The Arrhythmia of Finance Fall 2017 Syllabus Sections 1 & 2 Peter R. Fisher Woodbury 104 917 ...

32 Pages·2017·0.29 MB·English

by  Peter Fisher

The Arrhythmia of Finance

Fall 2017 Syllabus
Sections 1 & 2

Peter R. Fisher
Woodbury 104
917-915-7536

NOTE: There is a one-page, written assignment due at the start of the first class
on Monday, September 11. (See Session 1.)
Section 1. The objective of this syllabus.

This syllabus is intended to help you decide whether you want to take this course
and, if you do, to help make your effort to master the material more likely to be
successful.

In business, in government, in teaching and in life, I have found that continuous
effort to clarify the objective is the most effective way that I can contribute to
successful outcomes. Thus, one reason this syllabus is so long and detailed is so that
I can be as precise as possible about my objectives for the course and for each class.

A second, related, reason is to align your expectations as closely as possible with my
intentions. Expectations play a central role in human perception, in learning, and in
m uch of what contributes to human contentment. With that in mind, I want to align
y our expectations, as best I can, with how I intend the course to unfold.
Section 2. The objective of this course.

My objective is to provide you with insights, and to help you practice analytic skills
(principally non-quantitative) that can help you better understand the sources of
volatility in financial asset prices: why the heartbeat of finance appears to be
irregular. Put differently, my objective is to help you understand why the future so
often surprises us, as reflected in asset prices, in order to help you better
understand how money and finance work.

A former student told me that this course is actually about “how to make a decision”
and that is certainly an important part. In order to think clearly about finance, to
make wise financial decisions, we need to be able to think carefully and
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probabilistically about any outcome that is beyond our certain knowledge or
control. But clear thinking about how to make a decision will be the starting point
fFooru erx cphlaolrleinngg efisn wanec fea.c e in understanding finance.

that can be overcome witIh s eefef ofortu r important reasons why
we are surprised by financial outcomes each of which reflect conceptual limitations
and mistakes on our part to help reduce the
frequency and severity of our surprises. First, we fail to understand the role of
chance. Second, we do not appreciate both the power and the malleability of our
expectations and how they influence our perception of risk. Third, we gloss over the
central role of liquidity illusion in the financial system. Fourth, we fail to
understand the harsh mechanics of balance sheets that both reflect and constrain
oTuhre orobljee cotfi vcehsa.n ce.

We humans are story-telling creatures. We are drawn to causal
explanations that appeal to our sense of what is plausible even when these are not
the more probable explanations. As a consequence, we underestimate the role of
chance, we fail to understand probability and random outcomes (how often unlikely
things happen) and we make decisions based on these misconceptions. With effort
and practice, we can learn to apply statistical and probabilistic reasoning as a check
on our cognitive biases. We can also learn to apply the logic of conditional
pTrhoeb paobwileitry a anndd m thaell eparbinilcitipy loefs o oufr d eexcpiseicotna-tmionaks.ing in conditions of uncertainty.

The conventions of finance critically
depend on our expectations. We cannot assess or transfer value across time
without expectations about the likely cash flows, interest rates and the relevant
horipzoernc oepvteiro nwshich varluelee visa tnot be assessed. But our expectations and our horizons
are not stable: they change when the facts change (the future is uncertain) and when
our of the facts change (which happens more often than we
recognize). We also frequently fail to define our objectives specifically and
consistently and we conflate our expectations with our objectives. With
unarticulated and inconsistent reference points, we fail to think clearly about the
risks we face and the choices we make. When “we change our minds” we change the
asset prices. With effort and practice, we can. learn to distinguish our expectations
from our objectives and we can learn to identify clearly the reference points we rely
oTnh ew cheenntr aasl sreoslesi onfg l ioquuri driitsyk sil launsdio onu. r choices

Our financial system depends on liquidity
illusion: we cannot all withdraw our “money” from the banks, nor convert our
stocks and bonds into “money” at the same time. But we are each comforted by the
thought that individually we can convert our assets into “money” whenever we
want. An important way that we sustain this collective illusion is by thinking of
money as if it were a tangible object, like a commodity, and ignoring the fact that
money is overwhelmingly a mere promise – a claim we have on one another that is
exchangeable. Understanding the elusive concept of money is an important starting
point for appreciating the reliance of our financial system on credit and also helps us
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understand that liquidity illusion is central to how finance works and how finance
Tsehrev hesa rtshhe meceocnhoamnicys. of balance sheets.

Double-entry book keeping is a profound
analytic tool that lets us see how institutions and individuals intermediate value
across time and among different parties. To understand its force and effect we
need:

To look beyond the (important) rules of accounting to understand our
“economic balance sheets” that encompass all positive and negative cash flows –
explicit and implicit, current and expectaerdit, hcmometmiciatltleyd and contingent;
mismatches
To recognize that while balance sheets balance (positive and
negative values), by design and of necessity balance sheets reflect
among the expected values – and volatility – of liabilities and assets; and
volatility mismatches
To comprehend assets and liabilities simultaneously (not sequentially) so that
A bewttee rc aunn daeprpsrteacnidaitneg t hoef f(icnoamncbei.n ed) .
In sum, it is my objective to persuade you that you
will be less likely to be surprised by the arrhythmia of finance, and will be more
likeRlye tcoo gmnaizkee t wheis bea fliannacnec siahle dete cmisiisomnast, cihf yeso uth caatn y:o u (and others) are running,
p articularly when relying upon liquidity illusion;

Recognize how your expectations were formed, when and how they change, and
how changes in your expectations (and the expectations of others) affect the value
of assets and liabilities;

Be explicit and consistent in setting your objectives, so that you are conscious of the
reference points you rely on in assessing the riskiness of your choices; and

Recognize the role of chance and apply statistical and probabilistic reasoning and
the logic of conditional probability when you make decisions in conditions of
uncertainty.

Section 3. What this course is not.
not

This is a quantitative course and we will not address technical aspects of
volatility. Even so, students have found it intellectually challenging. The focus is
conceptual, not quantitative, because experience has taught me that the big
mistakes we make, that lead to the big surprises, are more often conceptual than
computational: we had the wrong idea, the wrong assumptions, or the wrong
framework. We will work with numbers and we will tackle a famous formula
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with effort
expressing conditional probability. But the challenge of this course and its material
is not in numbers but in concepts – concepts that are accessible to
anyonen woti th a basic knowledge of economics and corporate finance.
Thinking, Fast and Slow
This is a course on behavioral economics. We will read much of Daniel
Kahneman’s impofritnaanntc beook and wbeo twhill touch on a number
of themes from behavioral ecaonndomics. But this course aspires to give you a deeper
understanding of and this requires understanding the humans who
populate the financial world the constraints that the conventions of finance
i mpose on them.
Section 4. Outline of class sessions.

The sequence of class sessions loosely follows the sequence of “four reasons” why
the financial future surprises us, described in Section 2. But we will frequently
“bend back” and revisit ideas and insights introduced in earlier sessions both
because of the linkages between the behavioral and the financial concepts (like
expectations) and so as to provide you with the opportunity to practice and retrieve
what you learned in different settings.

Sessions 1 through 5 (Sept. 11 to 25) introduce the challenge of overcoming our
cognitive biases, how we underestimate the role of chance, how we can think
carefully and probabilistically about the likelihood of any uncertain or unknown fact
or outcome, and how our perception of our risks and our choices are framed.

Sessions 6 through 9 (Sept. 26 to Oct. 10) introduce, in several different ways,
liquidity illusion and balance sheet mechanics while also providing the chance to
review analytic skills introduced in Sessions 1 through 5.

Sessions 10 through 14 (Oct. 11 to 31) explore a variety of balance sheet
“mismatches” so that students can, through practice, come to appreciate the
importance of thinking simultaneously about all positive and negative cash flows
and how they drive and constrain financial agents and us all. The balance sheet
mismatches of banks, insurance companies, pension funds, and mutual funds are
considered both for the purpose of understanding the risk-reward profile of their
respective business strategies and, more generally, to understand them as types of
mismatches that can and do recur.

In Sessions 15 through 18 (Nov. 6 to 14) we will reconsider the role of expectations,
and changes in expectations, for the behavior of financial agents and asset prices. In
Session 15 we will consider the impact of monetary policy on our expectations, asset
values and economic activity. In Session 16 we will take up John Maynard Keynes’
views on how expectations and “a Gneimnearla slp Tihrietos”r yinfluence economic and financial
activity. (Indeed, the most of the course can be thought of as preparing you to
appreciate Chapter 12 of Keynes’ , which we read for Session 16.)
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Briefly in each of Sessions 10 through 15 and, in more detail, in Session 17 we will
consider more recent insights into how our body chemistry may influence risk-
t aking behavior. In the last session we will review your and my reflections on the
e ntire course.
Section 5. Requirements.

As described below in greater detail, you are expected (a) to have read this entire
syllabus carefully before the course begins; (b) to adhere to both its rules and
suggested norms of behavior; (c) to read the assigned readings, (d) to prepare for
each class, as suggested below; (e) to complete a total of seven written assignments
(two on your own, five as part of a study group), including Assignment A due at the
start of the first class session on Monday, September 11; (f) to listen to your
classmates and to try to understand their views; and (g) to participate actively in
class discussion.
Section 6. Preparation for class.

Attending class is a complement, not a substitute, for the learning you can
accomplish by your effort to master the readings and by preparing for class.
the effort novel
The acquisifteioednb, raectkention and ability to deploy knowledge or skill accumulate when
we make to recall and apply what we previously recognized as and
we receive within a relativreelya ds hwoirtht ppeurripoods eof time.

In preparing for classw, Ih uart gseu ryporuis teos you – meaning the purpose of
answering the questions posed in the syllabus for that class session. As you read, I
urge you to focus on , what you find to be novel. We are often
tempted to focus on the things that we recognize, that we are already comfortable
with or which echo something we already know. I urge you to resist this temptation
and, instead, ask you to focus on those things that you did not anticipate and that
struck you as novel or surprising.

Most of the class sessions have both “Questions about the readings” and “Questions
for class”, although some only hwaviteh tohuet latter. When you finish the reaedffionrgts for a
particular class, I urge you thoo twry w teo lwearritne: out your own kbnroiewf asnomsweethrsin tgo the know
“hQouwe stions about the re.adings” looking back at the texts. The of doing
this is an important part of how we both and
to recall and use it After doing this, prepare an outline of your answers to the
Questions for class. if you read
with purpose
It should take you two to three hours to prepare for most class sessions –
. Some will take less than that and a few may take as many as four
hours in total. You should spend no more than two-thirds of your available study
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time reading the assigned materials, leaving you with a minimum of one third of
your study time to test your own ability to retrieve what you read with the
“Questions about the readings” and to outline your answers to the “Questions about
class” or, when necessary to prepare a written assignment. If you follow these
suggestions in preparing for class, and treat the written assignments as “problem
sets”, as suggested in Section 7 below, actually writing the assignments will not
require much time.
Section 7. Written Assignments.

Each student will complete a total of seven written assignmnoetn tass, etwssoa yosn your own
and five as a member of a study group. All of these written a ssignments, except the
final assignment, should be approached as “problem sets” think – a ebaocuht being
limited to a single-page outline, of no more than 250 words,of answers to specific
questions. The purpose of these written assignments is for you to the
questions and to express your answers succinctly. The final written assignment,
which you will complete on your own and is due before the final class session, does
ask three brief essays, as explained in Session 18 (Nov. 14).
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All study groups will complete the first, three study-group written assignments
(Assignments B, C and D) and each study group will complete out of the five
written assignments E, F, G, H and I.

Schedule of written assignments
Written
Assignment Session Date Topic To be completed by
A 1 Sept 11 Chance in your life All individual students
B 6 Sept 26 US financial crisis All study groups
C 7 Oct 2 FM balance sheet All study groups
D 9 Oct 10 How to value assets All study groups
E 10 Oct 11 Equity in banks Selected study groups*
F 11 Oct 23 Insurance Selected study groups*
G 12 Oct 24 PBGC Selected study groups*
H 13 Oct 30 Mutual fund cash Selected study groups*
I 14 Oct 31 Euro crisis Selected study groups*
J* Each s tudy gr1o8u p is t o c Nomovp 1le4t e onlFyi tnwalo p oafp tehre se five assAiglnl minednivtsid. ual students

Once study groups have been formed (See Section 8, below), each study group will
be asked to submit their ordinal ranking of their preferences from among
Assignments E through I (ranking them from your first to your fifth choice). We will
optimize for as many highly ranked choices as possible, but we will avoid assigning
two in the same week to any one study-group (so you should place each of your top
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three choices in different weeks). Detailed descriptions of all written assignments
are in the syllabus.

We will discuss the process for submitting your preferences in class and then you
w ill be asked to send in your study group’s ordinal ranking via email, to both me and
A nne Givens, by no later than noon on Friday, September 22.
Section 8. Study groups.

no later
Ythoaun a nroeo enx ponec Ftreidd atoy, fSoerpmte ymobuerr o 1w5n study groups of four members. Please inform
Anne Givens, via email, (and copy me) of the members of your group by
. Students who have not formed study groups by
that time will be assigned by me to a study group. Depending on the exact number
of students who ultimately take the course, we may have to make changes to your
proposed study groups and one or two groups of three members may be necessary
to make the math work. But please propose study groups of four members.

A division of labor within study groups is both a reasonable and an effective
strategy. But the conclusions of study group written assignments should reflect the
study group discussion, not a complete delegation. When presenting in class, study
groups should find ways to reflect each member’s contribution and each member’s
u nderstanding of the group’s conclusions.
Section 9. Participation in class.

One of the most important things you can do to advance your career after Tuck is to
be an effective contributor at meetings. If you are effective, you will be invited to
more meetings; if you are not, you will tend not to be invited. To be an effective
contributor you must learn not to talk too much, nor to talk toporo lvititdleed. Your
interventions should help advance the collective understanding of a subject or
question, which you can do even if you disagree with others, that you
recognize what stage of the dialect process is unfolding (from thesis to antithesis to
synthesis). Your interventions should avoid going down dead ends. You should
recognize the importance of bringing as many of your colleagues along as possible.
This is also how you should participate in class discussions.

The quality and thoughtfulness of the questions that you pose to other students, or
study groups, who are presenting, will also be an important part of your grade for
class participation.

Please come to class with writing materials (paper and a pen or pencil) as there will
be times when I ask you to write down your own thoughts or those of a small group
of students in response to a question. Please always display your name card during
class.
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Section 10. Class attendance and absences.

You are expected to attend class. If you need to miss a class, for any reason, you
must inform me in advance, via email and copy Anne Givens. Also inform the other
members of yoaunrt sictiupdayt egdr oaubpse. n ce do not have

If you have an , on a day when you a written
assignment due, if you want to receive credit for class participation for that day,
prior to the class meeting, please send me via email (copy to Anne Givens) a brief
outline of youru annasnwtiecrips atote tdh iell qnuesess tthioen ms opronsiendg foofr c tlhaasst class that day.

If you have an , please let me know prior to
class via email (copy to Anne Givens) but submitting a one-page outline will not be
required. If you experience a prolonged illness, or for medical reasons known in
advance that you need to miss a class, please speak to me so that we can discuss
how you can muankaen utipc ifpoart leods ta bclsaesnsc tei muner. e lated to illness

If you have an you must still inform me via
email prior to class (copy to Anne Givens).

Failure to inform me in advance of class that you will be absent will result in minus
1 point being applied to your final grade for the course. If there is a second
occurrence, it will result in minus 5 points. For a third occurrence, the result will be
minus 10 points. And for a fourth occurrence, the result will be minus 20 points. So,
missing class but informing me of the fact before hand is riskless but missing class
and not informing me is costly.

Any student who misses several classes, for whatever reason, should plan and
e xpect to speak with me about whether and how they will be able to make up for the
l ost ground.
Section 11. Reading materials.

Thinking, Fast and Slow,
Most of the readings are available in Canvas or as links frTohme HCoaunrv aBse. t wTweeon oDfo tgh ea nd
rWeaodlfi, ngs are not in Canvas. These are Kahneman’s that we
will be discussing in Sessions 2, 3, 5 and 16, and Coates’
that we will be discussing briefly in Sessions 10 through 15 and, in depth, in
Session 17. We will be reading significant portions of each of these books so I
suggest that you purchase your own copies. However, a few copies will be available
in Feldberg.

We will begin reading Coates’ book at the time of Session 10 (Monday, October 11)
and will read roughly 30 pages for each of Sessions 10 – 15. We will briefly discuss
these readings in each of these class sessions (and students not in study groups
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assigned written assignments on these days should especially be prepared to
discuss the selection from Coates). By completing the reading of Coates prior to the
last week of class, you can avoid having any readings to complete while working on
y our fin al papers and Session 17 will provide us with an opportunity to use Coates’
b ook to review and put in context a number of themes from the entire course.
Section 12. Grading.

Your grades will be based on points that you accumulate where there are a
maximum number of points that you earn as follows:

Individual Written Assignment A . . . . . . . . . . . . . . . . . . . . . . . . 5 points
Written Assignments B through I . . . . . . . . . . . . . . . . . . . . . . . . 6 points each (30 total)*
Class Participation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 points
*FOinf awl hInicdhi veiadcuha sl tWudreitntte nw Aills csiogmnpmleetnet fJi v. e. .a . s. m. . e. m. . b. .e .r .s . o. f. a. 2st5u dpyo ignrtosu p.

Section 13. Late submission of written assignments.

Written Assignment A is due to me, in person, before the start of the first class
session on Monday, September 11. Written Assignments B, C, D, E, F, G, H, and I are
due by 7:00 AM (for both Section 1 and Section 2) via Canvas prior to the relevant
class session. In the absence of an explicit, prior arrangement with me, any of
Written Assignments A through I not submitted on time will lose 2 points; those
more than 24 hours late will lose an additional 2 points; those more than 48 hours
late will lose all points.

In the absence of an explicit, prior agreement with me, the Final Written Assignment
J, must be submitted, in Canvas, prior to 7:00 AM on Tuesday, November 14; any
Assignment J’s received after 7:00 AM on November 14 will lose 5 points; those
m ore than 24 hours late will lose an additional 10 points; those more than 48 hours
l ate will lose all (25) points.
Section 14. Tuck Honor Code
.

Y ou are expected to adhere to the Tuck Honor Code.
Section 15. Laptops and handheld electronic devices
.

I can see no need for laptops, tablets or handheld devices to be used in class and,
thus, they are not permitted. Consistent with each session’s assignments, one or
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two pages of notes (printed, when completing one of the written assignments)
answering the various questions posed for class is all that you should need with you.
If this presents a hardship for you please speak to me. Use of electronic devices will
negatively affect your grade for class participation.
Section 16. Office Hours.

My office hours will be on Monday’s from 1 to 2 PM. But if you would like to discuss
any subject and cannot make those office hours, please feel free to reach me via
email and we can schedule another time to meet.
Section 17. Contact information.

Peter R. Fisher Email: [email protected]
Cell: 917-915-7536

Anne Givens will serve as teaching fellow for the course.
Email: [email protected]

Andrew Coombs will serve as academic coordinator for the course.
Email: [email protected]

Section 18. Selected Bibliography.

The Bankers’ New Clothes – What’s Wrong with Banking and What to Do about It,
Admati & Hellwig, Princeton
University Press (A2n0i1m3a).l Spirits – How Human Psychology Drives the Economy, and Why it Matters for Global
Capitalism,
Akerlof & Shiller,
EPmrinpcireet oonf CUontitvoenr –si Aty G Plorebsasl (H2i0st0o9r)y.,

Beckert, S., Against the Gods – The RemarkabVlien Statogery B oofo Rkissk (,2 015).

Bernstein, P.L., Investments, John Wiley & Sons (1996).

Bodie, KanEe n&o uMgahr c–u Tsr, ue Measures oMf cMGornaewy-, HBiulls iInrewsisn a, nNdin Ltihfe E, dition (2011).

Bogle, J.C., The Moral Economy – Why Good Incentives Are No SuJboshtnit uWtei lfeoyr &G oSoodn Cs i(t2iz0e0n9s).

Bowles, S., , Yale University Press
(2014). make it stick – The Science of Successful Learning,

Brown, Roediger & McDaniel, The Belknap Press of Harvard
University Press (2014). Money, Banking, and Financial Markets,

CCeocactheest, tJi. ,& T Shceh Hoeonuhr oBltezt,w een Dog and Wolf – Risk Taking, Gut FMeceGlirnagws Hainlld E tdhuec Batioiolno,g Tyh oifr dB oEodmiti oann d(2 B0u1s1t),.
Penguin (2012).