Economics 434 Theory of Financial Markets

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

Facts About The Course • Examinations • Two Mid-Terms • TBA • TBA • One Final Exam • Thursday, Dec 10th • Only excused absences permitted • Final Exam Date • Thursday, Dec 10th • 2PM • No Exceptions • Grading • Everyone hates this

What Material is Covered? • Fixed Income Markets • Modern Portfolio Theory • Leverage and High Yield • Derivatives

What is the Reading? • Malkiel – “Random Walk” • Burton – “Theory of Financial Markets • $ 40 within 1st week available • Pickup at VNB Office • “Panic” by Michael Lewis

For Today A Brief History of Financial Markets

The Dow Jones Averages Began On May 26th, 1896 40.94

380 The Dow Jones -- The Early Years 160 120 110 101.71 75 40.94 1896 1906 1916 1919 1921 1929 1926

381 Sept 290 The Great Crash 260.64 230 June 170 198 Oct 80 Jan 41.22 Jan July 1932 1929 1930 1931

The Thirties in Review 381 190 150 41.22 1929 1932 1939 1936

1020 1939 -1960 670 530 500 300 230 150 100 1939 1942 1946 1949 1953 1959 1956 1966

1966 -1981 1050 1030 1020 1010 800 780 760 770 AUG DEC 580 DEC 1976 1966 1969 1981 1973 - 1974

Aug, 1981 -July, 1987 2700 July 1500 1000 780 1981 1987 1983 1986

1987 - The “Rip Van Winkle” Year 2700 2300 2200 2200 2200 1700 Jan July October Dec

1988 - 2000 12,000 9328 11,500 6800 4,000 Peak in March, 2000 2200 1988 1994 1997 1998 1999 2000

Since 2000 14,000 12,000 9,500 8,600 8,400 6,400 2000 2003 2007 2008 2009

The Financial Crisis – The Recession • The Financial Crisis • Subprime Lenders Collapse in 2006 • ABS Market Freezes Up in Summer of 2007 • Collapse of Bear Stearns in Mch 08 • FNM and FMC taken over Sept 5th • Lehman bankruptcy on September 15th • The Economy Collapses • Mid-Sept to Mid-October • Unemployment goes from 4.5 % in the Spring of 2007 to 9.5 % in the Spring of 2009 • GDP drops 4 percent from October to June

So, what is the Fed doing • Lowering the FF target rate • Opening the FRS window to non-banks and accepting weak collateral • Negotiating bail outs, e.g. Bear Stearns

The Bursting of the Housing “Bubble” • Dramatic overbuilding of residential housing • Huge escalation of prices • Easy financing • Up to late 2006 • Oops

Questions • Why is the economy as a whole still okay? • Why did Bear Stearns collapse • What are Fannie and Freddie? • Why are Lehman Brothers and Wachovia on the ropes?

The End

Economics 434 Theory of Financial Markets