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Economics 434 Theory of Financial Markets

Economics 434 Theory of Financial Markets. Professor Edwin T Burton Economics Department The University of Virginia. Administrative. Professor Burton returns Sept. 11 th Sunit Shah – Introduction UVA ‘01, B.A. Economics & Mathematics Work in finance: Modeling bond movements

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Economics 434 Theory of Financial Markets

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  1. Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

  2. Administrative • Professor Burton returns Sept. 11th • Sunit Shah – Introduction • UVA ‘01, B.A. Economics & Mathematics • Work in finance: Modeling bond movements • Research in finance: Treasury bond auctions • UVA ’11, Ph.D. Economics • Fields: Finance, Industrial Organization, Econometrics • Dissertation in Game Theory

  3. Availability Professor Burton • Monroe Office: Room 262, 434-924-4054 • VNB Office: 1900 Arlington Blvd., Suite C, 212-731-2340 • Office Hours: 11am-12pm Tues/Thurs • Email: etb6d@virginia.edu Sunit Shah • Will hold Prof. Burton’s office hours in his Monroe office • Email: sunit@virginia.edu • Teaching Philosophy – Extending Small Class Principles

  4. Administrative • Add/Drop • Attendance = Mandatory • Class Website: http://people.virginia.edu/~etb6d/classes.htm • Syllabus posted on site w/ required readings • Additional course material to be posted here (textbook chapters, etc.)

  5. Course Overview Topics Covered • Fixed Income Markets • Modern Portfolio Theory • Leverage, Corp. Balance Sheets, Buyouts • Alternative Assets Pre-requisites: • Econ 3010 – Intermediate Micro • Econ 3030 – Money and Banking • Econ 3710 – Intro to Statistical Analysis • Questions/Concerns – See me (esp. xfer students)

  6. Grading Three Exams: • First mid-term – Thursday, October 11th • Second mid-term – Thursday, November 8th • Final – Wednesday, December 12th, 2pm - 5pm There is no “Dutch knockout” – you must take all exams Honor System • Applies to all graded assignments/exams • Conscientious Retraction Option

  7. Theory of Financial Markets Several types of financial markets • Stock (i.e. Equity) Market – most well-known • Bond Market (Fixed Income) Many others as well… • Commodity Market – corn, oil, electricity, gold, etc. • Derivatives Market – options, futures, etc. • Foreign Exchange Market – Euro, Yen, etc.

  8. Theory of Financial Markets First quarter of course covers bond market - but first, a review of US stock market history Dow Jones Industrial Average • Representation of the market as a whole • Began May 26th, 1896 at 40.94 • Over 13,000 today – increase of over 30,000%

  9. Dow Jones Industrial Average – 1900-2010

  10. Dow Jones Industrial Average – 1900-2010 Four Great Market Crashes

  11. Dow Jones Industrial Average – 1900-2010, Scaled Four Great Market Crashes

  12. 1900 - Setting the Context Very different climate than 2010 • Economically • No federal income tax; highest rate today = 35% • Federal debt = $2.6 B; today debt = $15,946 B • Politically • Only 45 states – states’ rights up for debate • 20 years before womens’ suffrage • Socially • 12 years before the Titanic • 16 years before radio tuners

  13. Dow Jones Industrial Average – 1900-1920 • Typical market behavior • General upward trend • Some volatility about trendline

  14. Dow Jones Industrial Average – 1920-1929 • “Roaring Twenties” • U.S. as world leader in wake of WWI • Decade of economic prosperity • Social and cultural advancement

  15. Dow Jones Industrial Average – 1929-1942 The Great Crash • Black Tuesday – October 29, 1929 • Market drops over 20% in two days and ~40% in one month • $1 invested in mid-September, 1929 stayed under $1 until November, 1954 • Ushered in the Great Depression

  16. Black Tuesday & The Great Depression Effects • U.S. unemployment rate rose to 25% (natural rate ~5%) • Industrial production dropped over 50% • Market dropped 89% from peak to valley • Global Depression – Affected all industrialized western nations Theories of cause: • Loose credit • Wealth disparities • Halt to int’l trade (Smoot-Hawley Tariff Act) • Poor policy

  17. The Recovery The “New Deal” • Vast increase in size and spending of government • Birth of entitlement programs (e.g., welfare, social security) • Wide spectrum of other programs as well (e.g., FDIC, SEC, TVA) • Effects ambiguous World War II • Dec. 7th, 1941 – Pearl Harbor; U.S. declares war the next day • Women join the workforce • Military spending increased significantly • Unemployment drops below 10% for first time since 1920s • Market trends upwards through mid-1960s

  18. Dow Jones Industrial Average – 1942-1966 The Recovery • Steady upward trend lasting two decades • Market climbs from about 100 to almost 1,000

  19. Dow Jones Industrial Average – 1966-1980 Market Stagnation • Vietnam War • 1973 oil crisis – OPEC constricts oil supply • “Stagflation” – High unemployment with high inflation • Emergence of new industrialized nations

  20. Dow Jones Industrial Average – 1980-1987 Early to Mid 80s • Longest Peacetime Economic Boom in US History • Theories of cause • Low tax rates & less government intervention • Market correction from lost potential of previous 15 years

  21. Dow Jones Industrial Average –1987 1987 • Black Monday – October 19, 1987 • Market drops 22.6% in one day (!!) • Shrouded in mystery • Full-year movement flat overall

  22. Dow Jones Industrial Average – 1988-2000 Late 80s and 1990s • Continued Economic Prosperity • Several Technological Advances, including Internet • Widely available venture capital allows Dot Com Bubble to form

  23. Dow Jones Industrial Average – 2001-2002 Dot Com Bubble Bursts • Loss of fundamental analysis – market correction • Market psychology

  24. Dow Jones Industrial Average – 2003-2008 The Housing Bubble • Fed lowers rates due to ‘01 crash – mortgages cheaper • Sharp increase in sub-prime lending (10% -> 20% in 2004)

  25. Dow Jones Industrial Average – 2008-2010 Another Bubble Bursts – Chain of Events: • Housing prices drop substantially starting in 2005 • Foreclosures increase dramatically by 2006 • Sub-prime lenders start to go under in late 2006 • Toxic assets pervasive throughout • banking industry – by 2008, • banks in trouble

  26. Government Action Government Gets Involved • March ‘08 – Gov’t negotiates Bear Stearns buyout • Sept ’08 • Gov’t allows Lehman to go under after 180 years in business • Fed attempts to coordinate private AIG bailout to no avail • Decides on public bailout for AIG – “too big to fail” • Oct ‘08 • Bush signs TARP into law • Treasury assumes 90% of risk for $300 billion of Citigroup’s assets • Dec ‘08 – Treasuries hit a negative yield (!!)

  27. Wrap-up Motivation for the Course • Better understanding of various assets, incl. what affects their market prices • Financial theory fundamentals, e.g.: • How should one construct an investment portfolio? • How does a company’s financial leverage affect its value? • Further discussion on financial market history (esp. ‘08)

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