graduate class,in my undergraduate class, the undergraduates,by the way, always do better

than the graduate students. so this knowledge isdistributed in the whole environment,and we're going to see what happens when i start a chaoticinteraction between all of these sixteen people. what's going to happen? and you would think it'd betotal chaos and nothing sensible is going to happen. and if that does happen it'llbe very embarrassing for me.

but what the efficient marketsguys would say is, "something amazing isgoing to happen. the market is going to discoverwhat everybody thinks it's worth and figure out exactly the bestand right thing to do and that's what's going to happen." now, it's hard to believe thatwith this little preparation that you've had,zero, zero training, zero experience,and you're only going to have two minutes to do this.

so see the class has got eightminutes to go. you're going to miss the grandfinale. anyway, so you've only goteight minutes to go. so with only two minutes oftraining they're going to get to a result,which if i had to do it myself and read all the numbers andsort them out and sort through them would take me much morethan two minutes, and all this is going to happenin two minutes. it's hard to believe.

it probably won't happen thistime. so here are the rules. i'm going to put you alltogether. start inching your way towardseach other, and try not--now, when i say go,which won't be for two minutes you're going to start yellingout an offer. so if you think it's worthfifteen and you're a seller you're not going to sell it forfifteen. you're going to say give metwenty, or give me thirty,

or give me twenty-five. you're going to try and get asmuch as you can. you have to yell it out. the buyers are going to bemaking their offers. when two of you see thatthere's a deal you have to shake hands, exchange the football,and leave, and tell your numbers to (ta). where's (ta)? (ta), you're going to standoutside the group that way.

so once you make a deal youjust leave and tell what's happened to (ta) who's nowstanding back here, back there. so it has to be public outcry. it's very important that you'reyelling these things publically and all the other people canhear you, and you've only got two minutes. now two minutes sounds like anincredibly short period of time, which it is,but it's much longer than you

think, wait, quiet here. you shouldn't trade--i'm givingyou valuable advice-- you should not trade in thefirst ten or fifteen seconds because you have to hear whateverybody else is offering. if you trade right away you'reprobably doing something really stupid. two minutes,though, it sounds short, is actually a very long periodof time. so be patient.

try to get the best possibleprice and we'll see what happens. any questions about what you'redoing? and now, in the heat of themoment you might be so frustrated that you can't sellwhen you think it's worth fifteen that you sell it forten. i'm going to expose you infront of all these people if you do that, so keep track of whatyou think the thing is worth. all right, any questionsanybody about what is going on?

so you have two minutes. is there a second hand there? i can't see it. no? student: it's on theten, or coming to. prof: where is it? student: now it's on thethree. student: it's moving. prof: it's on the three.

i think i see something. when it gets to the four we'regoing to start. so start, go. <> prof: oh, no collusion. no collusion. prof: come out and tell(ta). if you made a deal tell (ta). prof: how much time isleft?

one minute left,plenty of time, one minute. any other deal made? write down the price and thetwo, what price they agreed. how much time? twenty-five seconds, stay cool. i can't see. fifteen. stay cool.

don't make any mistakes,ten, five, four, three, two, one,stop. did you get all the numbers? <> prof: give me back thetickets. student: was thisdesigned to make us look bad on camera? student: you designedthis to make us look bad on camera.

prof: no,you're going to look great on camera, you are. give me all the tickets back. (ta), you getting done there? teaching assistant: yeah. prof: all the tickets. i need them all back,all the stuff. god, you're big folders here. these tickets have lasted tenyears until you guys took over.

they're all crumpled up. all the tickets,i need them all back. you can sit down now. everybody's reported in? now let's see what happened. you've got them all? five traded. teaching assistant: fivetraded. prof: five bought andsold.

so here's what happened. here were the numbers. so we have five minutes just tolook at this. so all the buyer prices are inblue, forty-four, forty, thirty-six,you should recognize these you buyers, and the red ones werethe sellers. so you notice that everyseller, for everybody there's a seller who's underneath. so it could have happened thatthirty-eight sold to forty-four,

and thirty-four sold to fortyat thirty-seven, and twenty-eight sold tothirty-six at thirty-two. you could have had eight trades. so what did happen? nothing like that happened. you had five trades,five pairs of people traded, and there are those three poorschlumps, pairs of people at the endlooking despondent, hopeless, unable to trade,worried that they were on

now, let's see,who are the people who traded? so, (ta), name the buyers whobought. teaching assistant: idon't know the names. prof: the prices. teaching assistant: theseller got it for nine and managed to sell it for twentydollars. it was all quick so i don'thave everybody's name, because they were all rushing. prof: you got them.

teaching assistant: igot them.. prof: that'severything, great. teaching assistant: ijust don't have their names. prof: here's whathappened. mister seller ten sold tothirty-six at a price of twenty. mister seller nine sold tobuyer twenty, so nine, there is no nine. teaching assistant: six. prof: nine sold totwenty at a price of what?

six. teaching assistant:sorry. prof: that's okay. so seller six sold to twenty ata price of twenty. student: yeah,even though it's cheaper > prof: no,no, buyer twenty paid twenty, so seller six did well. we won't ask who buyer twentyis.

buyer twenty is going to screweverything up. so buyer fourteen through--ican't read this either. teaching assistant:forty-four. prof: buyer fourteensold to buyer forty-four for twenty,and buyer twenty sold to buyer forty for twenty-two,and seller twenty-four sold to buyer thirty for twenty-five. so five people traded,now which five were they? the sellers were ten,six, fourteen and twenty-four,

one, two, three,four, five, the bottom five. the five buyers werethirty-six, twenty, forty-four, forty and thirty. so basically forty-four,forty, thirty-six, thirty, twenty-six didn't buy,twenty bought instead. so if you look at it,so it's not quite the way theory would have predicted,but almost. if you look at it,if you just shuffle the order and you put the sellers,instead of from top to bottom

you put them from bottom to top,you get what looks like a demand curve and a supply curve. and so what happened? all these five people ended upselling, one, two, three, four,five, those are exactly the sellers. the price they sold for was allbetween twenty and twenty-five, and the five buyers wereforty-four, forty, thirty-six, thirty.

twenty-six didn't manage tobuy, but twenty bought. so what is the theory of thefree market? the theory of the free marketsays, "this chaotic situationwhere they had less than two minutes to decide what to docould be analyzed as if you put a demand curve together with asupply curve and there was one price that they miraculouslyknew. here it should have beentwenty-five. it turned out to be twenty ortwenty-two that all the trade

took place at. at that one price you get allthe trades happening. the people have the highestvaluation buyers they're the ones who get the tickets. the people with the lowestvaluation sellers sell it. so the people who end up withthe tickets are these red guys at the top and the blue guys atthe top. all the tickets go from thepeople who value the stuff least to the people who value it more.

so the market has done anextraordinary thing in two minutes. so there was one mistake. mister or miss twenty,whose identity we are protecting, although i'msearching the faces, mister or miss twenty got avery bad deal. she or he, let's say he,bought at twenty when the value was twenty. that was a horrible deal.

he didn't get any extra out ofit. so he should probably have onlybought if the price were lower, and then twenty-six would havebought instead of twenty. so twenty sort of squeezed hisway into the market, so twenty-six and twentybetween them somehow there was a slight inefficiency. but basically with no training,no background, no practice,these sixteen undergraduates managed to reproduce--they gathered all the

information in the wholeeconomy, and they discovered who werethe eight people who valued the tickets the most and they endedup with all the tickets. for me to do it and sort it outwould have taken longer. the market solves a complicatedproblem, and gets information incredibly quickly,and puts things into the hands of the people who value it themost. and the marginal buyer thoughtit was worth about twenty-five or twenty and that's what theprice turned out to be.

so anyway, we're going to comeback to this parable at the beginning of the next class.