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Chapter 27: The Basic Tools of Finance

Recent Posts
(Note: Page numbers referenced in posts prior to June 1, 2011 refer to 5th edition)

 

March 4

The Divide over Market Efficiency

How accurate is the Efficient Markets Hypothesis? Clifford Asness and John Liew provide a detailed discussion of the debate over the answer to the question. They conclude that the Efficient Market Hypothesis is valuable, even if it is not completely correct.

Textbook References:

Pages 585-589 “The Efficient Market Hypothesis”

October 27

Fact-Checking The Economist

Mankiw points out an error in a statement about compounding from The Economist magazine.

Textbook References:

Pages 578-580 “Present Value: Measuring the Time Value of Money”

July 27

On Au

Mankiw reviews the academic literature on gold as a portfolio investment. He concludes that it is reasonable to hold about two percent of one's long-term investments in the form of gold.

Textbook References:

Pages 580-584 “Managing Risk”

May 18

On Stock Investing

Mankiw summarizes what economists know about investing in the stock market. He recommends a diversified global portfolio.

Textbook References:

Chapter 27 “The Basic Tools of Finance”

April 2

Five Lessons from the Financial Crisis

Olivier Blanchard says that economists should be more humble. He also says that financial systems and interconnectedness matter, and that the life of central bankers has become more complicated.

Textbook References:

Page 561 “Financial Crises”

March 28

What is the purpose of insurance?

Should insurance just cover unpredictable, catastrophic events, or should it also cover small, predictable expenses?

Textbook References:

Pages 580-584 “Managing Risk”

November 11

An Interview with Eugene Fama

Robert Litterman conducts a wide-ranging interview with Eugene Fama. They discuss principles of finance, financial institutions, and financial reform.

Textbook References:

Pages 584 “The Basic Tools of Finance”

May 30

A Bond Market Meme, Revisited

Mankiw provides more evidence that timing the market is very difficult.

Textbook References:

Pages 584-590 “Asset Valuation”

April 16

On Market Timing

Dilbert gives his boss advice on buying stocks.

Textbook References:

Pages 584-590 “Asset Valuation”

February 26

IQ and Investment Decisions

According to Robert Schiller, people with high IQs make somewhat better financial investments.

Textbook References:

Chapter 27 “The Basic Tools of Finance”

February 9

Should health insurance be required to cover birth control?

John Cochrane argues that insurance is supposed to cover large, unanticipated expenses, not small, regular, and predictable expenses.

Textbook References:

Pages 581-582 “The Markets for Insurance”

December 5

15 Years Later

Over the past 15 years, the return from the U.S. bond market has surpassed the return from the U.S. stock market.

Textbook References:

Pages 583-584 “The Trade-off between Risk and Return”

September 28

Robert Shiller on Stock Valuations

Robert Shiller points out that the price-to-earnings ratio in the stock market is still above its long-run average.

Textbook References:

Page 559 “Key Numbers for Stock Watchers”
Pages 584-589 “Asset Valuation”

April 25

Shiller vs Siegel on Stock Market Valuation

Robert Shiller thinks that stocks are a bit overvalued. Jeremy Siegel disagrees.

Textbook References:

Page 579 “Key Numbers for Stock Watcher”
Pages 606-610 “Asset Valuation”

March 16

An Ec 10 Success Story

A Harvard undergraduate wrote her thesis on the meltdown of the market for CDOs. Michael Lewis calls it "more interesting than any single piece of Wall Street research on the subject."

Textbook References:

Pages 600-605 “Managing Risk”
Pages 606-610 “Asset Valuation”
Pages 654-655 “The Financial Crisis of 2008”

March 1

Tobin's Q

A graph shows Tobin's Q for the whole economy from 1900 to the present. In this case Tobin's Q is the total price of the stock market divided by the replacement cost of all the companies listed. Its current value suggests that the stock market is overvalued.

Textbook References:

Pages 606-610 “Asset Valuation”

February 2

Moral Hazard

Mankiw provides an example of moral hazard from his own life.

Textbook References:

Pages 484-485 “Hidden Actions, Principals, Agents, and Moral Hazard”
Pages 601-603 “The Market for Insurance”

January 14

An Interview with Burt Malkiel

There is a short video in which Burt Malkiel discusses the Efficient Market Hypothesis.

Textbook References:

Pages 606-610 “Asset Valuation”

December 26

Malkiel's Recommended Asset Allocation

Burton Malkiel recommends index funds for baby boomers. The latest edition of his book suggests a larger allocation towards foreign assets than previous editions.

Textbook References:

Pages 606-610 “Asset Valuation”

December 16

The Economics of Seinfeld

Clips from the TV show "Seinfeld" are used to illustrate a variety of economic concepts.

Textbook References:

Pages 4-5 “Principle 1: People Face Trade-offs”
Pages 5-6 “Principle 2: The Cost of Something is What You Give Up to Get It”
Page 6 “Principle 3: Rational People Think at the Margin”
Pages 7-8 “Principle 4: People Respond to Incentives”
Pages 10-12 “Principle 7: Governments Can Sometimes Improve Market Outcomes”
Chapter 3 “Interdependence and the Gains from Trade”
Pages 67-72 “Demand”
Pages 73-76 “Supply”
Pages 144-153 “Controls on Prices”
Chapter 10 “Externalities”
Pages 226-227 “The Different Kinds of Goods”
Pages 227-232 “Public Goods”
Pages 230-232 “The Difficult Job of Cost-Benefit Analysis”
Pages 232-237 “Common Resources”
Pages 274-275 “Fixed and Variable Costs”
Page 281 “Economies and Diseconomies of Scale”
Pages 312-315 “Why Monopolies Arise”
Chapter 16 “Monopolistic Competition”
Pages 370-378 “The Economics of Cooperation”
Pages 399-400 “The Supply of Labor”
Page 414 “Compensating Differentials”
Page 442 “Utility”
Page 465 “Utility: An Alternative Way to Describe Preferences and Optimization”
Pages 484-489 “Asymmetric Information”
Pages 556-558 “Technological Knowledge”
Pages 578-580 “Financial Intermediaries”
Pages 598-600 “Present Value: Measuring the Time Value of Money”
Pages 603-604 “Diversification of Firm-Specific Risk”
Pages 606-609 “The Efficient Market Hypothesis”
Pages 630-631 “The Economics of Unions”
Pages 703-705 “The Prices for International Transactions: Real and Nominal Exchange Rates”
Pages 707-708 “The Basic Logic of Purchasing Power Parity”
Page 833 “Time Inconsistency”

November 4

Malkiel's Recommended Reading

Burton Malkiel recommends five books on investing.

Textbook References:

Pages 606-610 “Asset Valuation”

July 31

Stocks Look Cheap

By one measure, stocks look under-priced.

Textbook References:

Pages 577-578 “The Stock Market”
Page 579 “Numbers for Stock Watchers”
Pages 606-610 “Asset Valuation”

July 19

Jeremy Siegel's Forecast

Jeremy Siegel is Bullish on stocks.

Textbook References:

Pages 577-578 “The Stock Market”
Pages 606-610 “Asset Valuation”

July 6

An Interview with Bob Hall

A wide-ranging interview with Robert Hall touches on a variety of topics.

Textbook References:

Pages 7-8 “Principle 4: People Respond to Incentives”
Pages 566-567 “Property Rights and Political Stability”
Pages 604-605 “The Trade-Off Between Risk and Return”
Pages 654-655 “The Financial Crisis of 2008”
Pages 740-742 “Three Key Facts About Economic Fluctuations”
Pages 778-787 “How Monetary Policy Influences Aggregate Demand”
Pages 787-793 “How Fiscal Policy Influences Aggregate Demand”
Pages 793-797 “Using Policy To Stabilize The Economy”

July 2

A New Problem for Insurance Markets

The discovery of genetic markers for longevity will affect markets for life insurance and annuities.

Textbook References:

Pages 485-486 “Hidden Characteristics: Adverse Selection and the Lemons Problem”
Page 488 “Screening to Induce Information Revelation”
Pages 601-603 “The Markets for Insurance”

June 15

Stock Market Valuation

By two common measures, the stock market is substantially overvalued.

Textbook References:

Pages 577-578 “The Stock Market”
Page 604 “Market Risk”

May 28

Fama on Financial Reform

There is a video of an interview with Eugene Fama. He discusses the recent financial crisis and suggested reforms.

Textbook References:

Pages 8-10 “Principle 6: Markets Are Usually A Good Way To Organize Economic Activity”
Pages 10-12 “Principle 7: Governments Can Sometimes Improve Market Outcomes”
Pages 606-610 “Asset Valuation”
Pages 654-655 “The Financial Crisis of 2008”
Pages 821-822 “Bernanke's Challenges”

March 24

A Fiscal Train Wreck

In an "exceedingly rare" event, bonds issued by a private company (Warren Buffet's Berkshire Hathaway) paid a lower yield than bonds of a similar maturity issued by the U.S. Treasury. That is evidence that investors are getting nervous about the size of the U.S. deficit.

Textbook References:

Pages 246-248 “The Fiscal Challenge Ahead”
Pages 576-577 “The Bond Market”
Pages 589-593 “Policy 3: Government Budget Deficits and Surpluses”
Pages 604-605 “The Trade-off Between Risk and Return”
Pages 842-843 “Dealing with Deficits”

March 16

An Ec 10 Success Story

A Harvard undergraduate wrote her thesis on the meltdown of the market for CDOs. Michael Lewis calls it "more interesting than any single piece of Wall Street research on the subject."

Textbook References:

Pages 600-605 “Managing Risk”
Pages 606-610 “Asset Valuation”
Pages 654-655 “The Financial Crisis of 2008”

March 7

A Life in Finance

Eugene Fama writes an autobiographical sketch.

Textbook References:

Pages 606-609 “The Efficient Markets Hypothes”
Pages 484-485 “Hidden Actions: Principals, Agents, and Moral Hazard”
Chapter 27: The Basic Tools of Finance
Archived Posts

 

February 20

What I've Been reading

Mankiw recommends Emanuel Derman's book, My Life As A Quant: Reflections on Physics and Finance. Derman details his experiences as a physicist and on Wall Street.

Textbook References:

Chapter 27 “The Basic Tools of Finance”

December 20

Readings on Financial Regulatory Reform

Mankiw provides a list of articles that discuss financial regulatory reform.

Textbook References:

Pages 576-580 “Financial Institutions in the U.S. Economy”
Chapter 27 “The Basic Tools of Finance”
Pages 654-655 “The Financial Crisis of 2008”

October 28

Is the Efficient Markets Hypothesis Kaput?

Jeremy Siegal argues that the current financial crisis has not discredited the efficient market hypothesis.

Textbook References:

Pages 606-607 “The Efficient Market Hypothesis”
Pages 654-655 “The Financial Crisis of 2008”

October 24

A Defense of Insider Trading

Donald Boudreaux argues that insider trading is "impossible to police and helpful to markets and investors."

Textbook References:

Pages 8-10 “Principle 6: Markets Are Usually a Good Way to Organize Economic Activity”
Pages 10-12 “Principle 7: Governments Can Sometimes Improve Market Outcomes”
Pages 606-607 “The Efficient Market Hypothesis”

October 23

How Harvard Economists Invest

Three Harvard economists explain their personal investment strategies.

Textbook References:

Pages 600-606 “Managing Risk”


October 14

Maskin on the Financial Crisis

Nobel laureate Eric Maskin discusses the financial crisis. He contends that economists did anticipate the crisis but that policymakers did not listen. He also provides a reading list on the subject.

Textbook References:

Pages 484-485 “Hidden Actions: Principals, Agents, and Moral Hazard”
Pages 601-603 “The Markets for Insurance”
Pages 642-643 “The Functions of Money”
Pages 649-658 “Banks and the Money Supply”
Pages 779-781 “The Theory of Liquidity Preference”
Pages 783-785 “Changes in the Money Supply”


September 24

Posner on Keynes

Richard Posner discusses why he became a Keynesian after reading The General Theory.

Textbook Reference:

Pages 609-610 “Market Irrationality”
Page 770 “The Origins of Aggregate Demand and Aggregate Supply”
Pages 779-781 “The Theory of Liquidity Preferences”
Pages 794-795 “The Case for Active Stabilization Policy”


September 20

Book Review

Mankiw reviews Robert Skidelsky’s new book, “Keynes: the Return of the Master.”

Textbook Reference:

Pages 609-610 “Market Irrationality”
Page 770 “The Origins of Aggregate Demand and Aggregate Supply”
Pages 779-781 “The Theory of Liquidity Preferences”
Pages 794-795 “The Case for Active Stabilization Policy”


September 19

Levine on Macro

David Levine accuses Paul Krugman of ignoring advances in modern macroeconomics.

Textbook References:

Pages 494-500 “Behavioral Economics”
Pages 606-610 “Asset Valuation”
Chapter 33 “Aggregate Demand and Aggregate Supply”
Chapter 34 “The Influence of Monetary and Fiscal Policy on Aggregate Demand”
Chapter 35 “The Short-Run Trade-off between Inflation and Unemployment”
Chapter 36 “Five Debates over Macroeconomic Policy”


September 17

Kocherlakota on Macro

Narayana Kocherlakota makes ten claims about the state of modern macroeconomics.

Textbook References:

Pages 494-500 “Behavioral Economics”
Pages 606-610 “Asset Valuation”
Chapter 33 “Aggregate Demand and Aggregate Supply”
Chapter 34 “The Influence of Monetary and Fiscal Policy on Aggregate Demand”
Chapter 35 “The Short-Run Trade-off between Inflation and Unemployment”
Chapter 36 “Five Debates over Macroeconomic Policy”


September 10

How Did Economists Get It So Wrong?

Barry Eichengreen and John Cochrane defend economic theory in the face of the current crisis.

Textbook References:

Pages 494-500 “Behavioral Economics”
Pages 606-610 “Asset Valuation”
Pages 751-761 “The Aggregate Supply Curve”
Chapter 34 “The Influence of Monetary and Fiscal Policy on Aggregate Demand”
Pages 817-818 “Rational Expectations and the Possibility of Costless Deflation”
Chapter 36 “Five Debates over Macroeconomic Policy”


September 3

Krugman on Macro

Paul Krugman argues that most macroeconomists have preferred beauty to truth.

Textbook References:

Pages 494-500 “Behavioral Economics”
Pages 606-610 “Asset Valuation”
Pages 751-761 “The Aggregate Supply Curve”
Chapter 34 “The Influence of Monetary and Fiscal Policy on Aggregate Demand”
Pages 817-818 “Rational Expectations and the Possibility of Costless Deflation”
Chapter 36 “Five Debates over Macroeconomic Policy”


June 26

Was Keynes Really a Savvy Investor?

It’s easy to make money if one has unlimited funds.

Textbook References:

Pages 606-610 “Asset Valuation”
Pages 654-655 “The Financial Crisis of 2008”


Apr. 15

Yale Economists on the Financial Crisis

Robert Shiller, John Geanakoplos and Richard Levin discuss the financial crisis in a one-hour video. The roles of psychology and of leverage are emphasized.

Textbook References:

Pages 494-500 “Behavioral Economics”
Pages 498-499 “This Is Your Brain on Economics”
Pages 576-578 “Financial Markets”
Pages 608-609 “Neurofinance”
Pages 654-655 “The Financial Crisis of 2008”
Pages 778-787 “How Monetary Policy Influences Aggregate Demand”

A Lecture from Robert Merton

Robert Merton discusses derivatives, with an emphasis on put options.

Textbook Reference:

Chapter 27 “The Basic Tools Finance”


Mar. 29

Forecasting as Futuristic Fiction

Robert Shiller reports on how paying attention to peoples’ mind-sets can be useful in forecasting economic performance.

Textbook References:

Pages 498-499 “This Is Your Brain on Economics”
Pages 608-609 “Neurofinance”
Pages 654-655 “The Financial Crisis of 2008”


Mar. 22

Sumner on Financial Regulation

Scott Sumner defends the efficient market hypothesis and denies that more regulation would’ve prevented the financial melt-down.

Textbook References:

Pages 8-10 “Principle 6: Markets are Usually a Good Way to Organize Economic Activity”
Pages 10-12 “Principle 7: Governments Can Sometimes Improve Market Outcomes”
Pages 606-609 “The Efficient Market Hypothesis”


Feb. 25

The Formula that Killed Wall Street

There is a link to an article about David Li, who developed the formula that had a central role in the financial meltdown.

Textbook References:

Pages 576-580 “Financial Institutions in the U.S. Economy”
Chapter 27 “The Basic Tools of Finance”

Gleaser on the Mortgage Interest Deduction

Ed Gleaser argues that the tax deduction on mortgage interest payments should be limited to loans up to $300,000.

Textbook References:

Pages 7-8 “Principle 4: People Respond to Incentives”
Chapter 12 “The Design of the Tax System”
Pages 609-610 “Market Irrationality”
Pages 654-655 “The Financial Crisis of 2008”
Page 821 “Bernanke’s Challenges”


Feb. 15

Talking Down the Economy

Bradley Schiller says that the doom and gloom coming out of the Whitehouse is dangerous. Mankiw disagrees.

Textbook References:

Pages 608-609 “Neurofinance”
Page 749 “Why the Aggregate Demand Curve Might Shift”


Jan. 27

Shiller on Animal Spirits

Robert Shiller argues that restoring confidence is important.

Textbook Reference:

Pages 608-609 “Neurofinance”
Pages 749-750 “Why the Aggregate Demand Curve Might Shift”


Jan. 13

There is a graph and a link to commentary by Nick Bloom and Max Floetotto. They suggest that uncertainty has declined and the economy will begin to recover soon.

Textbook References:

Page 608-609 “Neurofinance”
Chapter 33 “Aggregate Demand and Aggregate Supply”


Jan. 8

There is a link to a blog by Eugene Fama and Ken French. Fama discusses the problem of how government injections of equity capital into troubled financial institutions can easily become nothing more than subsidies to debt holders.

Textbook References:

Pages 576-578 “Financial Markets”
Pages 601-603 “The Markets for Insurance”
Page 657 “Bank Runs and the Money Supply”
s Pages 778-785 “How Monetary Policy Influences Aggregate Demand”


Dec. 7

Life in the Left Tail

Mankiw shows a graph of the distribution of stock-market returns from 1825 to the present. 2008 is in the far left tail.

Textbook References:

Pages 577-579 “The Stock Market”
Pages 608-609 “Lessons from the Brain-Damaged Investor”
Pages 609-610 “Market Irrationality”
Page 767 “The Recession of 2001”