Financial Theory

Yale, , Prof. John Geanakoplos

Updated On 02 Feb, 19


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


Lecture 15: Uncertainty and the Rational Expectations Hypothesis

4.1 ( 11 )

Lecture Details

Financial Theory (ECON 251)

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 firms 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, todays one year rate grossly overestimates the long run annualized rate. If todays 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.

Complete course materials are available at the Open Yale Courses website httpopen.yale.educourses

This course was recorded in Fall 2009.



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Excellent course helped me understand topic that i couldn't while attendinfg my college.

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Great course. Thank you very much.