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Standard financial theory left us woefully unprepared for the financial crisis of 2007-09. Something is missing in the theory. In the majority of loans the borrower must agree on an interest rate and also on how much collateral he will put up to guarantee repayment. The standard theory presented in all the textbooks ignores collateral. The next two lectures introduce a theory of the Leverage Cycle, in which default and collateral are endogenously determined. The main implication of the theory is that when collateral requirements get looser and leverage increases, asset prices rise, but then when collateral requirements get tougher and leverage decreases, asset prices fall. This stands in stark contrast to the fundamental value theory of asset pricing we taught so far. We'll look at a number of facts about the subprime mortgage crisis, and see whether the new theory offers convincing explanations.
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.
