So, anyway, the course I’m going to teach is called Financial Theory and I’m going to teach an actual class. I’m going to spend the first half of the class talking about the course and why you might be interested in it. And then I’m going to start with the course. There are not that many lectures available in the semester, so I’m not going to waste this one.
So, the first half of the class is going to be about why to study it and the mechanics of the course, and the second half of the lecture is going to be actually the first part of the course. It’ll give you maybe an idea of whether you’ll find the course interesting, too.
So, I think I’ll turn this – I won’t have too much PowerPoint here. So, you should know that finance was not taught until ten years ago at Yale. It was regarded by the deans and the classically minded faculty of the arts and sciences as a vocational subject not worthy of being taught to Yale undergraduates. It was growing more and more famous, however, in the world and there was a band of business school professors, Fischer Black, Robert Merton, William Sharpe, Steve Ross, Myron Scholes, Merton Miller, who had a huge following in business schools teaching the subject, and whose students went off to Wall Street, and more or less dominated the investment banking parts of Wall Street and became extremely successful.
Finance became the most highly paid profession. It became the most highly paid faculty in the university, although they were all in business schools. There are more physics PhDs working in finance now than there are working in physics. So, this merry band of financial theory professors didn’t really believe in regulation. They believed markets left unfettered worked best of all. They believed in what they called efficient markets and the idea that asset prices reflect all the available possible information. So, an implication of that is that if you want to find out whether a company’s doing well or not, you don’t have to take the trouble to read all their financial reports, just look at their stock price. If you wanted to know whether a country’s doing well or not, you don’t have to study its entire political system and current events, just look at the general stock market of the country and that’ll tell you.
They believed that you could make as good returns in the market as a lay person as you could as an expert because all the experts were competing to try and get the best possible price, and so the price itself reflected all their knowledge and wisdom and opinions and so the lay person could take advantage of that by buying stocks. Everybody should be an investor, they felt. A monkey throwing darts at a dart board would do as well as any of the greatest experts.
Now, their own theory was basically contradicted by their own experience because all of them seemed to go out into the world and invest, and almost all of them made extraordinary returns and made a huge amount of money all of which made them even less popular in the faculty of arts and sciences.
So, a critical part of their theory was that the markets were so efficient, driven by people like them who are competing to exploit every advantage and therefore compete away every advantage and by doing that, put all the information they have into the prices. The implication of that theory is that there’s an extraordinary clever way of computing the value of most investment assets and about deciding when a financial decision’s a good thing to do or not and that was the heart of what they taught in these business schools, these algorithms for valuing assets and making optimal financial decisions.
One striking thing is that the people they studied, the business people and the investment bankers they studied adopted their language. So, this had never happened in academia before. I mean, anthropologists study primitive tribes and different kinds of people all the time and not one of them, I venture to say, has ever taken over all the language invented by anthropologists to behave themselves in their own societies, but the business people that these professors were studying ended up using exactly the language created in academia.
Now, Yale was very different. There was no divide between economists and finance people, the business school finance people. At Yale, the greatest economists in Yale’s history were actually very interested in finance. Maybe they were financial economists to begin with. So, the greatest Yale economist of the first half of the twentieth century was Irving Fisher who you hear a lot about. He wrote possibly, the first economics PhD at Yale. There was no economist to teach him so he had to write his PhD with Gibbs, maybe the greatest American physicist of the time. There’s a building, as you know, on Science Hill named after Gibbs and you’ll hear more about his dissertation in the 1890s, but he was a mathematical economist, an econometrician but he invented almost all of this economics in order to study finance.
Finance: A Course Intro Pt 1
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