### 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 Content

Lecture 1 – **Why Finance?**

Lecture 2 – **Utilities, Endowments, and Equilibrium**

Lecture 3 – **Computing Equilibrium**

Lecture 4 – **Efficiency, Assets, and Time**

Lecture 5 – **Present Value Prices and the Real Rate of Interest**

Lecture 6 – **Irving Fisher’s Impatience Theory of Interest**

Lecture 7 – **Shakespeare’s Merchant of Venice and Collateral, Present Value and the Vocabulary of Finance**

Lecture 8 – **How a Long-Lived Institution Figures an Annual Budget; Yield**

Lecture 9 – **Yield Curve Arbitrage**

Lecture 10 – **Dynamic Present Value**

Lecture 11 – **Social Security**

Lecture 12 – **Overlapping Generations Models of the Economy**

Lecture 13 – **Demography and Asset Pricing: Will the Stock Market Decline when the Baby Boomers Retire?**

Lecture 14 – **Quantifying Uncertainty and Risk**

Lecture 15 – **Uncertainty and the Rational Expectations Hypothesis: Applications to Predicting Stock Prices, Default Probabilities, and Hyperbolic Discounting**

Lecture 16 – **Backward Induction and Optimal Stopping Times**

Lecture 17 – **Callable Bonds and the Mortgage Prepayment Option**

Lecture 18 – **Modeling Mortgage Prepayments and Valuing Mortgages**

Lecture 19 – **History of the Mortgage Market: A Personal Narrative**

Lecture 20 – **Dynamic Hedging**

Lecture 21 – **Dynamic Hedging and Average Life**

Lecture 22 – **Risk Aversion and the Capital Asset Pricing Theorem**

Lecture 23 – **The Mutual Fund Theorem and Covariance Pricing Theorems**

Lecture 24 – **Risk, Return, and Social Security**

Lecture 25 – **The Leverage Cycle and the Subprime Mortgage Crisis**

Lecture 26 – **The Leverage Cycle and Crashes**

## Requirements

*Math in the course*

Finance is a quantitative subject that can only be understood by solving concrete problems. But it uses mostly elementary mathematics. You need to be good at arithmetic (the distributive law is the basis for double entry bookkeeping), and be able to solve two or three simultaneous linear equations (x + y =10; x – y = 4. Solve for x and y). You must also be able to differentiate three elementary functions: dxn/dx =nxn-1; d ln x/dx = 1/x; deax/dx= aeax. The functions “log” and its inverse “exponential base e” are so important to finance because of continuous compounding of interest. Though they may be the most important functions in all of mathematics, they were discovered by bankers. You will also be taught how to use Excel.

*Course reading*

The textbook readings are meant to clarify or elaborate material presented in class, or to give you an idea of alternative presentations of the same material. For example, we might discuss bonds, how they pay, and how to value them. The readings might cover the specifics of particular bond markets (local, state, different countries), how they are taxed etc.

There is no official textbook. In the past I have used *Corporate Finance*, by former Yale professor Steve Ross and two co-authors, and two others, by Sharpe and Merton, both Nobel Prize winners in economics (for contributions to financial economics). Their books were regarded as insufficiently quantitative, but might be useful to browse in.

Another very good book is by Luenberger, but it is a little too advanced for this course. I have listed a dozen or so good alternatives and supplements, to give you an idea of where you could read more if you become interested.

**None of these is required. You should be able to follow the course simply by attending the lectures, reading the web notes, and doing the problem sets.**

## Textbooks:

Instructor: **John Geanakoplos**, James Tobin Professor of Economics