Finance and Volatility
Optional course for last semester MA (Economics) students at Ashoka University, 2022-23
(Previously taught at Indian Statistical Institute, Delhi Centre, and Jawaharlal Nehru University since 2001)
This course is about understanding why we often see volatility or instability in the financial sector in a market economy or even a mixed economy. We will consider the related market failure and government failure (and sometimes academic failure). This is primarily a course on theory to explain the real world, and on lessons from theory for practitioners and policymakers who have to deal with financial instability. We keep an eye on broad stylized facts (and occasionally an empirical study). The course is useful for students aspiring to be academics, policy makers, and practitioners (in alphabetical order). The syllabus includes some behavioural finance.
An extreme form of volatility or instability is, what is familiar as, a financial crisis (and serious recession). Where excess volatility is absent, it can be a case of stability or it can be a case of financial repression that can have its own persistent cost.
Since the financial system is usually classified as consisting of two parts viz., financial markets and financial intermediaries, the syllabus is in two parts; one part deals with possible excess volatility in prices in financial markets (and more generally, asset markets including the real estate market), and the other part deals with occasional but costly (and possibly devastating) instability in financial institutions.
1. Asset markets, and possible excess volatility
Formal CAPM model and evidence, stochastic discount factor, efficient markets hypothesis and behavioural finance, fundamental risk and noise trader risk, limits to arbitrage, stabilizing speculation and destabilizing speculation, equity risk premium, anomalies, safe asset, bubbles - rational and irrational, Ponzi scheme, high price due to scarcity of good assets in emerging market economies (EMEs), debt and asset prices, leverage cycle, fire-sales, Tobin's-q and (real) investment, balance sheet recession, asset prices and volatility in interest rates, dynamic hedging, risk aversion and risk appetite, financial assets and non-financial assets (like real estate), neglected risks, diagnostic expectations, agency cost (including dual agency cost perspective).
2. Financial intermediaries, and instability
Banking crises, bank runs (sunspots, and fundamentals-based runs, inefficient and efficient, partial and complete), non-performing loans, ‘sudden stop’ and banks, rationale for demand deposits, money and financial intermediaries, shadow banks, narrow banking, endogenous risk, value at risk, lending booms, liquidity (many different meanings), fluctuations in interest rates, contagion (and connectedness), financial repression, 'peculiar' case of stable and efficient Canadian banking, instability and fragility (and the idea of an anti-fragile arrangement), suspension of convertibility, deposit insurance, lender of last resort, credit lines, and capital adequacy.
Reading list (in alphabetical order)
1. Allen, Franklin, and Douglas Gale (ed.), 2008, Financial Crises, An Elgar Reference Collection, Chapter 20.
2. Campbell, John Y., 2018, Financial decisions and Markets - A course in Asset Pricing, Princeton University Press, New Jersey (sections 4.1.1 - 4.1.4, and section 5.2).
3. Diamond, Douglas W., and Raghuram G. Rajan, 2001, Banks and liquidity, American Economic Review Papers and Proceedings, 91(2), 422- 425.
4. Eichberger, Jurgen, and Ian R. Harper, 1997, Financial Economics, Oxford University Press, New York (section 2.2.2).
5. Feldstein, Martin, 2016, The future of fiscal policy, in Progress and Confusion: The State of Macroeconomic Policy, Edited by Olivier Blanchard, Kenneth Rogoff, Raghuram Rajan, and Lawrence Summers, International Monetary Fund, Cambridge, MA: The MIT Press (this is a short reading on policy for macroeconomic stability - policy which is without adverse side-effects for financial stability).
6. Geanakoplos, John, 2010, The leverage cycle, Cowles Foundation Discussion Paper No. 1304.
7. Gennaioli, Nichola, and Andrei Shleifer, 2018, A Crisis of Beliefs - Investor Psychology and Financial Fragility, Princeton University Press, chapter 5 (p. 137-156).
8. Gennaioli, Nichola, Andrei Shleifer, and R.W. Vishny, 2012, Neglected risks, financial innovation, and financial fragility, Journal of Financial Economics, 104, 452-468 (p. 452-461 for the course).
9. Glaeser, Edward L., Gyourko, Joseph, and Saiz, Albert, 2008, Housing supply and housing bubbles, Journal of Urban Economics, 64(2), pages 198-217 (the first part of the paper on rational bubbles).
10. Koo, Richard, 2013, Central banks in balance sheet recessions: A search for correct response, Institute for New Economic Thinking (INET), April.
11. Romer, David, 2012, A model of debt crisis, section 12.10 in Advanced Macroeconomics, 4th edition, McGraw Hill.
12. Shin, Hyun Song, 2010, Risk and Liquidity, Clarendon Lectures, Oxford University Press, New York (chapters 1, 2, 3 (sections 3.1, and 3.3), 4 and 5).
13. Shleifer, Andrei. 2000. Inefficient Markets - An Introduction to Behavioural Finance, Oxford University Press, New York, chapters 1, 2, and chapter 6 (first part only).
14. Shleifer, Andrei, and R.W. Vishny, 2010, Unstable banking, Journal of Financial Economics 97, 306–318.
15. Tirole, Jean, 2002, Financial crises, liquidity, and the international financial system, Princeton University Press, Chapter 3.
16. Tirole, Jean, 2006, The Theory of Corporate Finance, Princeton University Press, chapter 3.
And finally,
16. The PPT presentations on data and some concepts that are used alongside lectures on theory in class; these are e-mailed after class.
Note: There may be a few changes in the syllabus or readings on the way; this is part of the ongoing up-gradation and updating.
Grading: Mid-semester exam 25%, end-semester exam 50%, presentations (and participation in classes) 15%, and home assignment(s) 10%.
Other information about the course:
About the readings
The reading list includes both books and original papers. Most of the publications are from the post 2008 financial crisis period. Some are very recent.
Motivation for studying Financial Economics in general
There are some wide-spread beliefs about Finance. First, it is for the purpose of getting rich (at the expense of others). Second, the subject matter is not serious enough for good academics. Third, Finance means only Corporate Finance; it has little to do with socially useful subjects like Development Economics. Fourth, sentiment matters so much in financial markets that the subject matter in Financial Economics cannot be scientific and serious anyway. Fifth, the discipline is relatively young as serious work began only in the 1950s; so it is not an advanced subject. Hence, there is little scope here for a study of a matured subject. Sixth, much of the material covered on Finance at the undergraduate level tends to descriptive rather than analytical. So, it is very likely that it is going to be not very different at the post graduate level too.
I will not say that there is no truth at all in some of these beliefs. However, it is important to make two observations. One is that there has been a gradual sea change in Finance so that the subject matter is very different from what it used to be. The other observation is that to the extent that the above statements are indeed true, it is because of the way Finance has been taught and studied in many places. However, there is inherently nothing in the subject matter so that the above propositions need be true. Let me now counter the above views more specifically.
First, there are new areas like Micro-Finance and Financial Development that are quite different from Corporate Finance. In these areas, the emphasis is on financial inclusion and economic development. So Finance need not be only for the purpose of getting rich or for the purpose of making the rich get richer (and in the process enriching oneself). In fact, the teaching of Economic Development gets incomplete without some teaching of Financial Development. Also, some finance experts work for pension funds and for endowment funds that university administrations have. A good example is David F. Swensen who is the chief investment officer at Yale University. He has managed to get very high returns on investments; in the process he has helped in the education of so many students at Yale! So Finance is what one makes of it. It will help to see the book, Finance and the Good Society by Robert J. Shiller (Nobel laureate), 2012.
Second, at least from mid-1950s onwards, there have been formal studies in Finance. Nobel prizes in Financial Economics include those won by Markowitz, Miller and Sharpe (1990) and Merton and Scholes (1997). In 2013, the Nobel Prize was won by three Finance academics - Eugene Fama, Robert Shiller and Lars Peter Hansen. One may also include macroeconomists like James Tobin and Franco Modigliani who won the Nobel Prize in 1981 and 1985 respectively; their work in Finance was serious and pioneering. A large number of PhDs in Finance are awarded from universities that include very prestigious universities. The graduate level courses and even the undergraduate level courses in Finance are serious. The IMF appointed a finance expert as economic advisor (Raghuram G. Rajan, 2003-06). There is considerable use of mathematics, econometrics, and in-depth intuitive reasoning in finance. All this suggests that the view that Finance is not a very serious subject is just not true.
Third, it is often said that though subjects like Macroeconomics are socially useful, the same cannot be said for Financial Economics. Again this is not true. In the nineteenth century, there was a somewhat oral tradition in Macroeconomics among practitioners and policy makers. This was closely integrated with work on financial stability. Even John Maynard Keynes dealt with both Macroeconomics and Finance. It is somehow on the way that the work on Macroeconomics received much more attention than the work on Financial Stability. However, there has been a sea change since the early 1980s. There is now considerable work on financial stability in research journals. It is true that much of this did not trickle down to textbooks and to syllabus in some universities. However, this is not generally true of the body of knowledge available.
Fourth, it is said that since sentiment matters in financial markets, the subject cannot be serious or scientific. This is again not true. The role of sentiment is a fact of life in financial markets. So it is only realistic to include it in a serious study. More important, sentiment can take a variety of forms. It is critical to find the more important forms and study the implications of each form. So there is a scientific study of the effect of each form of sentiment. There is also a question of what can possibly be done about sentiment in financial markets. All these considerations make the subject matter more challenging in Sciences. (It was at one time believed that the earth is flat. A correction of this wrong view required more scientific work and not less.)
Fifth, to say that the discipline is relatively young and that there is little scope is contradictory. Because the discipline is young, it is possibly the case that there is a lot to discover. So the scope for learning and research is possibly more and not less as compared to other older disciplines.
Sixth, the treatment of a subject can be quite different at the undergraduate level and at the post graduate level. The fact that it is primarily descriptive at the undergraduate level has no implications for the way it is dealt with at the post graduate level. In any case, the difference in the way a subject is taught at different levels can be sometimes country specific. It is, in fact, not true in general that Finance is taught as a descriptive subject at the undergraduate level all over the world.
Motivation for studying this course on 'Finance and Volatility' in particular
It is well known that there is considerable volatility in the financial system (though a small minority of economists refutes the basic idea of excess volatility). This volatility at times takes the extreme form of a financial crisis. There is a financial crisis in one way or another, in one country or another, quite frequently if we consider the last two centuries or so. In this course, we will attempt to understand why this is so. We will use theory to understand the real world. We will also try and see what can be done about this through appropriate policies – both in terms of preventing such events and in terms of tackling the situations that do arise.
It is interesting that some authors have even argued that some financial crises can play a positive role. We will consider this argument too.
Filling a gap
Volatility in the financial system and, in the extreme cases, financial crises are macroeconomic concerns. So a macroeconomic perspective helps. At present, standard macroeconomic courses do not pay adequate attention in a very meaningful way to issues of financial stability. But these issues are very important. On the other hand, standard finance courses for various reasons do not deal with financial crises adequately. Real estate economics falls in ‘no man’s land’ in some places, if not many places, even though housing is the single most important asset for households in very many parts of the world and even though large changes in real estate prices have caused or aggravated many a financial crisis or recession. This course fills the gap in finance courses (and also in macroeconomics courses).
It is interesting that an important concern in standard Macroeconomics is some kind of price rigidity (as opposed to price flexibility). In contrast, an important concern in Finance is volatility in prices (as opposed to price flexibility). It appears that macro-financial instability is related in part to price rigidity and in part to price volatility. Though an integrated approach that encompasses all this is not available, this course at least sets out to show how price volatility can be harmful for the real sector (the other part on price rigidity is familiar in Macroeconomics courses).
Economic Models, and Economics
An economic model is an abstraction for clarity of thought on a particular aspect. Each economic model deals with a particular aspect. However, there is a need for putting the pieces together to get a sense of the Economics of it all. Economic models are only a means to understanding Economics; this is particularly true in a course like this one. Though economic models on different aspects can differ quite considerably, an attempt is made at a unified approach to the extent possible so that it is easier to get the overall picture right. We will spend time on specific models and on putting the pieces from various models together.
Pre-requisites for the course
This is a postgraduate course and in the last semester of the MA programe. It helps if the students have had some exposure to Finance previously. However, this is not absolutely necessary. The reason is that students have studied courses in areas like economics of information, game theory, statistics and macroeconomics over the previous three semesters of the MA programme before this course is taught in the fourth and the final semester. So they are in a position to follow the material prescribed, if they are interested and are willing to put in some work.
Course taught since 2002
This course has not been designed in response to the financial crises in the US and Europe beginning in 2007 or so (which is when the area of macro-financial stability became somewhat acceptable and even fashionable in many places). This course has been taught since 2002 though not exactly in the form in which it is being taught now. It is natural that a course evolves over time. It was previously taught in the MA (Economics) programme at Centre for International Trade and Development (CITD), School of International Studies (SIS), Jawaharlal Nehru University (JNU) till 2009. It has been taught in the MS (QE) programme at ISI, Delhi Centre from 2010 to 2022. And, it is being taught now at Ashoka University.
Teaching based on ongoing research
The teaching in this course is related to my research in the area of macro-financial stability. This includes published work such as my book, Banking Cries, Liquidity, and Credit Lines (2012, Routledge, Abingdon). This book has (1) previously unpublished work, (2) theoretical research, (3) several papers, (4) work for which ‘the whole is greater than the sum of parts’, and (5) fresh work on role of markets and government in the context of liquidity problem in banking crises. Another book on "Macroeconomics and Asset Prices - Thinking Afresh on Policy" is is in advanced stages. There are other research papers (and 'columns') in this area by the instructor; for 'columns', see Gurbachan Singh at Ideas for India (portal run by IGC and Tata Centre for Development at Chicago), and Business Standard.
Research can have two meanings. First it shows up as published or unpublished writings. Second, there is ongoing reading and assimilation of new material in the thought process and in teaching. This can be equally important. This, in my view, gets reflected in the improvements in the course over years.
'Inter-disciplinary' approach
Given the nature of the course, there is a need to look at theory, empirical evidence, institutional reality, historical background, and policy. So there is a need for a ‘broad’ study in the sense that several facets of the problems need to be looked into. There is a need for an ‘inter-disciplinary' study in the sense that while we focus on the theory and policy related to the financial aspect, there is a need to borrow from Macroeconomics, Monetary Economics, Public Economics, Real Estate Economics, and even Institutional Economics here and there.
Teaching style
It is in the nature of the subject under consideration that the reading material would be somewhat scattered. So a seemingly long reading list comes into the picture (considering the different chapters in the books and in the edited volumes prescribed, and journal papers ). Given that the reading matter is by different authors and in different styles, it becomes important for the teacher then to connect the contents in different readings. So it becomes somewhat inevitable that there would be time spent discussing the linkages between readings. This aspect is usually dealt with by the author of a main textbook that is written by a single author or a small set of authors in a unified manner. When such a textbook is absent, the role of the teacher as a coordinator between authors of different readings becomes more important than is usually the case. This is the situation in this course.
There is emphasis on both mathematical and non-mathematical rigour in the course. I will make use of both the traditional black board (or green board or white board) in the classroom and the power-point method with the computer to save time in teaching. This will also save time for students who need not note all that is said in the class. Again to save time, the mathematical details need not all be done mechanically in the class. These can be worked out at home (and they should be worked out meaning that these should not be left out at all). So the time spent in classroom will be more on introduction, perspective, conclusion, linkages with other readings, related research issues, and of course, questions and answers (these are taken very seriously).
Some of the readings are presented by the students. This helps in getting them to independently read and understand the material. They often need to look into other books or journals to clarify related issues. It is also a way of getting the students to interact with each other in this process as one paper may be assigned to a group pf students for preparation. So a group of students would interact with each other. They may also interact with others to clarify doubts. This is particularly true if the presentation by one group is related to a presentation by another group, which is often the case.
The KISS (keep it simple, stupid) Principle
Throughout an attempt is made to keep the matter simple. It is important to keep in mind the distinction between simple and easy. It is not always easy to keep things simple but it is worthwhile incurring the cost of keeping matters simple in teaching (and research). It must be added however that simplicity is not to be attained at the cost of compromising on the content. Also, simple is different from simplistic.
Use for the job market
This course is useful for the job market. This is for four reasons.
1. It deals with finance, which has a very important place in the sectoral composition of the GDP and also in the employment. So it is obviously useful.
2. This course deals with not only theory but also policy. One important factor for decision makers in practice in the industry is the policy framework within which industry operates. In this context, this course in financial economics is far more useful than standard courses in finance in business schools. The emphasis there is usually on finance, given a set of policies. Here we will study finance and policy in an integrated manner. This gives an edge to students who choose to work in regulatory bodies or even in the industry.
3. In the light of the financial crises in the US and in Europe beginning in 2007 or so (and elsewhere before that), there has been growing criticism in recent years about teaching and research in finance. It has been felt that many mechanical models are used and a narrow view of the real world is taken in the standard finance courses. In this respect, this course is different. It is not narrow in its approach.
4. The emphasis is on education rather than training. So students are encouraged to think on how to approach a question rather than give a ready-made answer which is likely to be anyway outdated soon in an area such as finance. At the end of the course, if a student happens to say ‘I don’t know but I can think and check’, then it is a positive in the job market – particularly in these days of ‘Google’ and ‘Google scholar’ where one can find out provided one knows how to approach an issue meaningfully.
Use of the course for research
The global financial crisis (GFC) in and around the year 2007 and several other crises have increasingly shown that there is a need for research in the area of finance and volatility in general, and financial crises in particular. This course can be useful in this context. This issue is mentioned in brief here because it is explained at length elsewhere. For more on this, see See https://sites.google.com/site/gurbachansingh61/research