One thing we have to understand in understanding the progress of financial technology is its fundamental relation to information technology. Computers, the Internet and communication devices are fundamental to financial progress and they make things possible that wouldn’t have been possible before. Oftentimes, inventions that seem in the abstract to be good ideas impossible because something that you have to do to make it actually come into practice is too expensive and so it’s not economic to produce the invention.
But then, developments in other fields can change the relative prices and suddenly make an idea that had been hypothetical and unapplied suddenly work well. So, financial inventions also involve experimentation. Like in any other invention, nobody knows what will work and abstract theory doesn’t guide you completely. Once an invention is seen to work, it is rapidly copied around the world.
We can see various breaks in financial history when some new idea was suddenly proven workable. Traditionally, financial inventions were not granted patent rights, but now in the United States and in a number of other countries it has become possible to patent financial inventions. I know I’ve done that in my life and so I think it gives a different perspective on finance.
Then, I want to talk about insurance. The institution of insurance is something that really came in. It’s one of the earliest – I consider it a division of finance – really came in the 1600s when probability theory was invented. The mathematical theory of probability was unknown until that time and you can see that insurance suddenly made an appearance at that time. This will be a historical as well as a theoretical discussion of insurance.
Then, I will move to portfolio diversification and supporting financial institutions. This is again, a more theoretical lecture. It will be about the capital asset pricing model. It will be about the securities market line, about the data, about the mutual fund theorem and it will also be about institutions that we have, about investment companies and their management. So, it’s really parallel to an insurance discussion. Insurance pools risks like life risks or fire risks by writing policies to individual policyholders. Portfolio management pools risks in a different way by assembling a diversified portfolio or a portfolio that’s negatively correlated with a risk that someone has.
Then, I want to go to the efficient markets theory. Efficient Markets is a theory about, well, it came in about three decades ago, maybe it’s closer to four decades ago, it’s a theory that financial markets work very well and incorporate information very well. The efficient markets hypothesis was encouraged. Actually, the idea goes back over 100 years. It’s encouraged by the observation that financial markets seem to respond with great speed to new information and, when new information appears, prices will suddenly adjust in the financial markets.
Finance and Insurance: Powerful Economic Forces Pt 4
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